Cost of Capital

Caselet 1
• SAIL is one of the leading producers of steel in India. As
steel is a highly capital as well as labour intensive
industry it requires high amounts of capital. During the
1990s the company borrowed heavily at a high interest
rate of 17% to finance its expansion and modernization
plans. After 2000 the money market conditions
improved and the interest rates declined to around
11%. The 6% decline in the cost of debt could give a
large savings in cash out flow on interest payments.
SAIL replaced its old high cost debt with fresh new debt
carrying low interest rate and in turn reduced its cost
of capital.
 Key Financial Issues
• Capital
• Sources of capital
• Cost of capital
 Significance
• Capital refers to funds that remain with the co.
for a long period of time and provide financial
support for long term uses
• Comes from various sources, each with its own
cost
• Cost of capital is the overall cost of all the sources
of capital considered together
• It is important for the co. to know its cost of
capital in order to know whether its investments
/ ventures are worthwhile or not
 Significance
• Broadly capital refers to the long term sources of
financing that are generally required for financing
long term uses / investments
• Capital expenditure on setting up new plant,
expansion of operations, replacement of old
machinery, modernization, product
improvement, new product development,
product promotion and marketing etc.
• Typically such uses take place over long time
periods and require prolonged financial support
 Significance…
• Multiple sources of capital
• Collectively they appear in the liabilities side of the
balance sheet
• Each source has a specific cost
• It reflects the rate of return expected by the provider
of that source of capital
• Cost of capital refers to the average cost of all the
sources of capital used by the firm
• It is the minimum rate of return that the firm should
earn on its capital employed
 Contents
• Sources of capital
• Costs of specific sources of capital
• Concept of WACC
• Determination of weights / proportions
• Divisional & Project Cost of Capital
• Floatation Costs & Cost of Capital
• Interrelationship between investment &
financing
 Sources of Capital
• Two broad categories:
• Shareholders’ funds (Equity)
• Debt

• Note: A lesser used hybrid source of financing

is preference share capital which has the
characteristics of both equity shares and debt
 Equity
• Funds provided by the equity shareholders
• Remain with the co. throughout its existence
• Residual claim on the income and assets of the co.
• Dividends paid to shareholders do not provide any
tax benefit to the co.
• 3 types:
• Paid up equity share capital
• Retained profits
• External equity
 Debt
• Borrowed funds
• Interest payable
• Interest paid provides tax benefit to the co.
• Effective cost of debt after adjusting the tax
benefit is lower than the nominal interest rate
• 2 types:
• From financial institutions
• From capital market
 IMPORTANT
• When the co. borrows it uses financial
leverage; so it can increase its profitability but
it is also exposed to financial risk
• Equity is the most expensive source because
equity shareholders have the highest risk and
are only entitled to residual returns
• In general cost of debt is lower than cost of
equity
 Preference Capital
• Preference shares are a hybrid type
• Like equity entitled to a residual claim
• Preference dividend paid does not provide any
tax benefit to the firm
• Like debt it carries a fixed charge
• Preference shareholders have higher risk than
debt-holders and lower than equity shareholders
• Generally cost of preference capital is higher
than cost of debt & lower than cost of equity
 NOTE
• Cost of any source of capital is expressed in
percent (%)
• As tax is an important factor the costs of all
sources of capital are most meaningful in
post-tax terms
• So costs of different sources of capital are
estimated in post-tax terms
 Cost of Debt: Loan
• kt = I (1 – t)
• kt = Post-tax cost of loan
• I = Nominal rate of interest charged by bank (%
converted to decimal)
• t = Corporate tax rate (% converted to decimal)

• 1. Unique Products Ltd. has taken a loan of Rs. 10

lakh from ICICI bank, which carries an interest rate of
12%. The corporate tax rate is 35%. What is the cost
of loan?
 Cost of Debt: Debentures / Bonds
• kd = Post-tax cost of debentures
(F - P)
I(1 - t) 
• I = Coupon amount (Rs.) k  n
d
FP
• F = Maturity value (Rs.) 2
• P = Current market price of the debenture or
issue price of debenture or net amount
realized per debenture (Rs.)
• n = No. of years remaining to maturity
• t = Corporate tax rate (% converted to
decimal)
 Cost of Debt: Debentures…
• 2. Alpha Industries Ltd. has issued debentures
with par value Rs. 100, which are redeemable
after 5 years. The net amount realized from
the issue is Rs. 96 per debenture and the
debenture is redeemable at a premium of 5%.
The coupon rate is 12% and the corporate tax
rate is 40%. Calculate the cost of the
debenture.
 Cost of Preference Shares
• Formula very similar to cost of debentures
• No tax adjustment required
• kp = Post-tax cost of preference capital
FP
• D = Preference dividend (Rs.) D
n
k 
FP
•
p
F = Maturity value (Rs.)
2
• P = Issue price or current market
• price or net amount realized
• per preference share (Rs.)
• n = No. of years to maturity
 Cost of Equity
• Paid up equity share capital
• Retained earnings
• External equity
 Cost of Equity: Paid Up Equity
Share Capital
• Various approaches:
• Gordon’s Model
• Bond Yield Plus Risk Premium Approach
• Earnings-Price Ratio Approach
• CAPM Approach
 Cost of Equity: Paid Up Equity…
• Gordon’s Model:
D1 D 0 (1  g)
ks  g g
P0 P0
• ks = Cost of paid up equity share capital
• D0 = Current (year 0) DPS (Rs.)
• D1 = Dividend expected at the end of year 1 (Rs.)
• P0 = Current market price of the share (Rs.)
• g = Annual growth rate in DPS (% converted to
decimal)
 Cost of Equity: Paid Up Equity…
• 3. Orient Products is expected to pay a DPS of
Rs. 3.20 after 1 year and the dividends are
expected to grow @ of 5% pa. The present
market price of its share is Rs. 20. What is the
cost of equity capital of the co?
• 4. Precision Equipments has recently paid a
DPS of Rs. 3.00 and its dividends are expected
to grow @ 6%. The market price of its share is
Rs. 24. What is the cost of equity capital?
 Cost of Equity: Paid Up Equity…
• Estimating the growth rate (g): 2 methods
#1. g can be estimated by the CAGR on the basis
of 5-10 years’ dividend data.
• Eg.A Year 1 2 3 4 5
DPS (Rs.) 3.50 3.50 4.00 4.25 4.75

• g = (4.75 / 3.50)1/4 – 1 = 0.079335 = 7.93%

 Cost of Equity: Paid Up Equity…
# 2. g = Retention Ratio x ROE
• Eg.B If retention ratio is 40% and ROE is 20%
then:
• g = 0.40 x 0.20 = 0.08 = 8%
 Cost of Equity: Paid Up Equity…
• Bond Yield Plus Risk Premium Approach:
• Subjective approach
• Equity is more risky than debt
• So cost of equity should be higher than the
cost of long term bonds issued by the firm
• Cost of equity = Yield on long term bonds
• + Risk Premium
• Limitation: How to determine the Risk
Premium?
 Cost of Equity: Paid Up Equity…
• Earnings-Price Ratio Approach:
• Cost of equity = E1 / P0

• E1 = Expected EPS for the next year

• P0 = Current market price per share

• E1 may be estimated as:

• Current EPS x (1 + growth rate of EPS)
 Cost of Equity: Paid Up Equity…
• CAPM Approach:
• Ri = Rf + βi(Rm – Rf )
• According to this approach the cost of equity
should be equal to the expected return on the
share as per the CAPM
 Cost of Equity: Retained Earnings
• Cost of retained earnings ( kr ):
• Retained earnings belong to the equity shareholders
• Shareholders could receive the earnings as dividends
and reinvest the same in investments having risks
similar to that of the firm
• Alternatively they can forego their dividends and
allow the firm to retain their earnings
• When the firm retains its earnings it reinvests the
same at the existing risk level
• So cost of retained earnings should be equal to the
cost of paid up equity share capital
 Cost of Equity: External Equity
• Cost of external equity ( ke ):
• When the firm issues external equity it incurs
floatation costs: underwriting, issue expenses
and underpricing
• Due to these ke is higher than the cost of
internal equity k
A. k e  s
1 f
D1
B. k e  g
Po 1  f 
 Cost of Equity: External Equity
• Where:
• ke = Cost of external equity
• ks = Cost of existing (or internal) equity
• f = Floatation costs proportion (% converted
to decimal)
 Cost of External Equity…
• 5. Unique Products is proposing to raise Rs. 100 lakh
by public issue of new equity shares. The cost of its
existing equity capital is 20%. Estimate its cost of
new equity if the floatation costs amount to 5%.
• 6. Power Equipments Corporation is planning to
raise Rs. 150 lakh by a fresh issue of equity shares to
public. The current market price of its share is Rs.
32, expected DPS after 1 year is Rs. 5.60 and growth
rate in DPS is 5%. Floatation costs are expected to
be 4%.
 Weighted Average Cost of Capital
• It is the weighted average of the costs of the
various sources of capital used by the firm
• Weights are the proportion of each source in the
total capital of the firm
• Proportions may be based on Book Values or
Market Values of the sources used
• Simply referred to as Cost of Capital ( k )

k   wiki
 Weighted Average Cost of Capital
• k = WACC,
• wi = weight of i’th source of capital
• ki = Post-tax cost of the i’th source
 WACC…
• 7. Calculate the WACC given the following
data:
Source Book Value Market Value Cost (%)

Common stock 25,00,000 Rs. 65 per share 14.0

62500 shares

Retained profits 7,50,000

Preferred Stock 5,00,000 Rs. 35 per share 12.0

20000 shares

Bonds 50,00,000 Rs. 1050 per bond 5.4

5000 bonds
 Determination of
Weights/Proportions
• Weights for calculating WACC may determined
on the basis of Book Values or Market Values
of the various sources of capital
• Weights should be based on the target capital
structure of the firm
• Target capital structure is the desired capital
structure of the firm
• Current capital structure may not reflect the
target capital structure
 Determination of Weights…
• Weights based on Market Values of the various
sources of capital are most appropriate
• Market values represent the current values of
the investment made by the providers of capital
• The firm must earn competitive returns on the
current values of the investment made by the
shareholders & debtholders
• Demerit: Market values are volatile
 Determination of Weights…
• Merits of Book Value Weights:
• Available for every co. whether listed or
unlisted (or closely held)
• More stable than market values
Divisional & Project Cost of Capital
• If the co. is engaged in multiple businesses of
different nature and it is organized into
divisions, it should not use WACC for
evaluating its divisions
• For each division it should use a different cost
of capital that appropriately reflects the risks
of that particular division
 Divisional & Project Cost of
Capital…
• WACC is appropriate for evaluating the
feasibility of new investments (projects) of the
same co. only if the new projects are similar to
the existing ones and have similar risks
• When new projects have significantly different
risks they should not be evaluated using
WACC of the firm
• Instead each project should be evaluated
using a cost of capital that reflects its risk own
profile
 Floatation Costs & Cost of Capital
• When co. has to raise financing from various
sources through fresh public issue of various
instruments it has to incur floatation costs
• The total amount of capital raised reduces to
the extent of floatation costs incurred
• This raises the cost of capital
• The existing WACC should be adjusted for
floatation costs
 Floatation Costs & Cost of Capital
• Revised WACC = Original WACC
1  Average Floatation Costs

• Average floatation costs is the average of the

floatation costs of the various sources of
capital raised from outside
• fa = wrfr + wefe + wpfp + wdfd … …
• wi and fi refer to the weights and floatation
costs of various sources of new financing:
retained profits, external equity, preference
shares, debentures etc.
 Floatation Costs…
• 8.Southern Industries Ltd. is planning to raise
Rs. 50 lakh through various sources. The
average floatation costs have been estimated
to be 6% . The existing cost of the capital of
the company is 18%. Calculate the WACC for
the new capital raised.
 Interrelationship Between
Investment & Financing
• The use of WACC for evaluating the financial
feasibility of projects assumes that every
project is financed by the same mixture of
financing sources present in the capital
structure of the firm
• Projects not only differ in their risk
characteristics but their financing patterns as
well – debt capacity, subsidies available etc.
 Interrelationship Between
Investment & Financing
• Investment & financing decisions are
interrelated
• So financial evaluation of projects should take
into account the financing impact of the
investment
 Home Work
• Textbook: Prasanna Chandra, Financial Mgt.
Theory & Practice
• p393: Q.14.7, 14.8; p394: Q.14.9.1
subquestion (a) only; p395: Q.14.10 only
subquestions (a) & (b)

• Book: Brealey Myers et al, Principles of

Corporate Finance
• P538: Q.13
 Minimum Suggested Study Plan
• Textbook: Prasanna Chandra, Financial Mgt.
Theory & Practice
• Vital: Ch.14:p367-377 (students should revisit
those portions which use the concept of DCF
analysis, after completion of the module: Time
Value of Money); p379 -386 (students should
revisit unit 14.7, p379, after completing the
module: Capital Budgeting)
• Desirable: Unit 14.6 (p377-379): Weighted
Marginal Cost of Capital
THANK YOU