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UNIT- II

Cost of Capital
Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. It is used as a discount rate in determining
the present value of future cash flows associated with capital projects. Cost of capital is also called
as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are using
different sources of finance, the finance manager must take careful decision with regard to the
cost of capital; because it is closely associated with the value of the firm and the earning capacity
of the firm.
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its
market value and attract funds. Cost of capital is the required rate of return on its investments
which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected
rate, the market value of the shares will fall and it will result in the reduction of overall wealth of
the shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and concept of
the cost of capital.
According to the definition of John J. Hampton Cost of capital is the rate of return the firm
required from investment in order to increase the value of the firm in the market place.
According to the definition of Solomon Ezra, Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure.
According to the definition of James C. Van Horne, Cost of capital is A cut-off rate for the
allocation of capital to investment of projects. It is the rate of return on a project that will leave
unchanged the market price of the stock.
According to the definition of William and Donaldson, Cost of capital may be defined as the
rate that must be earned on the net proceeds to provide the cost elements of the burden at the
time they are due.
IMPORTANCE OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to decide the
capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to net
present value method, present value of cash inflow must be more than the present value of cash
outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses
particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take
decision regarding structure.
Importance to Evaluation of Financial Performance
Cost of capital is one of the important determine which affects the capital budgeting, capital
structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market
value of share, earning capacity of securities etc. hence, it plays a major part in the financial
management.
Types of Cost of Capital
A firm raises capital from different sources to finance a project. Therefore it is necessary to
calculate the cost of capital for each source. In order to attract new investors, a firm creates a
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wide variety of financing instruments or securities, such as debentures, preference shares, equity,
etc. Cost of a particular source of capital is referred to as the specific cost of capital.
While we calculate the cost of capital of a firm, we calculate specific cost of capital of each source
of raising funds at first, and then the overall cost of capital is calculated by combining the specific
costs into a composite cost. The specific cost of capital also helps assessing the relative cost of
pursuing one line of financing over other. In this article we will discuss the methods of measuring
specific cost of various sources of capital.

1.
2.
3.
4.
5.

Cost of equity
Cost of debt
Cost of preference share
Cost of retained earnings
overall cost of capital or Weighted Average Cost of Capital (WACC)

1. Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value.
Conceptually the cost of equity capital (Ke) defined as the Minimum rate of return
that a firm must earn on the equity financed portion of an investment project in order to
leave unchanged the market price of the shares.
Cost of equity can be calculated from the following approach:
Dividend price (D/P) approach
Dividend price plus growth (D/P + g) approach
Earning price (E/P) approach
Dividend Price Approach
The cost of equity capital will be that rate of expected dividend which will maintain the
present market price of equity shares.
Dividend price approach can be measured with the help of the following formula:
Ke = D / Np
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Dividend Price Plus Growth Approach
The cost of equity is calculated on the basis of the expected dividend rate per share plus
growth in dividend. It can be measured with the help of the following formula:
Ke = D / Np + g
Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
Earning Price Approach
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Cost of equity determines the market price of the shares. It is based on the future earning
prospects of the equity. The formula for calculating the cost of equity according to this
approach is as follows.
Ke = EPS / Np
Where,
Ke = Cost of equity capital
EPS = Earning per share
Np = Net proceeds of an equity share

2. Cost of Debt:

Debt is the external source of financing. Cost of debt is simply the interest paid by the firm on
debt. But interest paid on debt is a tax-deductible expenditure; hence effective cost of capital is
lower than the amount of interest paid. Again, debt may be redeemable or irredeemable.
Redeemable debts are those which will be repaid to the suppliers of debt after a specific period,
while irredeemable or perpetual debt is not repaid back to the suppliers of debtonly interest on
this is paid regularly.
Methods of calculating redeemable and irredeemable debt have been discussed below:
i. Cost of Irredeemable Debt or Perpetual Debt:
Irredeemable debt is that debt which is not required to be repaid during the lifetime of the
company. Such debt carries a coupon rate of interest. This coupon rate of interest represents the
before tax cost of debt. After tax cost of perpetual debt can be calculated by adjusting the
corporate tax with the before tax cost of capital. The debt may be issued at par, at discount or at
premium. The cost of debt is the yield on debt adjusted by tax rate.
Symbolically, cost of perpetual debt (Kd) can be calculated using the following formula:
Cost of irredeemable debt (Kd) = I/NP (1 t)
Where, I = Annual interest payment,
NP = Net proceeds from issue of debenture or bond, and
t = Tax rate.
Note:
Sometimes a firm incurs floatation costs such as brokerage, commissions, and legal and
accounting fees. These costs are to be subtracted to arrive at the net proceeds. Another important
point to be noted here is that interest and net proceeds must represent same relationship, i.e. if
interest I is taken for the whole of the debentures issued the net proceeds NP of the debt must be
of the whole of debentures. Similarly if the interest payment I is taken only for a single debenture
then the net proceeds of only one debenture is to be taken.
Example 4.1:
A company issued 12% debentures at par for Rs 2, 00,000. Compute the after-tax cost of
debentures assuming the tax rate at 30%.
Solution:
We know that cost of debt Kd = I/NP (1 t)
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3. Cost of Preference Share Capital:

Like debt, preference share is of two types as well: Redeemable and irredeemable. Preference
shareholders are entitled to get a fixed rate of dividend if the company earns profit. But dividend
payable on preference shares is not a tax-deductible expenditure.
Hence no adjustment for corporate tax is required for computing the cost of preference shares. It
is to be noted here that there is no such obligation in regard to preference shares as we find in
case of debt. The holders of preference shares only get preferential right as regards payment of
dividend as well as return of principal, compared to equity shareholders.
i. Cost of Irredeemable Preference Share:
Irredeemable preference share is not required to be repaid during the lifetime of the company.
Such preference shares carry a rate of dividend, which is the cost of irredeemable preference
shares. Since the shares may be issued at par, at premium or at a discount, the cost of preference
shares is the yield on preference shares. Cost of irredeemable preference shares is calculated by
using the following formula:
KP = DP /NP
Where, DP = Preference dividend and
NP = Net proceeds from issue of preference shares.
Note:
Here also adjustment for flotation cost is to be made and parity between dividend and net
proceeds is to be kept, i.e. either these two will be for a single preference share or for whole of
the preference shares.
Example 4.2:
A company issued 1,000, 12% irredeemable preference shares of Rs 100 each. Find out the cost
of the preference share capital, the tax rate being 30%.
Solution:
We know that cost of debt

ii. Cost of Redeemable Preference Shares:


Redeemable preference shares are those that are repaid after a specific period of time. Hence
while calculating the cost of redeemable preference shares, the period of preference shares and
redeemable value of the preference shares must be given due consideration.

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Like irredeemable preference shares, redeemable preference shares may also be issued at par,
discount or at a premium. Moreover there may be floatation costs. So to calculate net proceeds,
adjustment for floatation cost is necessary. Since it is redeemable the redeemable value may
differ from its face value depending on whether the preference shares are redeemed at par,
discount or at premium.
The cost of redeemable preference share can be calculated by using the following
formula:

Where, DP = Preference dividend,


n = Period of preference share,
RV= Redeemable value of preference share, and
NP = Net proceeds from issue of preference shares.
Example 4.3:
Baibhav Ltd., issued 10,000, 12% preference shares of Rs 100 each at a premium of 6%); the
floatation cost being 2.5% on issue price. The shares are to be redeemed after 5 years at a premium of 5%. Compute the cost of preference share capital.
Solution:
We know that the cost of preference shares may be calculated as

4. Cost of Retained Earnings:

Retained earnings are one of the important internal sources of finance. Profit available to equity
can be distributed as dividend; but a proportion of that is distributed and remaining is kept for
reinvestment. So retained earnings is the dividend foregone by the equity shareholders. Since
equity shareholders are the actual claimants of the retained earnings, the cost of retained
earnings, is equivalent to cost of equity. According to this assumption cost of retained earnings
(Kr) will be calculated in the same manner as we do with equity.
So Kr = Ke
However in practice, retained earnings are cheaper than the cost of equity capital. If the retained
earnings are distributed as dividend to equity shareholders, tax on dividends is to be paid by
equity shareholders. If they want to reinvest their funds, the company will have to incur expenses
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as brokerage, commission, etc. Thus cost of retained earnings under this approach can be
calculated after making adjustments for tax and expenses for brokerage, commission, etc.
Cost of retained earnings (Kr) = Ke (1 t) (1 c)
Where, Ke = Cost of equity,
t = Tax rate, and
c = Brokerage, commission, etc.
Example 4.5:
The net profit of a company is Rs 40,000. The required rate of return of the shareholders is 10%.
The shareholders have the option to invest their earnings after incurring 4% by way of brokerage
and commission. Calculate the cost of retained earnings assuming the tax rate at 30%.

5. Measurement of Overall Cost of Capital (WACC)


It is also called as weighted average cost of capital (WACC) and composite cost of capital.
Weighted
average cost of capital is the expected average future cost of funds over the long run found by
weighting the cost of each specific type of capital by its proportion in the firms capital structure.
The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the help of the following formula;
Ko= Kd Wd + Kp Wp + Ke We + Kr Wr
Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following formula also:
Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.

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CAPITAL BUDGETING
Capital Budgeting: Capital budgeting is the process of making investment decision in
long-term assets or courses of action. Capital expenditure incurred today is expected to
bring its benefits over a period of time. These expenditures are related to the acquisition
& improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a
number of years. It is the process of deciding whether or not to invest in a particular
project, as the investment possibilities may not be rewarding. The manager has to choose
a project, which gives a rate of return, which is more than the cost of financing the
project. For this the manager has to evaluate the worth of the projects in-terms of cost
and benefits. The benefits are the expected cash inflows from the project, which are
discounted against a standard, generally the cost of capital.
Features of Capital Budgeting
1) Benefits for future: Capital is invested with a view to gain benefits for future.
2) Huge Funds: Generally capital budgeting involves huge amount of funds.
3) Irreversible Decisions: Decisions once taken cannot be changed, if we have already
started work on our decision.
4) Investment of funds: Capital budgeting is mainly related with the investment of
capital for long term profit.
5) Non-flexible Activities: Funds are invested for non-flexible activities.
6) Decision for long term: In capital budgeting decisions are taken for long term profit
or for long term commitment of funds
7) Complexity: Investment Decisions are firms most difficult decision. It is difficult to
estimate future cash inflows of an investment. Environmental factors cause
uncertainty in cash flows estimation
Capital Budgeting Proposals
A firm may have several investment proposals for its consideration. It may adopt after
considering the merits and demerits of each one of them. For this purpose capital
expenditure proposals may be classified into :
1) Independent Proposals
2) Dependent Proposals or Contingent Proposals
3) Mutually Exclusive Proposals
1) Independent Proposals: These proposals are said be to economically independent
which are accepted or rejected on the basis of minimum return on investment
required. Independent proposals do not depend upon each other.
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2) Dependent Proposals or Contingent Proposals: In this case, when the acceptance of


one proposal is contingent upon the acceptance of other proposals. it is called as
"Dependent or Contingent Proposals." For example, construction of new building on
account of installation of new plant and machinery.
3) Mutually Exclusive Proposals: Mutually Exclusive Proposals refer to the acceptance
of one proposal results in the automatic rejection of the other proposal. Then the
two investments are mutually exclusive. In other words, one can be rejected and
the other can be accepted. It is easier for a firm to take capital budgeting decisions
on such project

Capital budgeting Methods/Techniques:


The capital budgeting appraisal methods are techniques of evaluation of investment
proposal will help the company to decide upon the desirability of an investment proposal
depending upon their; relative income generating capacity and rank them in order of
their desirability. These methods provide the company a set of norms on the basis of
which either it has to accept or reject the investment proposal. The most widely accepted
techniques used in estimating the cost-returns of investment projects can be grouped
under two categories.
1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods
These methods are based on the principles to determine the desirability of an investment
project on the basis of its useful life and expected returns. These methods depend upon
the accounting information available from the books of accounts of the company. These
will not take into account the concept of time value of money, which is a significant
factor to determine the desirability of a project in terms of present value.
A. Pay-back period method: It is the most popular and widely recognized traditional
method of evaluating the investment proposals. It can be defined, as the number of
years required to recover the original cash out lay invested in a project.
According to Weston & Brigham, The pay back period is the number of years it takes the
firm to recover its original investment by net returns before depreciation, but after
taxes.
According to James. C. Vanhorne, The payback period is the number of years required to
recover initial cash investment.
Under this method, the projects are ranked on the basis of the length of the payback
period. A project with the shortest payback period will be given the highest rank and
taken as the best investment.
If the project generates equal or constant cash flows, the formula is:

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Cash outlay (or) original cost of project


Pay-back period =
------------------------------------------Annual cash inflow
If the project generates unequal cash flows, the payback period can be found by adding
up the cash inflows until the total is equal to the initial cash outflows or outlay.
C1 + C2 +C3 = Cash outlay/Investment

Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It does not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the
books.
Demerits:
1. This method fails to take into account the cash flows received by the company
after the payback period.
2. It doesnt take into account the interest factor involved in an investment outlay.
3. It doesnt take into account the interest factor involved in an investment outlay.
4. It is not consistent with the objective of maximizing the market value of
the
companys share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of
cash in flows.
B. Accounting (or) Average rate of return method (ARR):
It is an accounting method, which uses the accounting information repeated by the
financial statements to measure the probability of an investment proposal. It can be
determine by dividing the average income after taxes by the average investment i.e., the
average book value after depreciation.
According to Soloman, accounting rate of return on an investment can be calculated as
the ratio of accounting net income to the initial investment, i.e.,
Average net income after taxes
ARR = ------------------------------------ X 100
Average Investment
Total Income after Taxes
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No. of Years
Total Investment
Average investment =
---------------------2
On the basis of this method, the company can select all those projects whos ARR is
higher than the minimum rate established by the company. It can reject the projects with
an ARR lower than the expected rate of return. This method can also help the
management to rank the proposal on the basis of ARR. A highest rank will be given to a
project with highest ARR, where as a lowest rank to a project with lowest ARR.
Merits:
1. It is very simple to understand and calculate.
2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
Demerits:
1. It is not based on cash flows generated by a project.
2. This method does not consider the objective of wealth maximization
3. It ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.
II: Discounted cash flow methods:
The traditional method does not take into consideration the time value of money. They
give equal weight age to the present and future flow of incomes. The DCF methods are
based on the concept that a rupee earned today is more worth than a rupee earned
tomorrow. These methods take into consideration the profitability and also time value of
money.
A. Net present value method (NPV)
The NPV takes into consideration the time value of money. The cash flows of different
years and valued differently and made comparable in terms of present values for this the
net cash inflows of various period are discounted using required rate of return which is
predetermined.
According to Ezra Solomon, It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.
NPV is the difference between the present value of cash inflows of a project and the initial
cost of the project.
According the NPV technique, only one project will be selected whose NPV is positive or
above zero. If a project(s) NPV is less than Zero. It gives negative NPV hence. It must be
rejected. If there are more than one project with positive NPVs the project is selected
whose NPV is the highest.
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The formula for NPV is


NPV= Present value of cash inflows investment.
C1
C2
C3
Cn
NPV = ------ + ------- + -------- + ------- investment
1
2
3
(1+r)
(1+r)
(1+r)
(1+r)n
C1, C2, C3 Cn= cash inflows in different years.
r= Cost of the Capital (or) Discounting rate
n= Years.
Merits:
1.
2.
3.
4.

It recognizes the time value of money.


It is based on the entire cash flows generated during the useful life of the asset.
It is consistent with the objective of maximization of wealth of the owners.
The ranking of projects is independent of the discount rate used for determining
the present value.
Demerits:
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. But the
concept of cost of capital, itself is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different
amounts of investment.
4. It does not give correct answer to a question whether alternative projects or
limited funds are available with unequal lines.
B. Internal Rate of Return Method (IRR)
The IRR for an investment proposal is that discount rate which equates the present value
of cash inflows with the present value of cash out flows of an investment. The IRR is also
known as cutoff or handle rate. It is usually the concerns cost of capital.
According to Weston and Brigham The internal rate is the interest rate that equates the
present value of the expected future receipts to the cost of the investment outlay.
When compared the IRR with the required rate of return (RRR), if the IRR is more than
RRR then the project is accepted else rejected. In case of more than one project with IRR
more than RRR, the one, which gives the highest IRR, is selected.
The IRR is not a predetermine rate, rather it is to be trial and error method. It implies that
one has to start with a discounting rate to calculate the present value of cash inflows. If
the obtained present value is higher than the initial cost of the project one has to try with
a higher rate. Like wise if the present value of expected cash inflows obtained is lower
than the present value of cash flow. Lower rate is to be taken up. The process is
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continued till the net present value becomes Zero. As this discount rate is determined
internally, this method is called internal rate of return method.
P1 - I
IRR = L+ --------- X D
P1 P2
L- Lower discount rate
P1 - Present value of cash inflows at lower rate.
P2 - Present value of cash inflows at higher rate.
I - Original investment
D- Difference in Discount rates.
Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return
projects are selected, it satisfies the investors in terms of the rate of return an
capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firms objective of maximum owners welfare.
Demerits:
1. It is very difficult to understand and use.
2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.

C. Probability Index Method (PI)


The method is also called benefit cost ration. This method is obtained cloth a slight
modification of the NPV method. In case of NPV the present value of cash out flows are
profitability index (PI), the present value of cash inflows are divide by the present value of
cash out flows, while NPV is a absolute measure, the PI is a relative measure.
It the PI is more than one (>1), the proposal is accepted else rejected. If there are more
than one investment proposal with the more than one PI the one with the highest PI will
be selected. This method is more useful incase of projects with different cash outlays
cash outlays and hence is superior to the NPV method.
The formula for PI is

Probability index =

Present Value of Future Cash Inflows


----------------------------------------

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Investment
Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the
index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the
index.
5. It takes into consideration the entire stream of cash flows generated during the
useful life of the asset.
Demerits:
1. It is somewhat difficult to understand
2. Some people may feel no limitation for index number due to several limitation
involved in their competitions
3. It is very difficult to understand the analytical part of the decision on the basis of
probability index.

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