1.

COST OF CAPITAL
The cost of capital i.e. cost of having capital for long period from different sources of finance.
Generally the sources of finance for non-corporate entity could be either internal (savings,
investments in current and non-current assets etc.) or external borrowings (loan from financial
institutions, local borrowings etc.).

SIGNIFICANCE OF THE COST OF CAPITAL

The cost of capital is important to arrive at correct amount and helps the management or an
investor to take an appropriate decision. The correct cost of capital helps in the following
decision making:
(i) Evaluation of investment options: The estimated benefits (future cashflows) from
available investment opportunities (business or project) are converted into the present
value of benefits by discounting them with the relevant cost of capital. Here it is pertinent
to mention that every investment option may have different cost of capital hence it is
very important to use the cost of capital which is relevant to the options available. Here
Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two options
(projects).
(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a
particulars project or business. The performance of a project or business in compared
against the cost of capital which is known here as cut-off rate or hurdle rate.
(iii) Designing of optimum credit policy: While appraising the credit period to be allowed
to the customers, the cost of allowing credit period is compared

Cost of Irredeemable Debentures

The cost of debentures which are not redeemed by the issuer of the debenture is known as
irredeemable debentures. Cost of debentures not redeemable during the life time of the
company is calculated as below:
Cost of Irredeemable Debenture ( Kd) = I (1-t) / NP
Kd = Cost of debt after tax
I = Annual interest payment
NP = Net proceeds of debentures or current market price
t = Tax rate

Cost of Redeemable Debentures (using approximation method)

The cost of redeemable debentures will be calculated as below:
Cost of redeemable Debenture ( Kd) = I (1-t) + (RV-NP) / n
RV+NP
2
Where,
I = Interest payment
NP = Net proceeds from debentures in case of new issue of deb or Current
market price in case of existing debt.
RV = Redemption value of debentures
t = Tax rate applicable to the company
N = Life of debentures.
Cost of Redeemable Preference Shares
Preference shares issued by a company which are redeemed on its maturity is called
redeemable preference shares. Cost of redeemable preference share is similar to the cost of
redeemable debentures with the exception that the dividends paid to the preference
shareholders are not tax deductible. Cost of preference capital is calculated as follows:

PD+ (RV-NP)
Cost of Reedemable Preference Share (K ) = N .
p
RV+NP
2
Where
PD = Annual preference dividend
RV = Redemption value of preference shares
NP = Net proceeds on issue of preference shares
n = Life of preference shares.

Cost of Irredeemable Preference Shares

The cost of irredeemable preference shares is similar to calculation of perpetuity. The cost is
calculated by dividing the preference dividend with the current market price or net proceeds
from the issue. The cost of irredeemable preference share is as below:
Cost of Irredeemable Preference Share (K ) = PD / P0
Where,
PD = Annual preference dividend
P0 = Net proceeds in issue of preference shares

COST OF EQUITY SHARE CAPITAL

It may prima facie appear that equity capital does not carry any cost. But this is not true. The
market share price is a function of return that equity shareholders expect and get. If the
company does not meet their requirements, it will have an adverse effect on the market share
price. Also, it is relatively the highest cost of capital. Due to relative higher risk, equity
shareholders expect higher return hence, the cost of capital is also high.

In simple words, cost of equity capital is the rate of return which equates the present value of
expected dividends with the market share price. In theory, the management strives to maximize
the position of equity holders and the effort involves many decisions.

Different methods are employed to compute the cost of equity share capital.
i) Dividend OR Dividend Price Approach
ii) Earnings / Earnings Price Approach
iii) Realised Yield Approach
iv) Capital Asset Pricing Model (CAPM)
Practical Questions:

Q.1. The Company issued 12% debentures of Rs. 200 each. Find the cost of the debt if the
debentures are issued i) at par ii) at 10% premium and iii) at 5% discount.
What will be your answer if the rate of tax is 30%.

Q.2. Ravi Ltd. issued 1,000, 10% Debentures of Rs. 100 each redeemable after 10 years. The
tax rate is 35%. The floating cost is 4%. Determine pre tax and after tax cost of the debt if
the debt is issued i) At par ii) at 10% premium and iii) at 10% discount.

Q.3. Andrews Limited issued 10,000, 10% preference shares of Rs. 50 each redeemable after
20 years at par and the flotation cost is 5%. The tax rate is 35%. Determine the cost of the
preference shares if the shares are issued i) At par ii) at 10% premium and iii) at 10%
discount.

Q.4. The Xavier Corporation, a dynamic growth firm which pays no dividends, anticipates a
long run level of future earnings of Rs 7 per shares. The current price of Xavier’s shares
is Rs. 55.45, floatation costs for the sale of equity shares would average about 10% of the
price of the shares. What is the cost of new equity capital to Xavier Corporation?

Q.5. Following is the cost structure of a firm:

Rs. Cost
Equity Capital 4,50,000 14%
Retained Earnings 1,50,000 13%
Preference Share Capital 1,00,000 10%
Debts 3,00,000 4.5%
10,00,000
Calculate the new weighted average cost of capital of the firm.
6. From the following Capital Structure of Perfect Ltd. calculate overall cost of capital, using
(a) book value weights and (b) market value weights.

Source Book Value Market Value:

Equity Shares Rs. 10 each 4,50,000 9,00,000
Retained Earnings 1,50,000 --
Preference Share capital 1,00,000 1,00,000
Debentures 3,00,000 3,00,000
The after tax cost of different sources of finance are Equity Share Capital 14%, Retained
Earnings 13%, Preference Shares 10% and Debentures 5%.

Q.6. Calculate the weighted average cost of capital from the following data. Ignore taxation:
Particulars Rs.
7% Debentures 1,30,000
8% Preference shares 70,000
Equity Shares (of Rs. 100 Face Value) 6,00,000
Total 8,00,000
(There are no retained profits or securities premium)
A dividend of 10% a year has been paid on the equity shares in recent years. All of the
company’s securities are quoted on the local stock exchange. The prices of these Securities
have recently been at par (i.e market and issue price same)
Q.8. The Aaroha Company has the following capital structure:
Particulars Rs.
Common Shares (4,00,000 Shares) 80,00,000
6% Preference shares 20,00,000
8% Debentures 60,00,000
Total 2,00,00,000
The shares of the company sells for Rs. 20. It is expected that company will pay next year a
dividend of Rs. 2 per share which will grow at 7 per cent for ever. Assume a 35 per cent tax
rate.
(a) Compute the weighted average cost of capital based on existing capital structure.
(b) Compute the new weighted average cost of capital if the company raises an additional
Rs. 40,00,000 debt by issuing 10 per cent debentures. This would result in increasing
the expected dividend to Rs. 3 and leave growth rate unchanged, but the price of share
will fall to Rs. 15 per share.
(c) Compute the cost of capital if in (b) above growth rate increases to 12 per cent.

Q. 9. G. Ltd. has the following capital structure as on 31st March 2002.

Particulars Rs.
Equity Shares (2,00,000 Shares) 60,00,000
10% Preference shares 25,00,000
14% Bonds 15,00,000
The shares of the company are presently selling at Rs. 25 per share. It is expected that the
company will pay next year dividend of Rs. 2 per share which will grow @5% forever. Assume
tax rate of 40%. You are required to
(i) Compute the weighted average cost of capital based on existing capital structure.
(ii) If the company raises an additional Rs. 50 lakhs debt by issuing 15% debentures,
the expected dividend at year end will be Rs. 3, the market price per share will fall
to Rs. 20 per share, the growth rate remaining unchanged. Calculate the new
weighted average cost of capital.

Q. 10. A company wants to raise additional funds of Rs. 10 lacs for meeting the investment
requirement. It has Rs. 2,10,000 as the retained earnings available for the investment.
Debt : Equity ratio = 30:70
Cost of Debt ;
Upto Rs. 1.8 lacs = 10% (Before tax)
Beyond Rs. 1.8 lacs = 16% (Before tax)
EPS = 4 DPS = 50% of earnings Growth rate = 10%
Current market price = Rs 44 and tax rate = 50%
You are required to determine the weighted average cost of capital.