Cost of capital

Basic terms
Capital structure is the proportion of debt and preference and equity
shares on a firms balance sheet.
Optimum Capital Structure: It is the capital structure or that
combination of debt & equity that leads to the maximum value of the
firm.
According to 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

Basic terms
Financial leverage involves the use of funds obtained at a fixed cost (debts
debentures, term loans etc.) in hope of increasing the return to the equity
share holders.
Levered firm is a firm which has used fixed cost components (debt) in its
capital structure.
Unlevered firm is a firm which has not used fixed cost components (debt) in
its capital structure and depends only on equity
Opportunity Cost is the rate of return forgone on the next best
alternative investment opportunity of comparable risk.

Significance of cost of capital

Evaluating Investment Decisions : The primary purpose of measuring the cost of
capital is its use as a financial standard for evaluating the Investment
project.
In the NPV method an Investment project is accepted if it has a positive
NPV, NPV is calculated by discounting its cash flows by the cost of capital, In this
sense the cost of capital is the discounting rate used for evaluating the desirability
of an investment project.
In the IRR method the investment project is accepted if it has an Internal
rate of return greater than the cost of capital. Hence the Cost of capital is the
minimum required rate of return on an Investment project.

Designing Debt Policy : Debt policy is significantly influenced by the cost

considerations, debt also helps to save taxes, as interest on debt is a
tax deductible expense.
In designing the financing policy , that is , the proportion of debt and equity in
the capital structure the firms aims at maximizing the firm value by
minimizing the overall cost of capital.
The cost of capital is also useful in designing the methods of financing at a
point of time, for eg. Cost may be compared in choosing between leasing and
borrowing.

Performance Appraisal : The cost of capital framework can be used to

evaluate the financial performance of top management . Such an evaluation
will involve a comparison of actual profitability of the investment projects
overall cost of capital and the appraisal of the actual costs incurred by
management in raising the required funds.
Cost of capital also plays a very important role in dividend decision and
investment in current assets.

Weighted Average Cost

A firm obtains capital from various sources because of the risk differences and the contractual
agreements between the firm and the investors, the cost of capital of each source differs. The
cost of capital of each source of capital is known as component, or Specific cost of capital.
The combined cost of all sources of capital is called as Average cost of capital, The
component costs are combined according to the weight of each component capital
to obtain the averages costs of capital, Thus the overall cost is also called as the
weighted average cost of capital (WACC).

Cost of Debt
A company may raise debt in a variety of ways, It may borrow funds from
financial Institutions or public either in the form of public deposits or
debentures (Bonds) for a specific period of time at a certain rate of interest.
A debenture or bond may be issued at par or at a discount or premium as
compared to its face value.
Cost of Debt
Cost of debt is the after tax cost of long-term funds through borrowing. Debt
may be issued at par, at premium or at discount and also it may be perpetual
or redeemable.

Perpetual Debt Issued at Par

Debt issued at par means, debt is issued at the face value of the debt. It may be calculated
with the help of the following formula.
Ki = I / SV
Where,
I = Annual Interest Payment
Ki = Before Tax Cost of Debt
SV = Sale Proceeds of the Bond

Perpetual Debt Issued at

Premium or Discount
If the debt is issued at premium or discount, the cost of debt is calculated with the
help of
the following formula.
Kd = I ( 1 t ) / SV

Where,
Kd = Tax Adjusted Cost of Debt
I = Annual interest Payment
SV = Sale proceeds of the bond / Debenture
t = Tax rate

Numerical : 1
Exercise 1
(a) A Ltd. issues Rs. 100,000, 8% debentures at par. The tax rate applicable to the
company is 50%. Compute the cost of debt capital.
(b) B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate
applicable to the company is 60%. Compute the cost of debt capital.
(c) A Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is 60%,
compute the cost of debt capital.
(d) B Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of
floatation are 2%. The tax rate applicable is 50%. Compute the cost of debt-capital.
In all cases, we have computed the after-tax cost of debt as the firm saves on account of tax
by using debt as a source of finance.

Numerical : 2
A company Has 10 % perpetual debt of Rs 1,00,000. The tax rate is 35 % . Determine
the cost of capital ( before tax as well as after tax) assuming the debt issued at
1. Par
2. 10 % Discount
3. 10 % Premium

Answers
1. 6.5 %
2. 7.22 %
3. 5.91 %

Cost of Redeemable Debt

Where,
I = Annual interest payment
RV =Redeemable Value of debentures/ Debt
SV = Net sales proceeds from the issue of debenture/
debt
Nm = Term of Debt
f = Flotation Cost
d = Discount on Issues of Debentures
pi = Premium on Issue of Debentures
pr = premium on redemption of debentures
t = Tax rate

Kd = I ( 1 - t ) + (f + d+ pr
- pi) / Nm
(RV + SV ) / 2

Numerical 2
Exercise : A company issues Rs. 20,00,000, 10% redeemable debentures at a discount
of 5%.
The costs of floatation amount to Rs. 50,000. The debentures are redeemable after 8
years. Calculate before tax and after tax. Cost of debt assuring a tax rate of 55%.
Answer : 5.64 %

Numerical 2
A 7 year, Rs 100 debenture of a firm can be sold for a net price of Rs. 97.75. The rate of
Interest is 15 % per year, and bond will be redeemed at 5 % premium on maturity. The
firm tax rate is 35 %, Compute the after tax cost of debenture.
Answer : 10.31 %

Numerical 3
Exercise 3 : Lakshmi Enterprise wants to have an issue of Non- Convertible debentures for
Rs 10 Cr, Each Debenture is of a par value of Rs 100 having an interest rate of 15 %.
Interest is payable annually and they are redeemable after 8 years at a premium of 5 %.
The company is planning to Issue the NCD at a discount of 3 % to help in quick
subscription . If the corporate Tax is 50 %, what is the cost of debenture to the
company ??
Answer : 7.92

Cost of Preference Share Capital

Cost of preference share capital is the annual preference share dividend by the net proceeds
from the sale of preference share.
There are two types of preference shares irredeemable and redeemable.

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share

Cost of redeemable preference share is calculated with the help of the following formula

Where,
Kp = Cost of preference share
Dp= Fixed preference share
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.

Exercise 7
XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate cost of preference share capital if these shares are issued (a) at par, (b) at
a premium of 10% and (c) of a discount of 6%.

Exercise 8
ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Redeemable after 8 years at a
premium of 10%. The cost of issue is Rs. 2 per share. Calculate the cost of preference share
capital.

Exercise 9
ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each at a premium of 5%
redeemable after 8 years at par. The cost of issue is Rs. 2 per share. Calculate the cost of
preference share capital.

Cost of Equity
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

Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share

Exercise 1
A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The
company has been paying 25% dividend to equity shareholders for the past five years and
expects to maintain the same in the future also. Compute the cost of equity capital. Will it
make any difference if the market price of equity share is Rs. 175?

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

Exercise 2
(a) A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are
expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share initially and
growth in dividends is expected to be 5%.
Compute the cost of new issue of equity shares.
(b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity
share capital

Exercise 3
The current market price of the shares of A Ltd. is Rs. 95. The floatation costs are
Rs. 5 per share dividend amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You
are
required to calculate the cost of equity share capital.

Earning Price Approach

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.

Where,
Ke = Cost of equity capital
E = Earning per share
Np = Net proceeds of an equity share

Exercise 4
A firm is considering an expenditure of Rs. 75 lakhs for expanding its operations.
The relevant information is as follows :
Number of existing equity shares =10 lakhs
Market value of existing share =Rs.100
Net earnings =Rs.100 lakhs
Compute the cost of existing equity share capital and of new equity capital assuming
that new shares will be issued at a price of Rs. 92 per share and the costs of new issue will
be Rs. 2 per share.

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment proposal; it is different from
other sources like debt, equity and preference shares. Cost of retained earnings is the same as the
cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of
equity capital. Cost of retained earnings can be calculated with the help of the following formula:

Where,
Kr=Cost of retained earnings
Ke=Cost of equity
t=Tax rate
b=Brokerage cost

Exercise :
A firms Ke (return available to shareholders) is 10%, the average tax rate of shareholders
is 30% and it is expected that 2% is brokerage cost that shareholders will have to pay while
investing their dividends in alternative securities. What is the cost of retained earnings?

Weighted average cost of capital

It is also called as weighted average cost of capital 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.

Ko= Kd Wd + Kp Wp + Ke We + Kr Wr
Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Wp = Percentage of preference share to total
Ke = Cost of equity
capital
Kr = Cost of retained earnings
We = Percentage of equity to total capital
Wd= Percentage of debt of 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.

Determine the weighted average cost of capital using:

(a) Book value weights, and
(b) Market value weights.
How are they different? Can you think of a situation where the weighted average cost
of capital would be the same using either of the weights?

Answer : 7.66
%

The Capital Structure of Prakash Packers Ltd is as shown below (In Lakhs) :
Equity Capital (Rs 10 Per Value)

200

14 % Preference Share Capital Rs 100 100

Each
Retained Earnings

100

12 % Debentures (Rs 100 Each)

300

11 % Term Loan from ICICI Bank

50

Total
750
The Market Price per Equity share is Rs 32. The company is expected to declare a dividend per
share of Rs 2 per share and there will be a growth of 10 % in the dividends for the next 5
years.
The preference shares are redeemable at a premium of Rs 5 per share after 8 years and are
currently traded at Rs 84 in the market.. Debenture redemption will take place after 7 years at
a premium of Rs 5 per debenture and their current market price Rs 90 per unit. Corporate Tax
Rate is 40 %
Calculate WACC.

As a financial analyst determine the weighted average cost of capital of the company using (i) book value weights and
(ii) market value weights. The following information is available for your perusal:
The companys present book value capital structure is: Rs.
14 % Preference shares (Rs. 100 per share)
Equity shares (Rs. 10 per share)
13 % Debentures (Rs. 100 per debenture)

2,00,000
10,00,000
8,00,000

All these securities are traded in the capital market. Recent prices are:
Debentures @ Rs. 110 per debenture
Preference shares @ Rs. 120 per share
Equity shares @ Rs. 22 per share
Book Value : 12.8 % , Market Value :
14.2 %
Anticipated external financing opportunities are:
i) Rs. 100 per debenture redeemable at par; 10 year-maturity, 4% flotation costs, sale price Rs. 100.
ii) Rs. 100 preference share redeemable at par; 10 year-maturity, 5% flotation costs, sale price Rs. 100.
iii) Equity shares: Rs. 2 per share flotation costs, sale price @ Rs. 22.
In addition, the dividend expected on the equity share at the end of the year is Rs. 2 and the earnings are expected to increase
by 7% p.a. The firm has a policy of paying all its earnings in the form of dividends. The corporate tax rate is 50%