COST OF CAPITAL

The chapter covers

Meaning of cost of capital

Importance of cost of capital
Classification of cost
Computation of Cost of capital
 Computation of specific cost
 Cost of Debt
 Cost of Preference share
 Cost of Equity share
 Overall cost of capital
Meaning of Cost of Capital

The cost of capital to a firm is the minimum

return, which the suppliers of capital require.
For a firm it is a price for obtaining
cash.
In other words, COC means that rate which is
paid for the use of capital.
Each source of funds has different cost,such
as cost of equity share capital, cost of
preference share capital, cost of debt, cost of
retained earning.
Meaning of Cost of Capital

From the view point of investor:-

COC is the reward for the amount
he is investing which could have
otherwise been used for
consumption or for investment at
some other place.
Importance of Cost of
Capital
As determination of the COC is very important
in the area of financial management :-
Capital Budgeting
Capital Structure Decision
Dividend Policy Decision
Helpful in Evaluation of financial efficiency
of Top mgt.
Helpful in comparative Analysis of various
sources of finance
Classification of Cost

Specific or component cost :- refers

to the cost of individual components of
capital viz. equity share, preference
share,debentures, retained earning.

Combined cost/WACC :- refers to the

combined cost (or weighted avg COC) of
the various individual components.It is
also called the average /weighted cost
of capital or overall cost of capital.
Classification of Cost

Explicit and Implicit cost :-

Explicit cost is the one which is
attached with the source of capital
explicitly or apparently while
implicit cost is the hidden cost
which is not incurred directly.
Example of explicit and Implicit cost

Eg. debt capital :- the interest is explicit

cost.

if the company increase debt then

investment in the company becomes risky
investors will expect more return
These increased expectations of the investor
may be considered to be implicit cost of debt
capital.
Classification of Cost

Historical and Future Cost :-

Historial cost means the cost that
has been paid in the past for
financing a specific project.
Future cost is the estimated cost
to be incurred to finance a
project.Future cost is important for
taking financial decision.
Computation of Cost of
Capital
It includes:-
Computation of cost of specific source
of finance.
- Cost of Debt
- Cost of Preference share capital
- Cost of Equity share capital
- Cost of Retained Earnings
Computation of weighted average cost
of capital
Cost of Debt

Debt fund can be in the form of

debentures or loans from financial
institution. Debt can be of 2 types:-
Irredeemable or perpetual Debt
Redeemable Debt
Cost of Irredeemable Debt

Calculation of Irredeemable Debt,

before tax :-
Kd = Int
NP where
Kd = Cost of Debt before tax
Int = Interest NP = Net Proceeds
Example of Cost of Debt,
before tax:-
X Ltd. issues Rs 15 lakh, 8%
debentures (a) at par, (b) at a
discount of 7 % and ( c) at a
premium of 10%
You are required to calculate the
cost of Debt to the company.
Cost of Irredeemable debt,
after tax
Formula:-
Kda = Int(1- t) * 100
NP
Example:- X Ltd has 8% perpetual debt of
Rs 20 Lakh. The tax applicable to the
company is 40%. Determine the cost of
capital after tax assuming the debt is
issued (a) at par, (b) at 10%
discount,and © at 10% premium
Example of Cost of
Irredeemable Debt
X Ltd.issues 40,000, 8% debentures of Rs 100 each
and incurred the following expenditure:
Underwriting Commission 2% of issue price
Brokerage 0.5% of issue price
Printing and other expense Rs 20,000
Calculate cost of Debt assuming debt is issued
 At 10% premium
 At 10% discount
Tax rate is 40%
Cost of Redeemable Debt

Before tax :-
Kdb = Int +1/n( RV – NP ) *100
½(RV+ NP)
After tax :-
Kda = kdb X (1-t)
Example of
Redeemable debt
A company issues Rs 5,00,000 , 10%
redeemable debentures redeemable at
par after 5 years .The cost of Floatation
amount to 4% of face value. Tax rate is
35%
You are required to calculate before tax
and after tax cost of debt if debentures
are issued at par,at a discount of 10%,
at a premium of 5%
Example

A company issues 20,000, 7.5%

debentures of Rs. 100 each at a
discount of 2% t be redeemed
after 10 years at a premium of
5% .The cost of floatation amount
to Rs 50,000.. Calculate cost of
debt assuming tax rate at 40%
Cost of Preference Share
Capital
2 types of Preference share capital is there:-
 Irredeemable Preference share
 Redeemable Preference share
Formula of computing cost (irredeemable)
Kp = D / NP
where:-
Kp = cost of preference share
D = Dividend
NP = Net proceed
Redeemable Preference
share
Formula of computing:-
Kpr = D+ (MV-NP)/ n
½ ( MV + NP )
where:-
Kpr= cost of redeemable preference
Share
D = Dividend
MV = Market value
n = no of years
Example of preference
share
A company issues 10,000, 10%
preference share of Rs 100 each.
Cost of issue is Rs 2 per share.
Calculate cost of preference capital
if these are issued at par, at a
premium of 10 % , at a discount of
5%.
Example

A company issues 10,000 , 10%

preference share of Rs 100 each
redeemable after 10 years at a
premium of 5%. The cost of issue
is Rs 2 per share. Calculate the
cost of preference capital.
Cost of Common Stock

Is Equity Capital free of

cost ??????????
 Cost of Common Stock
There are 2 sources of Common
Equity:

1) Internal common equity (retained

earnings), and

2) External common equity (new

common stock issue)

Do these 2 sources have the same

cost?
Cost of Equity share
capital
The cost is difficult to measure, as
the rate of return fluctuates every
year
Its not legally binded to pay
dividend to equity share holder.
As the future earning and dividend
are expected to grow overtime.
Cost of Equity

The cost of equity can be computed with the

following methods:-
 Dividend yield method
 Dividend yield method plus growth in dividend
 Earning yield method
 Earning yield method plus growth in earning
 CAPM Approach
Dividend Yield Method

It is also known as Dividend/ Price method.

This method is based on the assumption that
when an investor invests in the equity
shares of a company he expect to get a
payment at least equal to the rate of return
prevailing in the market.
This method is suitable only when the
company has stable earnings and stable
dividend policy.
Cost of Equity Share
Capital
Formula of computing Cost of
Equity:- (Dividend yield method)
Ke = DPS/ MP * 100
where:-
ke = cost of equity
DPS= Dividend Per share
MP = Market Price
Example of Equity Share
Capital
Equity capital of a company consists
of 5,00,000 equity shares of Rs 10
each issued at a premium of Rs 2.5
per share.The average rate of dividend
paid by the company has been Rs 3
per share .The market value of the
share is Rs 25.Calculate the cost of
equity capital.
Dividend yield plus growth
in dividend method
This method takes care of the future growth in
the rate of dividend .hence, when dividend
are expected to grow at constant rate,we
compute cost by:-
Ke = DPS/ MP *100+G
Ex:- X Ltd pays a dividend of Rs 12 per share
initially and the growth in dividend is
expected to be 5 % . Compute the cost of
equity share if the current market price of
an equity share is Rs 150.
Earning Yield Method

Formula:-
Ke = EPS/ MP * 100
Example:- A company plans to incur an
expenditure of Rs 80 lakhs for expanding its
operations. The relevant operation is as
follows:-
No of existing share = 20 lakhs
Net earning = Rs 160 lakhs
Market value of existing share = 40 s
Compute the cost of equity capital.
Earning yield plus growth
in Earning Method
Formula:-
Ke= EPS/ MP *100 + G

Ex:- The current market price of the equity

share of a company is Rs 60 per share
.The expected earning per share after
one year is Rs 9 per share .Thereafter
EPS is expected to grow constantly at
4% per annum .Find out the cost of
equity capital.
Capital Assets Pricing
Model or CAPM Approach
Ke = Rf + b (Km – Rf)
where:-
Rf = risk free return
b = beta coeff.
Km= req return on
market return
Ex :- Calculate the cost of equity capital where
the beta factor (Risk) is 1.5. Risk free rate of
interest on Government Securities is 8% .
Return on market portfolio is 12%
The Weighted Average Cost
of Capital
We now need a general way to determine
the minimum required return
Recall that 40% of funds were from debt.
Therefore, 40% of the required return must
go to satisfy the debtholders. Similarly, 10%
should go to preferred shareholders, and
50% to common shareholders
This is a weighted-average, which can be
calculated as:
 Weighted Cost of Capital

The weighted cost of

capital is just the weighted
average cost of all of the
financing sources.
Calculating RMM’s WACC
Using the numbers from the RMM example, we can
calculate RMM’s Weighted-Average Cost of Capital
(WACC) as follows:

WACC = 0.40(0.07 ) + 0.10(010

. ) + 0.50(012
. ) = 0.098

❖ Note that this is the same as we found earlier

Finding the Weights

The weights that we use to calculate

the WACC will obviously affect the
result
Therefore, the obvious question is:
“where do the weights come from?”
There are two possibilities:
 Book-value weights
 Market-value weights
Book-value Weights

One potential source of these weights is

the firm’s balance sheet, since it lists
the total amount of long-term debt,
preferred equity, and common equity
We can calculate the weights by simply
determining the proportion that each
source of capital is of the total capital
 Book-value Weights
(cont.)
The following table shows the calculation of the
book-value weights for RMM:
Market-value Weights
The problem with book-value weights is that the book
values are historical, not current, values
The market recalculates the values of each type of
capital on a continuous basis. Therefore, market values
are more appropriate
Calculation of market-value weights is very similar to the
calculation of the book-value weights
The main difference is that we need to first calculate the
total market value (price times quantity) of each type of
capital
 Calculating the Market-value
Weights
The following table shows the current market prices:
Market vs Book Values
It is important to note that market-values is
always preferred over book-value
The reason is that book-values represent the
historical amount of securities sold, whereas
market-values represent the current amount of
securities outstanding
For some companies, the difference can be much
more dramatic than for RMM
Finally, note that RMM should use the 10.27
WACC in its decision making process
The Costs of Capital

As we have seen, a given firm may have

more than one provider of capital, each
with its own required return
In addition to determining the weights
in the calculation of the WACC, we must
determine the individual costs of capital
To do this, we simply solve the
valuation equations for the required
rates of return