Fa =~ OM ORG, earned by investing u the shareholders on the Funds j tr, their iny of retained earings (K, qual to the cost of equity nthe Ky due to differences in flotation cost. Thus 4 Kp = K.- Percentage Brokera; \ Where, K Cost of Retained Earnings Cost of Equity Capital ‘or example. Suppose a firm's K. (Cost of Equity or retum available to shareholders) js in. Pected that 2% is brokerage cost that shareholders will have ‘0 Pay While investing their in atemative securities, the cost of retained earings will be : K. = K.a-0,02) Would be approximately e tha: we or Flotation Cost) 12%and dividensof Redeemable Preference Capital : Tas to be retumed to the preference shareholders after a stil _(B) Computation of Cost date is calculated as follows cmable preference capital cost of preference capital which has a specific maturity p+tiav—np) Kp = —2———— x 100 (RV + NP)10,000 3,20,0 3,20,000_, = 4.5% Ano * 100 x 0.60 = 4.5% (8) Cost of Redeemable Debt : Xonnaliy a company issues a debt which is redeemable after a certain period during its life-time. ch a debt is termed as Redeemable Debt. Cost of redeemable debt may also be calculated before tax and after tax Before tax cost of redeemable debt is calculated as follows = 144 ery = NP) Kap= = x 100 Lay +nr) Where. | = Interest |, = amber of years in which debt isto be redeemed RV = Redeemable Value of Debentures/Debt Np = Net Proceeds trom the issue of Debentures/Debt After tax cost of redeemable debt is calculated as follows : Vd — +t eRv-NP) a Kga= =~ 100 Liny + NP)a narithe and weett Seo ee i v2 vy deductibie and preference dividend is not, the afler-tax cost of refer ia is subst "i 2 Hat 0 feLiee i afr cost eh preference capital is substantially ‘There are avo types of preference shares : jay rredeemable, and (i7) Redeemable. (a) Campuration of cost of Inredeemable (or perpetual) Preference Capital: “jhe cost of preference shares which has no specific maturity date is calculated as follows dD Ret yp * 100 where, Ky = Cost of redeemable Preference Capital D. = Annual Preference Dividend NP = Net Proceeds of Preference Share Capital The cost of preference shares is not adjusted for taxes because preference dividend is paid after the Corporate Taxes have beew paid. TLEUSTRATION 9. NX Lwd. issues 25,000, 8% preference shares ‘of 7100 euch, Cost of issue 1s %2 per share. Cateulate cost of preference eapital Mf these shares are issued (a) at pur, and at presi of 10%, SOLUTION: FS Beats "i Db Cost of Iedeemable Preference Capital, Ky > od x 100 (a 2.00,000___ pi) = 8.16% a © LS 35,00,000 + 10% of 2 = 200000. . 100 = 37,00,000100 = 12% tn Dividend Yield plus Growth in Dividend Method : oe fend yield method discussed above does not take care of future growth in the rate of dividend czas in actual practice shareholders expect growing rate of dividend, Hence, when the dividends of shin ere expected fo grow at a constant rate this method is used to compute the cost of equ K, = 2x10+6 Po Where, Ke = Cost of Equity Capital D; = _ Expected Dividend Per Share Py = Current Market Price Per Share G = Rate of growth in Dividend Dividend yield plus growth in dividend method is based upon the following assumptions (i) Price earning ratio does not change (id) The pay out ratio (the percentage of earnings distributed as dividend) does not chpinstitutions or public either in the form of public deposits of Cehenbures (bonds) tor a specified pe; time at a specified rate of interest. A debenture or bond may be issued at par, at a discouy vemium, The contractual rate of interest forms the basis for calculating the edst of any form» Debt may cither be irredeemable or redeemable after a certain period, Cost of Both these types may be calculated as follows : (A) Cost of trrédeemable Debt : (A Cost of Irredeemable (Perpetual) Debt, before tax : ~Formula for calculating cost of debt before tax is + = L Kab= WP * 100 Cost of debts before tax Annual Interest Charges NP = Net Proceeds Where Kap iThe coster’" ‘od ) Dividend Yield Meth — svesdend Method io Dividend Yield plus Growth in pividend Me “) Eaming Yield Method i) rea Yield plus Growth in Earning Method (v) Realised Yield Method iy a Ved Mata ased on the assumption that yy ivi i ‘This method is b: Af is also known as Dividend/Price method. This me! hi VST eosin the equity shares of a company Be expect epee eee io f vailing i cet, Hence, in order to asce ain a cing SE deed te he share. The equation Is : method dividend received is divided by the market value of tl Dy Ke = Py x 100 where, K, = Cost of Equity Capital a dD, = Expected Dividend Per Share Po. = Current Market Price Per Share ; Dividend yield method of Computation of cost of equity capital assumes that, (/) shareholds prime importance to dividends, and (ji) risk in the firm remains unchanged. ‘This method suffers from the following limitations :COST.OF CAPITAL _ ahere, Kye = D = n= RV 745 Cost of Redeemable Preference Capital ‘Annual Preference Dividend Number of years Redeemable Value of Preference Share Capital Net Proceeds of Preference Share CapitalIt : me be expected that 10% growth in dividends will be continue? I" xpected Current Year Dividend = 1.86 (1 + 0.10) = €2.05 ‘ 2B Ke Po * 100+G 2.05 ag 100 + 10% = 5.9% 10% = 15.69% « (iin) Earning Yield Method : AS per this method, the cost of equity cap! \cmning per share and the current market price of the share: stati calculated by establishing @ relationship bees “The equation is : Ke Bs x 100 where, Ke =~“ Cost of Equity Capital EPS = Eaming Per Share Po = Market Price Per Share pased upon the Following assumptions ° remain constant in future, 's share depends only upon eaming per projects at the same rate at which it Earning yield method is 1: share is expected to company” ‘on the new share. (@ Eaming pe ams on the exist (ii) The market price of the (iii), The company ean earn projects. This method is 8 suitable when the above mentioned assumptions are fulfilled. caioll(c) Cost of debt issued at a premium of 10% + NP = 15,00,000 + 10% of 15,0 A a 00, = Togan 000 = %16,50,000 x 100 = 7.27% Kass 76.50,000 (i) Cost of Irredeemable (Perpetual) debt, after tax : — When a company uses debt as a source of finance then it = Ss} ROUT “ of tax because the amount of interest paid on the debts is a dedi epeare Spee ts pay Thus, the effective cost of debt is reduced because of saving in taxation Cost of det afr aa - +t : Ky= yp 100(1- or Kg, (1-0) Where Kg, = Cost of debts after tax I Annual Interest Charges Net Proceeds Rate of Tax NP = vee tie to the company is 40%. DeterHence, Dy 12 per share i) Cost of Equity Capital on the basis of Dividend Yield Method : : Dy 12 = Dyer =22.x 100 =9.6% Ke = Bp x 100= 135 x 100 = 9.6% (1) Cost of Equity Capital on the basis of Earnings Yield Method : _ EPS _ 1s < kK Py 100= 75 % 100 = 12% (iv) Earr yield plus Growth in Earning Method : *_-Aaming yield method does not take care of future growth in the rate of eamings of the company whereas the earnings of a company are usually expected to grow in fuuure. If the EPS ofa company is expected to grow at a constant rate of growth, the cost of equity capital can be computed as follows EPS Ke =p % 100+ G Cost of Equity Capital Earning Per Share Market Price Per Share Rate of growth in EPS ILLUSTRATION 25. ected eamine i se share. The expected The current market price of the equily share of 4% per annum. Find et company is 860 pes ye ow constantly atdividends received by the shareholders in the past as well as appreciation in the value of equity , are considered. This method of computing cost of equity capital is based upon the follow, assumptions ; ; ; (i) No significant changes are expected in the risk complexion of the firm. ders would feel satisfied if they carn same rate of return in future, which they hae (i) d in the past. . ¥ . (iii) expect to eam the same rate of retum as the realised yield even if they iniey (a) ges are expected in the market price of company’s share. Computation of Cost of Newly Issued Equity Shares : _Wen 2 company issues new equity shares, it is not possible to realise the full market value on th: \iewly issued shares. This is because on new issues the company has to incur flotation cosis such s commission, brokerage. printing ete. As such, in order to ascertain the cost of capital of otation costs are deducted fiom the expected market price underari new issues In © Py (Market Price) will be changed with NP (Net Proceeds), Dd, D: As such Ko = x10, or hx 10046 or SS 100 or 8 5 100 +6 \o raise funds by issuing 5,00,000 new equity prem ef 820 ger share. Tei ce quity shares of [10 each at a premiul