CAF 06: Managerial & Financial Analysis CAF 06 : Chapter 12 Cost of Capital/Finance Premium Content

Chapter 12: Cost of Capital (For Spring 2023)

Secret Sheet for Quick Revision
(For students of Muhammad Asif, FCA)

LO 1: Meaning of Capital and Cost in Finance LO 3: Caculation of WACC

Capital: Cost:
Capital means any source of finance (whether from owner or from Cost means return (in %age) which should be paid to
third parties) which can be used to run business. capital providers.
Cost of Capital of a Firm is the Weighted Average Cost of
Sources of Long-Term Finance include: its all components of Capital (called WACC)
1. Bank Loan
2. Irredeemable Debentures/Bonds
3. Redeemable Debentures/Bonds (Non-Convertible, or Convertible)
4. Irredeemable Preference Shares
5. Redeemable Preference Shares
6. Equity Shares

LO 5 & LO 6: Cost of Debentures/Bonds

LO 2: Why Cost of Capital is Calculated
LO 4: Cost of Bank Loan
Irredeemable Debentures Redeemable Debentures Convertible Debentures
WACC is used in making Investment Decision.

KD= Rate of Interest * (1 – T) KD = IRR (using after tax cash flows) Convertible Debentures/ are those
KD = ID (1 – T)/PD debentures which can be converted into whose Return is more than their Cost i.e. whose NPV (using WACC as discount
(T means Tax Rate)
where: Shares at maturity. Return on Investment/IRR (in %age) > WACC factor) is positive.
I D = Interest on Debenture in rupees. (in %age).
P D = Price of Debenture in rupees.
T = Tax Rate Cost of Convertible Debenture
While calculating IRR, Terminal value to be used is
higher of:
Redemption Value at maturity Exam Tips
Conversion Value at maturity. 1. Value of a Redeemable Share or Debenture is “Present Value of its Cash Flows”.
2. Cost of a Redeemable Share or Debenture is its “Internal Rate of Return (IRR)”.

LO 7: Irredeemable Preference Shares
KPS = DPS /PPS
where:
D PS = Dividend Per Share in rupees,
P PS= Price of share in rupees
Capital Asset Pricing Model [CAPM]
Ke = KRF + βE * [KM – KRF]
Where:
K M = Required Rate of Return on Market
K RF = Risk Free Rate i.e. Rate on long-term Govt./
Treasury Bonds
K M – KRF = Market Risk Premium
β E = Measure of systematic risk of the company
CAF 06 : Chapter 12 Cost of Capital/Finance
Cost of Preference Shares
LO 8: Redeemable Preference Shares
KPS = Internal Rate of Return i.e. IRR
IRR is also called Effective Rate or Yield
to Maturity
Calculation of IRR Directly through Calculation of IRR: (by Trial & Error Method)
Calculator 1) Estimate L i.e. a lower rate (e.g. 8%).
Recommended. 2) Calculate NL i.e. NPV at lower rate (e.g. 8,638).
3) Estimate H i.e. a higher rate (e.g. 12%).
4) Calculate HL i.e. NPV at higher rate (e.g. – 5,358).
5) IRR = L + NL /(NL – NH) * (H – L) i.e. 10.47%.
Tip: Lower discount rate will increase NPV of
project, and vice-versa.
LO 9: Cost of Equity
Dividend Valuation Model
Without Growth With Growth
Ke = d1 / P0 Ke = (d1 / P0) + g
Where: Calculation of Growth using Calculation of Growth using
P 0 =Today’s Price of Common Share (Ex. Div.) Extrapolation of Historical Growth Gordon’s Growth Model
d 1 = Expected Dividend at year end
g = Growth Rate
End Price = Current Price * (1+g)^n g (Growth Rate %) = r (Cost of Equity/Rate of
Return %) * b (Retention Rate %)