THE COST OF CAPITAL

Learning Outcomes

 Appraise with the various concepts

and principles related to cost of
capital and their application

 Define and calculate the

component costs of debt, preferred
stock, Equity and WACC.
 INTRODUCTION
3

 The project’s cost of capital is the minimum

required rate of return on funds committed to the
project, which depends on the riskiness of its cash
flows.

 The firm’s cost of capital will be the overall, or

average, required rate of return on the aggregate of
investment projects
 SIGNIFICANCE OF THE COST OF CAPITAL
4

 Evaluating investment decisions

 Designing a firm’s debt policy

 Appraisingthe financial performance of top

management

https://assets.kpmg/content/dam/kpmg/de/pdf/Themen/2019/04/cost-of-capital-
en-2019.PDF
 Cost of Capital
5

 Viewed from all investors’ point of view, the firm’s

cost of capital is the rate of return required by them
for supplying capital for financing the firm’s
investment projects by purchasing various
securities.

 The rate of return required by all investors will be

an overall rate of return — a weighted rate of
return.
6
 DETERMINING COMPONENT COSTS OF CAPITAL
7

 Generally, the component cost of a specific source

of capital is equal to the investors’ required rate of
return, and it can be determined by using

 But the investors’ required rate of return should be

adjusted for taxes in practice for calculating the
cost of a specific source of capital to the firm.
 Cost Of Debt
8

 •Cost of Debt

 –Irredeemable
 •AT Par
 •AT Discount/Premium

 –Redeemable
 •AT Par
 •AT Discount/Premium
 Cost of Irredeemable Debt
9
 Cost of Irredeemable Debt( issued at par)
 kd= (1-T) * I
 k = cost of capital ( to be calculated)
 T= tax rate
 I= annual interest rate to be paid to the creditor ( in percentage)
 –Example: A company has issued debentured worth Rs 1,00,00 of par
value of Rs 1000.The coupon rate is 9%.What is the cost of debt. Tax rate
is 50%
 –There is no mention of the maturity date
 –Thus this is the case of irredeemable debt
 –kd= (1-T)I
 –Kd = 0.5X9% = 4.5%
 Cost of Irredeemable Debt
10

 Cost of Irredeemable Debt( issued at Premium or Discount)

 kd= (1-T) * I
Net Proceeds
 k = cost of capital ( to be calculated)
 T= tax rate
 I= annual interest rate to be paid to the creditor( in Rs)

 Net Proceeds = Total amount raised by the company by issuing the

debentures ( in Rs)
 Incase of par ---It is equal to the par value
 In case of discount ---it is less than par value
 In case of premium---it is more than the par value
 Example
11

 Example : A company issues the debentures worth Rs 1,00,000 at coupon

rate 10%.The company is in the tax bracket of 55%.Calculate the cost of
debt if the debentures are issued
 1.At PAR
 2.At a discount of 10%
 3.At a premium of 10%

 Kd = (1-T) * I
Net Proceeds

 I = Rs 10,000
 T= .55
 Example Cont..
12

 In case of Par Net proceeds = Rs1,00,000

Kd = 4.5%

 In case of Discount Net Proceeds = Rs 90,000

Kd = 5%

 In case of Premium Net Proceeds = Rs1,10,000

•Kd= 4.09%
  Rama & Co. wishes to issue 1000 debentures (10%) of Rs.100
13 each for which the company will be required to incur
following expenses:

 Underwriting Commission 2%
 Brokerage 0.5%
 Printing and other expenses 15000
 Calculate Cost of debt to be issued
 At par

 At 10% discount

 At 10% premium

 Tax rate 50%

14
 Cost of Redeemable Debt
15

 In the previous case

 we have assumed that the bonds are not maturing and

thus are continuously going on

 In case the bond matures after the certain period of

time then it is called redeemable debt
 Cost of Redeemable Debt
16

 Debt Issued at Par

INT
kd  i 
B0

 Debt Issued at Discount or Premium

n INTt Bn
B0   
t 1 (1  k d ) t (1  k d ) n

 Tax adjustment

After  tax cost of debt  k d (1  T)

 Example
17

 A company issues 10,000, 10% Debentures of Rs.

10 each and realises Rs. 95,000 after allowing 5%
commission to brokers. The debentures are
redeemed after 10 years.

 Calculate the effective cost of debt before tax.

 Short Cut Formula
18
19
 Problem
20

 Calculate the cost of capital in the following cases

X Ltd. issues 12% Debentures of face value Rs.

100 each and realizes Rs. 95 per Debenture.The
Debentures are redeemable after 10 years at a
premium of 10%.
 Problem
21

 Calculate the cost of capital in the following cases

X Ltd. issues 7 years15% Debentures of face value

Rs. 100 each and each bond is sold below par for
94.
22
Problem

Mohan Ltd. Issues 10000 10% debentures of Rs

100 each at a discount of 5%. The cost of
floatation are 2%. Tax rate is 50%.Compute the
cost of capital before tax and after tax.
 Problem
23

 Indebted Ltd issued 10,000, 10% Debentures of Rs.

100 each, redeemable in 10 years time at 10%
premium. the cost of issue was Rs. 25,000. The
Company’s Income Tax Rate is 35%. Determine
the cost of debentures if they were issued
 (a) at par
 (b) at a premium of 10% and
 (c) at a discount of 10%.
 Particulars Par Premium Discount

1. Gross Proceeds 10,000×100 10,000×110 10,000×90 =

24 10,00,000 11,00,000 9,00,000

2. Cost of Issue 25,000 25,000 25,000

3. Net Proceeds (1–2) 9,75,000 10,75,000 8,75,000

4. D Redemption Value (Face Value+10% premium) 11,00,000 11,00,000 11,00,000

5.Net Proceeds (NP) ÷ (2=(4+3) ÷ 2 10,37,500 10,87,500 9,87,500

6. Premium on Redemption =D – P 1,25,000 25,000 2,25,000

7. (D-P) + n 12,500 2,500 22,500

8. Interest payable at 10% of Face Value 1,00,000 1,00,000 1,00,000

9. After Tax Interest at 65% (Since Tax=35%) 65,000 65,000 65,000

10. Average Annual Payout = (7+9) 77,500 67,500 87,500

K = c+ (D-P)/ n
6.21% 8.86%
(D+P)/2
 Cost of the Existing Debt
25

 Sometimes a firm may like to compute the

“current” cost of its existing debt.

 In such a case, the cost of debt should be

approximated by the current market yield of the
debt.
 Determine the annual interest payment on the bond.

26 The annual interest payment will equal the stated interest rate times the
face value of the bond.

For example, if a bond has a face value of 1,000 and a stated interest rate
of 5 percent, then the annual interest is 50.

Determine the current market price of the bond.

For example, a bond is currently selling at 945.

Divide annual interest payment by the current market price of the

bond.
In the example, 50 divided by 945 equals a current yield of 0.0529 or 5.29
percent.
 Problems
27

 A 10 year, 8%, 1000 par bond sold at 950 less 4%

underwriting commission. Calculate the cost of
debt.

 A 5-year Rs.100 debenture of a firm can be sold for

a net price of Rs.96.50. The coupon rate of interest
is 14 %per annum and debenture will be redeemed
at 5% premium on maturity. The firm tax rate is
40%. Compute the after tax cost of debentures.
https://economictimes.indiatimes.com/markets/stocks/news/bonds-of-weaker-banks-to-
gain-more-post-psb-mergers/articleshow/70941799.cms

28
  Bonds of weaker banks to gain
29 Bond investors of smaller banks, with relatively lower credit rating,
are likely to benefit as they are proposed to be merged with stronger
and better rated banks,

 Re Assessment of credit rating

 The 10 banks together have ₹57,729.7 crore in

outstanding bonds, Prime Database statistics
showed.

Mutual Fund houses, such as Aditya Birla, HDFC, Kotak, Franklin,

Reliance Nippon, SBI, L&T, UTI, Sundaram and IDBI, have invested
in these bank bonds, according to Value Research data, updated until
July 31.
 COST OF PREFERENCE CAPITAL
30

 Irredeemable Preference Share

PDIV
kp 
P0
 Redeemable Preference Share

n PDIV t Pn
P0   
t 1 (1  k p ) t (1  k p ) n
 Example
31
 Cost Of Equity Capital
32

 Cost of equity capital is most difficult to determine because

 It is not directly observable
 There is no legal binding to pay any compensation, and
 It is not directly mentioned.

 Does this mean that cost of equity is zero?

 No, it has an opportunity cost.
 Types Of Equity Capital
33

 Equity capital is classified as

1) Internal: the profits that are not distributed but retained by the firm
in funding the growth, is referred as internal equity, and
2) External: equity capital raised afresh to fund, is called external equity

 And external equity may have cost differential on account of

 Floatation cost associated with raising fresh equity,
 Less price of fresh issue.
 COST OF EQUITY CAPITAL
34

 Cost
of Internal Equity: The Dividend-Growth
Model

 Normal growth DIV1

P0 
(k e  g)

DIV1 EPS 1
 Zero-growth ke   (since g  0)
P0 P0
 COST OF EQUITY CAPITAL
35

 Cost
of External Equity: The Dividend Growth
Model

DIV1
ke  g
P0

Formula for cost of new issue of equity capital

DIV1
ke  g
Pi
Pi is the issue price of new equity
 Example
36
 Earnings–Price Ratio and the Cost of
37
Equity

EPS 1 ( 1  b )
ke   br (g  br)
P0
EPS 1
 (b  0)
P0
 Example: EPS
38

 A firm is currently earning Rs 100,000 and its share is selling

at a market price of Rs 80. The firm has 10,000 shares
outstanding and has no debt. The earnings of the firm are
expected to remain stable, and it has a payout ratio of 100 per
cent. What is the cost of equity?
 We can use expected earnings-price ratio to compute the cost
of equity. Thus:
 Problems
39

 A 10 year, 8%, 1000 par bond sold at 950 less 4%

underwriting commission. Calculate the cost of
debt.
 Problems
40

 An ordinary share is selling at CMP 120 and paying

current dividend of 9 per share which is expected to
grow at 8%.
 Problems
41

 An ordinary share of a company which engages no

external financing, is selling for 50. EPS is 7.5 of
which 60% is paid in dividends. The company
reinvests retained earnings @ 10%.
 problems
42

 A preference share sold at 100 with 9% dividend

and going to redeem @ 10% premium and n=5
years. Find the cost for preference share.
43

 A person is going to receive 5000 twice in a year

(at the beginning of the year and at the end of the
year). If the amounts received is deposited with the
bank that pays an interest rate of 12% p.a, calculate
the value of deposit at the end of 5th year
Quiz
 A single, overall cost of capital is often used to evaluate projects
because:
a) it avoids the problem of computing the required rate of return for each
investment proposal.

b) it is the only way to measure a firm's required return.

c) it acknowledges that most new investment projects have about the same
degree of risk.

d) it acknowledges that most new investment projects offer about the same
expected return.
Quiz

 In calculating the costs of the individual components of

a firm's financing, the corporate tax rate is important to
which of the following component cost formulas?
a) common stock.

b) debt

c) Preferred stock

d) Retained Earnings
Quiz
 Electronics Galore has 950,00 shares of common stock outstanding
at a market price of 38 a share. The company also has 40,000 bonds
outstanding that are quoted at 106 percent of face value. What
weight should be given to the debt when the firm computes its
weighted average cost of capital?

a) 42 percent
b) 54 percent
c) 50 percent
d) 46 percent
Quiz
 A company has 10% perpetual debt of Rs
100,000. The tax rate is 35%. Determine the cost of
capital assuming the debt is issued at 10%
premium.

 Cost of debt= 5.91%

 Cost of debt=7.26%
 Cost of debt=8.62%
 Cost if debt= 8.91%
48

Preferred Ltd issued 30,000, 15% Debentures of Rs. 100

each. The cost of issue was Rs. 30,000. Determine the
cost of Preference Capital is shares are issued (a) at par
(b) at a premium of 10% and (c) at a discount of 10%.
49

Particular Par Premium Discount

Gross Proceeds 30,000×100 = 30,000 × 110 = 30,000×90 =

Less : Cost of Issue 30,00,000 33,00,000 27,00,000
30,000 30,000 30,000

Net Proceeds 29,70,000 32,70,000 26,70,000

Interest15% 4,50,000 4,50,000 4,50,000

Int
Kd 
15.15% 13.76% 16.85%
Net Pr oceeds
50

 Preferential Ltd. issued 30,000, 15% Debentures of

Rs. 100 each, redeemable at 10% premium after 20

years. Issue Management Expenses were Rs.
30,000. Find out of debenture if issued (a) at par (b)
at a premium of 10% and (c) at a discount of 10%.
51

Particulars Par Premium Discount

1. Gross Proceeds (30,000 Shares × Issue Price) 30,00,000 33,00,000 27,00,000

2. Cost of Issue 30,000 30,000 30,000

3. Net Proceeds = (1–2) 29,70,000 32,70,000 26,70,000

4. Redemption Value (Face Value+10% premium) 33,00,000 33,00,000 33,00,000

5. Average Liability (RV+NP) ÷ 2 = (4+3) ÷ 2 31,35,000 32,85,000 29,85,000

6. Premium on Redemption = RV – NP 3,30,000 30,000 6,30,000

7. Avg Premium on Redemption p.a. ÷ 20 yrs. 16,500 1,500 31,500

8. Interest at 15% of Face Value 4,50,000 4,50,000 4,50,000

9. Average Annual Payout = (7+8) 4,66,500 4,51,500 4,81,500

10. Kd = 9 : 5 14.88% 13.74% 16.13%

 Banks get pilot’s seat in Jet Airways, Naresh Goyal loses control
https://economictimes.indiatimes.com/industry/transportation/air
52 lines-/-aviation/banks-get-pilots-seat-in-jet-naresh-goyal-loses-
control/articleshow/68001753.cms
 Highlights
53

 The recast includes conversion of lenders' debt into

shares.
 Lenders led by SBI to become largest holders in
company.
 Resolution plan estimates Rs 8,500 crore funding
gap.
 Draft resolution consists of funds infusion, debt
restructuring and monetisation of assets.
 Co seeks approval to name lenders' nominees to
board.
 Case II
54
Storage Solution Ltd. is a large warehousing network company operating
through a chain of warehouses at 40 different locations across India. The
company now intends to undertake computerization of its owned ware houses
as it seeks to provide better value added and cost effective solutions for
scientific storage and preservation services to the market participants dealing
in agricultural products including farmers, traders, etc.
In context of the above case:

1. How is the decision to undertake computerization of owned warehouses

likely to affect the fixed capital requirements of its business?

2. Name any two sources that company may use to finance the
implementation of this plan.