Cost of Capital 2

objective of a business firm is to maximize the wealth of its shareholders in the long-run.
The main
shouldonly invest in those projects which give a return in excess of cost of funds
The management
form of equity and
various sources of funds to the company are in the
invested in the business. The
various suppliers of funds in
the rate of return the company has to pay to
debt. The cost of capital is
need to be offered to
and costs of debt are the rates of return that
the company. The costs of equity
these two groups of suppliers
of capital in order to attract funds from them.
must earn on its investments so
Cost of capital is defined
'as the minimum rate of return that a firm
to measure the worth of
remains unchanged'. It provides a yardstick
that market value per share
referred to as
investment proposal and thus performs
the role of accept or reject criterion. It is also
rate of return and standard return etc. Cost
cutoff rate, target rate, hurdle rate, minimum required
value of
firm has to earn to maintain it market value and
of capital is the minimum rate of return, a
of the firm is generally met from the following
sources:
its shares. The long-term funds requirement
(i)Equityshare capital
(i) Preference share capital
(ii) Retained earnings
(iv) Debentures and bonds

(vTerm loans from financial institutions and banks

would be differing for different sources.
The firm will incur cost in using the said funds. The costs
firm should earn enough profits to meet its
Cost of capital acts as a minimum benchmark return, a

cost of capital. The cost of capital consists of the following elements:

(a) Cost ofEquity Capital (K)

b)Cost of Retained Earnings (K,)
A) Cost of Preference Share Capital (K,)
Id) Cost of Debt, includes both Debentures, Bonds and Term Loans (Ka)

Cost of Equity Capital (K)

The funds required for the project are raised from the equity shareholders which are of permanent
nature. These funds need not be repayable during the life time of the organization. Hence it is a

permanent of funds. The equity shareholders are considered to be the owners of the
source

company. If the company' business is doing well the ultimate beneficiaries are the equity
shareholders who will get the return in the form of dividends from the company and the capital
appreciation for their investment. If the company comes for liquidation due to loses, the ultimate
and worst sufferers are the equity shareholders. Sometimes they may not get their investment back
during the liquidation process. Profits after taxation, less preference dividends paid out to the
preference shareholders, are funds that belong to the equity shareholders which are reinvested in

the company and therefore, those retained funds should be included in the category of equity. The

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 COST OF CAPTTA
FINANCIAL MANAGEMENT must earn on t
that a company
the minimum
rate of return
market price of the shar
F
of equity may be defined
as
cost so that
of an investment
project In
financed portion
equity share capital used in calculation of cost of equity. Ca
methods are
remain unchanged. The following

LDividend Yield Method this method, the

current market price per share. As per
expected on the
The dividend per share is value of all expected futur
rate that equates the present
cost of capital is defined as "the discount
of a share." This
the current market price)
dividends per share with the net proceeds of the sale (or related to the
market value of equity shares is directly
method is based on the assumption that the
dividends on those shares.

Ke Po

Where,
= Cost of equity capital

D Annual dividend per share on equity capital

= Current market price of equity share
Po allow for any
to be constant. t does not
This method emphasizes on future equity dividend expected
investment to grow
growth rate. But in reality, a shareholder expects the returns from his equity
Over timne.

on each equity share of 10.

Illustration 1: Radiant Ltd. is expected to disburse a dividend of 30
The current market price of share is { 80. Calculate the cost of equity capital as per dividend yield

method.

Solution:
Ke = 30/T 80 0.375 or 37.5%

llustration 2: Fox Ltd. issued 10,000 equity shares of 10 each at a premium of R 2 each. The
current issue expenses are of 5,000. The equity shareholders expects the rate of dividend to be
18% p.a. Calculate the cost of equity share capital. Will your answer be different if the current
market price of share is 21?

Solution: Since the equity shares are newly issued, the cost of capital of it can be calculated as
follows:
Ke
NP

Where,
D1 Expected dividend per equity share of current year
NP Net proceeds of each equity share
Net proceeds (10,000 Equity shares x12)-500-7 11,50
10,000 Equity shares per share
1.80
Ke 0.1565
11.50
or 15.65%
CA-IPCC 2.2 CA. RAJ K AGRAWAL
 COST OF CAPITAL
FINANCIAL MANAGEMENT calculation of cost of equity
taken as basis for
in case of existing equity shares, market price is to be
capital as follows:

e
?1.80
current year i.e.
Where, D1 Expected dividend per equity share of
Po Current market price equity share i.e. 21
per
Ke = 1.80/21 0.0857 or 8.57%

Dividend Growth Model not to remain

after year and
will dividend to increase year
Equity shareholders normally expect added to the
future growth in dividend is
constant in perpetuity. In this method, an
allowance for
expected
current market price
of a share reflects
Current dividend yield. It is recognized that the

future dividends. This model is also called as 'Gordon growth model.

Ke
Po
Where,
D Expected dividend per equity share
Current market price per equity share
Po
at a
Growth rate by which dividends are expected to grow per year
constant compound rate

llustration 3: The equity of Mercury Ltd. are traded in the market at 90 each. The expected
at the rate
Current year dividend per share is 7 18. The subsequent growth in dividends is expected
of 6%. Calculate the cost of equity capital.

Solution:
Ke =+0.06 0.20 +0.06 0.26 or26%

Illustration 4: Sun Ltd. has its shares of 10 each quoted on the stock exchange, the current price
per share is T 24. The gross dividends per share over the last four years have been R1.20, 1.32,
1.45 and 1.60. Calculate the cost of equity shares.

Solution:
Expected current year dividend

=1.60 X=R1.76
100
The dividends are growing@ 10% and are expected to continue to grow at this rate.

Ke 1.76
9 4 +0.10 = 0.07+ 0.10 = 0.17 or 17%
24

llustration 5: The detail of dividend paid by Cool Ltd. its

on existing equity shares of R 10 each for
the past 6 years is given below:

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 |FINANCIAL MANAGEMENT COST OF CAPITA

2004 2005 2006 2007 2008 2009

Year
Dividend pershare 1.05 1.10 1.16 1.21 1.27 1.34
The current market price of equity shares is 40. It is expected to maintain the fixed divida
dend
payout ratio in the future. The company has issued new equity shares of 10 each and the cost of
flotation is 0.50 per share. The expected dividend to be declared for the current year is 1A
t
0
Using the above information calculate the cost of equity capital.

Solution: During the last 5 years (The dividend of 2004 is compared with the dividend of 2009), th
dividend has increased from 1.05 to 1.34.
5%
D.
Ke
D Expected dividend ofcurrent year (2005) i.e., F 1.40
NP Net proceeds i.e., F10-70.50 = 9.50

0.1474+0.05 19.74%
Ke 0.05
9.50
0.1974 or

llustration 6: Bright Star Ltd. has its equity shares of 10 each quoted in a stock exchange has
market price of 56. A constant expected annual growth rate of 6%, and a dividend of 3.60 per
share has been paid for the current year. Calculate the cost of capital.

Solution:
Ke
Po
3.60 (1+0.06) + 0.06 =0.0681 +0.06 0.1281 or 12.81%
56

Price Earning Method

This method takes into consideration the earnings per share (EPS) and the market price of the share
It is based on the assumption that the investors capitalize the stream of future earnings of the share
and the earnings of a share need not be in the form of dividend and also it need not be disbursed to
the shareholders. It is based on the argument that even if the earnings are not disbursed as
dividends, it is kept in the retained earnings and it causes future growth in the earnings of the
company as well as the increase in market price of the share. In calculation of cost of equity share
capital, the earnings per share is divided by the current market price.
E
Ke M
Where, E = Current earnings per share M Market price per share

lustration 7: Prabhat Ltd. has 50,000 equity share of 10 each and its current market value is 45
each. The after tax profit of the company for the year ended 31 March, 2009 is 9,60,000
Calculate the cost of capital based on price /earning method.

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 FINANCIAL MANAGEMENT COST OF CAPITAL

Solution:
9,60,000 =19.20
EPS 50,000 equity share
19.20 = 0.4267 or 42.67%
Ke 45

LCapital Asset Pricing Model risk-free

The capital asset pricing model (CAPM) divides theof equity into two components, the
cost

return available on investing in government bonds and an additional

risk premium for investing in a
the average return on the overall
particular share or investment. This risk premium in turn comprises
market portfolio and the beta factor (risk factor) of the particular investment.

Ke Rr +B, (Rm- R)
Where,
Re = Risk-free rate of return

Rm Average market return

=Beta ofthe investment
investment is the
The appropriate discount rate to apply to the forecasted cashflows in an
the expected rate
opportunity cost of capital for that investment. The opportunity cost of capital is
of return offered in the capital markets for investments of a similar risk profile. Thus it depends
on

the risk attached to the investment's cashflows.

Illustration 8: Modern Ltd's share beta factor is 1.40 The risk free rate of interest on government
securities is 9%. The expected rate of return on company equity shares is 16%. Calculate cost of

equity capital based on capital asset pricing model.

Solution:
9% + 1.40 (16% -9%) = 9% +1.40 (7%) 18.8%
Ke

Sost of Preference Share Capital (K,)

The cost of preference share capital is the rate of return that must be earned on preference capital
financed investments, to keep unchanged the earnings available to the equity shareholders

Cost of Irredeemable Preference Shares

The cost of irredeemable preference share capital is the rate of preference dividend, also called the
coupon rate divided by net issue proceeds.

NP
Where,
Kp Cost of irredeemable preference shares
Preference dividend
NP Net proceeds received from issue of preference shares after meeting the
iSSue expenses

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 FINANCIAL MANAGEMENTT COST OF CAPITAI
lustration 9: Red Ground Ltd. has issued 10,00,000 irredeemable preference shares of 150.
at 15 per share. Calculate the
150 each
a coupon rate of 15% p.a. The issue expenses are preference
shar
capital

Solution:
Kp 30/185 = 16.22%

Cost of Redeemable Preference Shares

The cost of redeemable preference shares is calculated as follows:

D.S

K
Where,
Cost of preference shares
D Constant annual preference dividend payment
N Number of years to redemption
Rv Redeemable value of preference shares at the time of
Sv =
Sale value of preference shares less
redemption
discount and flotation expenses

llustration 10: Dell Ltd. has 100 preference share redeemable at a

premium of 10% with 15 years
maturity. The coupon rate is 12%. Flotation cost is 5%. Sale price is 95. Calculate the cost of
preference shares.

Solution:
12+ (

Kp 12+1.33 - 13.33
100 100
=
0.1333 or 13.33%

Çost of Debt (K)

The capital structure of a firm
normally includes the debt component also. Debt
of debentures,
bonds, term loans from financial institutions and may be in the forma
rate of interest banks etc. The debt carries a fixed
payable to them, irrespective of the
rate is fixed, the firm increases its
profitability of the company. Since the coupon
earnings through debt financing. Then, after
interest charges more payment of fixea
surplus is available for equity shareholders.
shareholders and preference shareholders is Dividends payable to equity
on debt is a
an
appropriation of profit, whereas the interest payabie
charge against profit. Therefore, any
and ultimately the payment towards interest will reduce the
company's tax liability would decrease. This profit
phenomenon is called 'tax shield-
CA-IPCC
2.6 CA. RAJ KAGRAWAL
FINANCIAL MANAGEMENT COST OFCAPITAL|
as a benefit accrrues to the company which is geared. To gain the full tax
The tax shield is viewed
conditions apply:
shield, the following of the tax
The company must be able to show a taxable profit every year to take full advantage
shield.
and cost of borrowing increases.
(i) if the company makes loss, the tax shield goes down

Cost of Perpetual Debt

The cost of perpetual debt (irredeemable debt) is calculated with the following formula:
I(1-
Ko NP

Where, Ka = Cost of debt

Annual interest payment
Company's effective corporate tax rate
NP Net proceeds of issue of debentures, bonds, term loans etc.

llustration 11: Maihar Cement Ltd. has issued 40,000 irredeemable 14% debentures of R 250 each.
The cost of flotation of debentures is 5% of the total issued amount. The company's taxation rate is
40%. Calculate the cost of debt.

Solution:
Total issued amount (40,000 debentures X 250) 1,00,00,000
Less: Flotation cost ( 45,00,000 X5/100) 5.00,000
Net proceeds from issue 95,00,000

Annual interest charge = 1,00,00,000 X 14/100 = 714,00,000

Ka 1(1-) 14,00,000 (1-0.40) = 8,40,000

8.84%
NP 95,00,000 95,00,0000

Cost of Redeemable Debt

The cost of redeemable debt is calculated
by applying the following formula:
Ka I (1-t) +(

Where,
= Cost debt

Annual interest payment

R =
Redeemable value of debt at the time of
maturity
Sale value less
N
di_count and flotation expenses
Number of years to maturity
Company's effective tax rate
CA- IPCC
2.7
 FINANCIAL MANAGEMENT COST OF CAPITA

Weighted Average Cost of Capital

Weighted average cost of Capital is defined as "as the average cost of the company's finance (eu
debentures, bank loans) weighted according to the proportion each element bears to the total
finance (equity
of capital, weighting is usually based on market valuations current yields and costs after tax po
Cost of capital is the overall composite cost of capital and may be defined
of each specific fund. A firm may procure long-term funds from various
as the average of the
r.Cos
sources like equity
shar
capital, preference share capital, debentures, term loans etc. at different cost depending on the ri
received by the investors. When all these costs of different forms of long-term funds weighted
their relative proportions to get overall composite cost of capital termed as 'weighted
t
of capital (WACC)'.
average co
llustration 12: ABC Ltd. has a gearing ratio of 40%. Its cost of equity is 21% and the cost of
debti
15%. Calculate the company's WACC.

Solution: WACC =
(21% X 0.60) (15% X 0.40) 12.6% +6% = 18.6%

llustration 13: The following figures are taken from the current balance sheet of Delaware &
Co
Capital 8,00,000
Share Premium
2,00,000
Reserves
6,00,000
Shareholder's funds
16,00,000
12% Perpetual debentures
4,00,000
An annual ordinary dividend of R 2 per share has
just been paid. In the past, ordinary dividends have
grown at a rate of 10 per cent per annum and this rate of growth is expected to continue. Annuai
interest has recently been paid the debentures. The
on
ordinary shares are currently quoted at
27.5 and the debentures at 80 per cent Ignore taxation.
You are required to estimate the weighted average cost of capital (based on market values) for
Delaware & Co.

Solution: In order to calculate the WACC, the

specific cost of equity capital and debt are to be
calculated as follows:
K =+B=2 X1.101 0 = 18%
27.50
The market value of equity is 80,000 X 27.50 22,00,000
K 15%
The market value of debt is 4,00,000 X .80 =
3,20,000.
Now, the WACC is (22,00,000/25,20,000) X.18+
(3,20,000/25,20,000) X .15 176 17.6% =

Note: In this case, the dividend

of 2 has just been paid. So, Do 2 and the D, i.e., dividend
expected after one year from now will be Do X (1+ g) 7X 1.10. =

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 FINANCIAL MANAGEMENT COST F CAPITAL

y, lustration 14: The following information has been extracted from the balance sheet of Fashions

Ltd
In Lacs
Equity Share Capital 400
e 12% Debentures 400
k 18% Term loan 1,200
2,000
t (a) Determine the weighted average cost of capital of the company. It had been paying dividends
at a consistent rate of 20% per annum. Shares and Debentures are being traded at par. Tax rate
is 40%
S (b) What difference will it make ifthe current price of 100 share is 160?

Solution: In the given case, the cost of Debt is : Rate of interest (1-t)
12% Debenture 12 X(1-40) =7.2%
18% Term Loan :18X(1-40) 10.8%
(a) The cost of capital after tax benefit:
Sources Cost Proportion Weighted cost
Equity 20.0% 4/20 4.00
12% Debenture 7.2% 4/20 1.44
18% Term loan 10.8% 12/20 6.48
Weighted average cost (%) 11.92

(b) The cost of capital after - tax benefit

In this case, the cost of debt would be same as above, but the cost of equity is 20 160 = 12.5%.
Now, WACC is as follows:
Equity 12.5% 4/20 2.50
12% Debenture 7.2% 4/20 1.44
18 Term Loan 10.8% 12/20 6.48
Weighted average cost (%) =10.42

liustration 15: XYZ Ltd. has issued 11% Debentures of R 100 each. These are being traded at ? 140
per debenture at present. The debentures are convertible into 5 equity shares per debenture. The
present market price of the equity shares is R 22 which is expected to increase @ 5% p.a. over next 5
years. Find out the cost of convertible debentures given the tax rate at 30%.

3ution: In the given case, the convertible debentures are being traded at R 140 per debenture. The
company has to pay interest of 11 per debenture for 5 years and thereafter it will be converted
into 5 equity shares. The market price of equity share is growing @5% p.a. So, the price of equity
share after 5 years would be:

CA-IPCC 2.9 CA. RAJK AGRAWAL

 FINANCIAL MANAGEMENT COST OF CAPITA
Ps 22 X( 1+.05)' =7 28.08
=

Kd 1(1-t)+ RV-NP/n
RVNP
28.08 x5-140
=
11 (1-.30) +
28.08 x5 140
2
7.7+ .08
140.20
= 5.55%

llustration 16: The following information is available from the Balance Sheet of a
Company:
Equity Share Capital -20,000 shares of R 10 each 2,00,000
Reserves and Surplus
T1,30,000
8% Debentures
1,70,000
The rate of tax for the
company is 30%. Current level of Equity Dividend is 12%. Calculate the
weighted average cost of capital using the above figures..
Solution:
Capital Structure Amount Proportion of Capital Structure
Equity Share Capital 2,00,000 40%
Reserves and Surplus 1,30,000 26%
8% Debentures 1.70.000 34%
5,00,000 100%

Capital Structuree Amount Proportion After tax Cost Weighted Cost

(weight)
Equity 2,00,000 40% 12% 12% X 40% = 4.80%
Reserves and Surplus 1,30,000 26% 12% 12% X 26% = 3.12%
8% Debentures 1,70,000 34% 5.6% 5.6% X 34% 1.90%
Total 5,00,000 100% 9.82%
As the current market price of equity share is not given, the cost of capital of
equity share has beer
taken with reference to the rate of dividend and the face value of the
share. So, ke 12/100 12% =

The opportunity cost of retained earnings is the dividends

foregone by shareholders. Therefore, the
firm must earn the same rate of return on retained earnings the
as on Equity Share Capital. Thus, the
minimum cost of retained earnings is the cost of
equity capital i.e., k, ke
=

llustration 17: PQR & Co. has the following capital structure Dec.
as on 31, 2010.
Equity Share Capital (5,000 shares of 100 each) 75,00,000
9% Preference Shares
2,00,000
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