Financial Management,

Chapter.5

(Outcome 5 and 6 – Use the time value of money to value the cost of capital. Evaluate the
cost of debt, preferred stock and common stock)

Cost of capital

The term cost of capital can be defined in two ways.

As a borrower of capital (for a firm), cost of capital is the rate at which funds can be borrowed
or new equity capital issued.
As a lender of capital (Investor), cost of capital is the minimum rate of return expected from
investment.
The operational definition of cost of capital is “the minimum rate of return expected by a firm
from its investment projects to pay a fair return to investors to unchange the market value of
a firms/share”.

Significance of cost of capital

1. As an acceptance criterion in capital budgeting

2. Designing firms capital structure or capital mix
3. Deciding the method of financing
4. Dividend decision.

Cost of various sources of Capital

Cost of Debt (Kd)

Cost of debt is the interest payable on debt or debentures

Interest
Before tax Cost of Debt (Kd) = Net proceeds

Interest x (1-tax rate)

After tax Cost of Debt (Kd) Net proceeds

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Financial Management,

Example # 1
A. X Ltd issues RO 50,000, 8%debentures at par. The tax rate of the company is 50%.
Compute cost of debt
B. Y Ltd issues RO 50,000, 8% Debentures at a premium of 10%. The tax rate applicable
to the company is 40%. Compute cost of debt capital
C. A Ltd issues RO 50,000, 8% debentures at a discount of 5%. The tax rate applicable is
30%. Compute the cost of debt
D. B ltd issues RO 100,000, 9% debentures at a premium of 10%. The cost of floatation is
2%. The tax rate applicable to the company is 50%. Compute the cost of debt

Answer

Cost of Preference Capital (Kp)

The cost of preference capital is a function of the dividend expected by investors. Although it
is not legally binding upon the firm to pay dividends on preference capital, yet it is generally
paid when the firm makes sufficient profits. Cost of preference capital can be calculated using
the following equation.

Cost of preference Capital (Kp) = Dividend

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Financial Management,

Net Proceeds
Example # 2
A company issues 10,000, 10% preference shares of RO 100 each. Cost of issue is RO 2 per
share. Calculate cost of preference capital if these shares are issued
a. at par
b. at 10% premium
c. at 5% discount
Answer

Cost of equity capital (Ke)

Share holders invest money in equity shares on the expectation of getting dividend and the
company must earn this minimum rate, so that the market value of the firm remains
unchanged.

Cost of equity capital (Ke) = Expected dividend per share

Net proceeds or Market price per share
Example # 3
A company issues 1000 equity shares of RO 100 each at a premium of 10%. The company has
been paying 20% dividend to equity share holders for the past five years and expects to
maintain the same in the future. Compute the cost of equity. Will it make any difference if the
market price of the equity share is RO 160.
Answer

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