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COST OF CAPITAL
COST OF CAPITAL
COST OF CAPITAL
8% (ii) After-tax cost of redeemable debt 1 Kl-)+ (RV-NP) 100000 ; 7 Ku 7 e 004 1-05) (10,00,000- -9,20,000) T 2BV+NP) econo +9200, 50,000 +16,000 _ 66,000 9,60,000 875% . The coupon im on maturity. ion 4. A 5-year % 100 debenture of a firm can be sold for a net price of & 96.5 of imerest is 14 per cent per annum, and the debenture will be redeemed at 5 per cent pre firm’s tax rate is 40 per cent. Compute the after-tax cost of debenture. tion : Before-tax cost of debt-redeemable at premium tL (RV-NP) D Kay = I = (RV+NP) ave 14+ 1105-96 50) 4.105+96.50) Alter-tax cost of debt redeemable at premium yay + (Rv-NP) i 105 +-96.50) 3! ) = 8404.70 _ 10.10 _ gorse 100.75, 100.75 © scanned with OKEN Scannernuney vse 1s payable irrespective OT te Tat! can be calculated as below : ee 1 + Inflation Rate Mstration 9. Excel Ltd. has issued 5000 10% Debent Calculate the real cost of debt. ures of € 100 each. The rate of inflation is 6y, . __ 1+ Nominal Cost of Debt eee adda 1 + Inflation Rate _ 140.10 _ 1.10 ~ 740.06 1.06 = 1.03774 Or say 3.77% 2. COST OF PREFERENCE CAPITAL A fixed rate of divided is payable on preference shares. of the Board of directors and there is no legal binding to pay dividend, capital is cést free. The cost of preference capital is a function of dividend expected by its investors, ie, its stated dividend. In case dividends are not paid to preference shareholders, it will affect the fund raising capacity of the firm. Hence, dividends are usually paid regularly on preference shares except when there are no profits 10 pay dividends. The cost of preference capital which is perpetual can be calculated as : D Though dividend is payable at the discretion yet it does not mean that preference where K,= Cost of Preference Capital © scanned with OKEN ScannerPreference capital ‘ Dd . coptel wad mu tC D= Annual Preference Dividend We Preference Share Capital (Proceeds ) if preference shares are issued at Premi rte, if Pre remiun oF Discount o fuse proference shares, the nominal or par Value of preference she 8 oat re ico ie net proceeds from the issue of he find OU! NP. ymay be noted that as dividends are E ce share capital h Preference shares, tn suc Pital has to be adjusted fade ted with the following formula " sch A case, the cost of ‘ ea "ot allowed 10 be deducted in computation oft, no edfsimea ied for taxes. 7 required J ® i Sonetmes Redeemable Preference Shares are sued which canbe redeemed or canceled on rmaturi ux Theos of redeemable preference share capital can. be ealeuien Y ps MV-NP where, K 5 1V = Maturity Value of Preference Shares a let Proceeds of Preference Shares, Cody ration 10. A company issues 10,000 10% Preference Shares of € 100 each. Cost of issue is Z . Calculate cost of preference capital if these shares are issued (a) at par, (b) at a premium of 10%, (c) at a discount of 5%. Annual Preference Dividend D Cost of Preference Capital, Kp NP | 1,00,000 = 1,00.000 199 = 10.2% || @ p= qo;p0o00£20,000 5 = 9,80,000" 100,000 100 ® Xp 1,00,000 » 7 70.80.0001 eer 6 7 1,00,000 x100 i 10,00,000-50. = 100,000 5.109 ~ 9,30,000 fe = 10.75% Preference Shares of € 100 each redeemable after 10 ni ee eae share. Caleulate the cost of preference capital ‘mium of 5%, The cost of issue is +] © scanned with OKEN Scanner) acm Costercenig _ 1.07.00. 100 = 10.54% 10.15.00 000-726 Preference Shares of € 100 each at a premium of, \ company issues 1 ; + of preference capital. MusteStion 12. us Contpute the cost ( redeemable“after $ years at pay Solution : 7 p+1(Mv-NP) n Listvenr) 4(1,00,000+ 110,000) _7,000-2.000 1,05,000 = 5.000_ 5100 = 4.76%. 1,05,000 100 3, COST OF EQUITY SHARE CAPITAL. ‘The cost of equity is the ‘maximum rate of return that the company must For Xt equity financed portion of its investments in order to leave unchanged the market price of its stock.’ The cost of equity capil ity is not the out-of-pocket cost of usins yon function of the expected return by its investors. The cost of equi Halders are not paid dividend at a fixed rate every year. Moreover, payret equity capital as the equity sharel seiividend is not a legal binding. It may or may not be paid. But it does not meal that equity share capita is a cost free capital. Shareholders invest money in equity shares on the expectation of getting dividend and the company must earn this minimum rate so that the market price of the shares remains unchanged. Whenevs company wants to raise additional funds by the issue of new equity shares, the expectations of Shaochelders have to evaluated, The cost of equity share capital, can be computed in the following ways: 7 @) Dividend Yield Method or Dividend/Price Ratio Method. According to this method, the cost of ‘equity capital is the ‘discount rate that equates the present value of expected future dividends per share with the net proceeds (or current market price) of a share’. Symbolically. where, D=Expected dividend per share ao NP = Net proceeds per share fall MP-=Market Price per share. dividers el assumptions underying this method are that the investors give prime im the om n le ee lunchanged. The dividend price ratio method does not seem 10 account 3He capital es not consider future earnin, i 4 (i it does ney s igs or retained earnings, and (#) it e company wins. This method of computing cost of equity capital is suitable only when stable eamin, flustraticn gy int® and stable dividend policy over a peri i BA y period of time. ett cor En paying 20% ay company issues 1000 equity shares of € 10 jum off ; 10 each 9f 10%. The lend to equity shareholders for the past five Ee eros maintain the af © scanned with OKEN Scanneros 5.13 Iso. Compute the cost of equity capital, W she future ill it make a ithe Oc My difference if the market price of equity solution # 20 119% 00 = 18.18% Ifthe market price of a equity share is Ra. 160, K-2 MP (©) Dividend Yield Plus Growth in Dividend Method. When the dividends ofthe firm are expected to grow at constant rate and the dividend-pay-out ratio is constant this method may be used to compute the cost of equity capital. According to this method the cost of equity capital is based on the dividends and DL yg. Pall the growth rate. te where K, = Cost of equity capital D, = Expected Dividend per share at the end of the year NP = Net proceeds per share G = Rate of growth in dividends rrevious year’s dividend. Further, in case cost of existing equity share capital is to be calculated, the NP should be changed with MP (market price per share) in the above equation. Dy kK =—6+G6 MP QR itustation 14 (a) A company plans to issue 1000 new shares of € 100 each at par. The floatation cost are exfected to be 5% of the share price. The company pays a dividend of 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares. (b) If the current market price of an equity share is € 150, calculate the cost of existing equity share capital, Solution : = 10 590 = 6.67% + 5% =11.67% 150 _UNGtration 15. ‘The shares of a company are selling at € 40 Vy an ae aera (84 per share last Year. The investor's market expects a growth rate o pe | (@) Compute the company’s equity cost of capital + (6) Ifthe anticipated growth rate is 7 per eent per annum calculate the indicated market price per share, © scanned with OKEN ScannerSd Solution : Alternatively ; Net Proceeds EPS “NP. where, the cost of existing “apital is to be calculated Kk, =—Eamings per share ° Market Price per share ~ EPS “MP This method of computing cost of equity capital may be emplo: (© When the earnings Per share are expected to remain constant (When the dividend Pay-out- ratio 100 per cent or when the reten WLltble profits are distributed oa dividends Git) When a fi wcted (0 earn an amount on new equity shares Gurren rate of earnings q &t price of the share js Mustration 16. A finn ig relevant information is as follows: in the folowing cases tion ratio ig ero, capital, which fluenced only by earnings per aie expenditure of & 60 lakhs fo considering an © scanned with OKEN Scanner305. or ae 989, 108s 1 #Key 3 Ro oe ethod usi c (Ke) (Ke-0.12) 3 and error method using py lue tables, we find that Sjayzanen “Ke (14K) goo scount rate, the equation becomes Ne MM tha K L440 7 byt wy 305.8 5 0877) 5.90 (0.769) + 6.96 (0.675) 4 8.24 (0.592) + 9.69 (0,519) 305.8 = 4.3944, 5-41,70-44. 8645.03 10.85 ’) OS (0519) +281.56. 3058 =305.8 i g cOMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL, Weighted average cost of capital is the ave : ital in proportion of th yess of finds to the total. The weights may be given ei i Pe eee talue ofthe source, IF there is a difference between market value and book value weights, the weighted average cost of capital would also differ. The market value weighted average cost would be overstated if the market value of the share is higher than the book value and vice-versa. The market value weights are sometimes preferred to the book value weights because the market value Tepresents the true value of the investors. However, the market value weights suffer from the following limitations : (i) It is very difficult to determine the market values because of frequent fluctuations. (i) With the use of market value weights, equity capital gets greater importance. For the above limitations, it is better to use book value which is readily available. Weighted average cost of capital can be computed as follows : EXW Ky = =¥ “Ew 5 where, K.= Weighted average cost of capital : X= Cost of specific source of finance cx W= Weight, proportion of specific source of finance : Mlusfration 19. A firm has the following capital structure and after-tax costs for the different sources of funds“ised Source of Funds agit Proportion Aeriaxcos Pebt 5,00,000 5 : *clerence Shares 12,00,000 Equity Shares 18,00,000 30 e Retained g 15,00,000 25 ined Earnings 5004 iz Tovat 60.00,000 00 Sony, Ot Me Fequired to compute the weighted average cost of capital. lution » Computation of Weighted Average Cost of Capital : Cost Weighted Cost % a Proportion % Proportion x Cost "02S Of Funds % 0 OM w 3 125 23 © scanned with OKEN ScannerS18 Proference shares equity Shon Retained Earnings Average Cost of Capital We the firm has 18,000 equity shares of 100 each ou culate the market value weighted average cost fhe debt and preference capital are same, stan, 20. Cor ation 19, it Mlustration 20, Continui of a and the current market price is € 300 per share, cale hhat the market values and book values of ( Solution = ‘Computation of Market ValueWeighted Average Cost of Capital Fi Amount QF Proportion Cost Weighted Ce Sources of Funds mm % Propet. w x XW | Debt 15,00,000 18.52 5 053 Preference Capital 12,00,000 14.81 10 148 Equity Share Capital (18000 shares @ & 300) 54,00,000 12 8.00 Weighted Average Cost of Capital Ulustration 21. The following is the capital structure of Saras Ltd. as on 31-12-2007 : Equity Shares —20,000 shares of @ 100 each 10% Preference Shares of 100 each 12% Debentures The market price of the company’s share is 110 and it i ividend 0 se is expected that a dividend of & 10 per: would be declared after 1 year. The dividend growth rate is 6%. ieee ‘ a oe Sa in the 50% tax bracket, compute the weighted average cost of capital. - - : ing a ied to finance an expansion plan, the company intends to borrow a fund of capital? This Fatale oF interest, what will be the company's revised weighted averast ? anit decision is expected to increase dividend from & 10 to & 12 pers! However, the market pric i a Price of equity share is expected to decline from & 110 to 105 pets" Cost of Equity Capital SO mp *100+G Cost of Equity Capita Auty Capital (Before Raising Term Loan) _ = Tip * 100+6% = 9.09 + 6% = 15.09% 12 Tos * 100+ 6% w ee = 1143 + 6% = 17.43% ‘Source of Fe n of Weight “ Mrce Of Funds ct Average Cost of Capital (Before Raising Term Loan) git Properion % | BeforeTax After Tax We) ery Cost (%) Cost (%) 7S 30 1505 15.00 : Revise "Sed Cost of Eguity Capitay (After ng Term Loan) = © scanned with OKEN Scanner