COST OF CAPITAL

Introduction
Important input in the capital budgeting It helps in determining present value Called weighted average of the cost Major long term sources of funds are 1) Debt , 2) preference shares, 3)retained earnings, and 4) equity capital Each source of fund has its cost called the specific cost of capital

SPECIFIC COST OF CAPITAL

SPECIFIC COSTS OF CAPITAL COST OF DEBT 1) Perpetual debt Ki= I/SV Kd= I/SV (1-t) where Ki= before tax cost of debt Kd= after tax cost of debt I= annual interest payment SV= amount of debt t= tax rate

EQUITY CAPITAL

COST OF EQUITY CAPITAL

DIVIDEND APPROACH METHOD:Ke = cost of equity capital D1 = expected dividend per share at the end of the year

Po = current market price

f = flotation cost g = growth in expected dividends

FORMULAE-: Ke = [D1/Po (1-f)]+g

CAPITAL ASSET PRICING MODEL (CAPM) APPROACH

Rf = required rate of return on risk free investment b = beta coefficient Km = required rate of return on market portfolio, i.e , the avg. rate of return on all assets. FORMULA:-

Ke = Rf + b(Km Rf )

WEIGHTED AVERAGE COST OF CAPITAL

Ko = overall cost of capital Wd = percentage of debt to the total capital Wp = percentage of preference shares to the total capital We = percentage of external equity to total capital Wr = percentage of retained earnings to total capital
Formula

Ko = KdWd +KeWe+KrWr

Problem
A financial consultant of HPCL recommends that the firm should estimate its cost of equity capital by applying the capital asset pricing model rather than the dividend yield plus growth model. He has assembled the following facts: (i) Systematic risk of the firm is 1.4 (ii) 182 days Government treasury bills currently yields 8% (iii) Expected yield on the market portfolio of assets is 13%

Determine the Cost of Equity Capital based on the above data

Formula
Cost of equity capital
where
Rf = Required rate of return on risk free investment b = Beta coefficient Km =Required rate of return on market portfolio, ie., the average rate of return on all assets

Solution To the Problem

Cost of Equity Capital Ke =R f +b(Km-Rf)

= 8% + 1.4(13%- 8%) = 15%

Note: Yield on treasury bills is considered a good proxy for risk free required rate of return

 Indian oil corporation sold Rs 1,000 16%debentures

carrying no maturity date to the public 5 years ago. Interest rate since have risen so that the debentures of the quality represented by this company are selling at 14% yield basis.
i.

ii.

Determine the current indicated market price of debentures would you buy the debentures for Rs 12,00? Assuming that the debentures of the company are selling at Rs 1,040 and if the debentures have 8 years to run to maturity, compute the approximate effective yield an investor would earn on his investment .

SOLUTION
i.

Vd= Interest on debentures(I) =Rs 160

=Rs 1,143

Current interest rate (Kd) 14% (No,the debenture is not worth purchasing for Rs 12,000)
ii.

Rs 825 = Rs 120 + Rs 1000 (1 + Kd)t (1 +Kd)8 Let us try the discount rates of 15% and 16% as coupon rate is 15%.
PV Year 1-8 8 Cashflow Rs 160 1000 15% 4.487 0.327 16% 4.344 0.305 TOTAL PV 15% Rs717.92 327.00 1,044.92 16% Rs 695.04 305.00 1,000.04

Effective yield=15%

WORK PROBLEM 2
2. Equity Shares of Essar Global are currently selling for Rs. 125 per share. The company expects to pay Rs. 15 per share as dividend at the end of the coming year and the estimated growth rate is 6%. It is expected that new equity shares can be sold at Rs 123; the company expects to incur Rs 3 per share as floatation cost. What is the cost of equity capital? SOL: Ke = D1 Po (1-f)
+

g = 15/120 + 0.06 = 18.5 %