Cost of Capital

Basic concepts
• It is the minimum rate of return that a firm must generate on
its investments in the form of shares, loans or debentures.

• It is that discount rate which is used in determining the present

value of the estimated future cash flows from a project.

• It is also referred as cut-off rate, target rate, hurdle rate,

minimum required rate of return, discount rate, and so on.

• It is related to the firm’s objective of wealth maximization.

• The firm should avail of only such investment opportunities

which promise a rate of return higher than the cost of capital.
 Basic assumptions

• Business risk of the new investment is the

same as the average business risk of existing
investments

• The capital structure of the firm will not be

affected by new investments – financial risk
remains the same
If a firm’s rate of return on its investments exceeds its cost of capital, equity
shareholders benefit.

Consider a project that requires Rs. 100 million investment and it generates a rate
of return = 12%. What would be the return on equity funds employed in the
project, if If ke = 14% and kd = 6%? Assume that debt equity ratio is 1:1

The average cost of capital will be = 14*0.5 + 6*0.5 = 10%

ROE
Cost of debenture

Consider a bond having a face value of Rs. 1000, coupon rate 12%, number of
years to maturity 4 and the current price as Rs. 1040. What will be the cost of
debenture if the prevailing tax rate is 50%?
Cost of term loan

Cost of preference capital

Consider a preference share having a face value of Rs. 100, dividend of 11%,
number of years to maturity as 5 and the current price as Rs. 95. What will be the
cost of preference share?
Cost of equity
CAPM approach

DDM approach

P/E approach
The cost of equity will be equal to the inverse of P/E ratio under two conditions

1. When the firm pays out 100% dividends

2. When the cost of equity will be equal to the ROE

Cost of retained earnings and external equity

ABC Ltd has got Rs. 100 lakh of retained earnings and Rs. 100 lakh of external
equity through a fresh issue, in its capital structure. The equity investors
anticipate a rate of return of 18%. The cost of issuing external equity is 5%.
What would be the cost of retained earnings and cost of external equity?

The cost of retained earnings,

The cost of external equity raised by the company,

 Weighted average cost of capital (WACC)

A1 Ltd has assets of Rs. 280000 which have been financed with
Rs. 64000 debt, Rs. 110000 equity and a general reserve of Rs.
18000. The firm’s total profits after interest and taxes for the year
ended March 31, 2019 were Rs. 25700. it pays 13% interest on
borrowed funds and falls in 60% tax bracket. It has 1000 shares of.
Rs. 110 each which are currently selling for Rs. 125 per share. If
the firm pays 60% of its earnings as dividends, calculate
1. EPS
2. Cost of debt
3. Cost of equity
4. WACC
1.

2.

3.

4.
 Weighted average cost of capital (WACC)

Particulars Rs.
Equity capital (80000 shares @ Rs. 10 each) 100,00,000
15% preference capital (6000 shares @ Rs. 100 each) 621,000
14% debentures (1000 debentures @ Rs. 1000 each) 970,000
16% term loan 800,000

The dividend per share expected next year is Rs. 3.5 which is expected
to grow at 12%. Preferential shares are redeemable after 5 years at a
premium of 5% and debentures are redeemable at face value after 10
years. If the applicable tax rate is 40%, determine the WACC using
market value as weights.
 Weighted marginal cost of capital
A schedule showing the relation between additional financing and weighted
average cost of capital is referred to as the weighted marginal cost of capital
schedule

1. Estimate the cost of each source of financing for various levels of its use
through an analysis of current market conditions.

2. Given the ratio of different sources of finance in the new capital structure,
find out the level of total new financing at which the cost of various sources
would change. These levels are called a breaking points (BP).

3. Calculate the WACC for various ranges of total financing b/w the BPs

4. List out the WACC for each level of total new financing. This is the weighted
marginal cost of capital schedule
Crypton Ltd is planning to raise capital in the following proportion

Equity 0.50
Preference 0.20
Debt 0.30

The cost these three sources of finance for different levels of usage has been
estimated as

Source of Range of new financing from the source

Cost (%)
finance (In Rs. Mn)
0-15 16
Equity 15-25 17
25 & above 18
0-3 14
Preference
3 & above 15
0-20 8
Debt
20 & above 10
 Calculation of breaking points

Source of Cost Range of new financing from BP (in Rs. Range of total new financing
finance (%) the source (In Rs. Mn) Mn) from the source (In Rs. Mn)
16 0-15 15/0.5 = 30 0-30
Equity 17 15-25 25/0.5 = 50 30-50
18 25 & above - 50 & above
14 0-3 3/0.2 = 15 0-15
Preference
15 3 & above - 15 & above
8 0-20 20/0.3 = 66.67 0-66.67
Debt
10 20 & above - 66.67 & above
WACC for various ranges of total new financing
Range of total
Source of
new financing Proportion Cost WACC (%)
finance
(In Rs. Mn)
Equity 0.5 16 8.00
0-15 Preference 0.2 14 2.80
Debt 0.3 8 2.40
  WACC   13.20
Equity 0.5 16 8.00
15-30 Preference 0.2 15 3.00
Debt 0.3 8 2.40
  WACC   13.40
Equity 0.5 17 8.50
30-50 Preference 0.2 15 3.00
Debt 0.3 8 2.40
  WACC   13.90
Equity 0.5 18 9.00
50-66.67 Preference 0.2 15 3.00
Debt 0.3 8 2.40
  WACC   14.40
Equity 0.5 18 9.00
66.67 & above Preference 0.2 15 3.00
Debt 0.3 10 3.00
    WACC   15.00