Cost of Capital

Cost of Capital
 The cost of capital is the rate of return that the
suppliers of capital require as compensation for their
contribution of capital.
 The minimum rate of return expected by its investors.
 The capital used by the firm in the form of
◦ Equity shares
◦ Preference capital
◦ Retained Earnings
◦ Debt
 Cost of Capital
Itis the weighted average cost of various
sources of finance.
In case the company not able to achieve
the cut-off rate, the market vale of its
shares will fall down.
Return should be more than cost of capital.
Cost of Capital is expressed in terms of
Percentage.
Basic aspects of Cost of Capital

Cost of capital is not a cost as

such.
Minimum rate of return that a
firm requires.
Importance of Cost of Capital
It plays a critical role in capital
budgeting decisions.
It determines acceptability of all
investment opportunities.
It provides useful guidelines in
determining optimum capital structure
of a company.
 Problems in
Determination of Cost of Capital
Conceptual controversies regarding the
relationship between the Cost of capital
and the Capital structure.
Historic cost and future cost.
Computation of cost of equity (it depends on the
expected rate of return by the investors)

 Computation of cost of retained earnings

Assigning weights
Computation of Cost of Capital
Computation of Cost of Capital

Costof specific source of finance

Weighted Average Cost of Capital
Cost of specific source of Finance

Cost of Debt

Cost of Preference Capital

Cost of Equity Share Capital

Cost of Retained Earnings

Cost of Debt
Cost of Debt
1. Cost of Perpetual/Irredeemable Debt
2. Cost of Redeemable Debt
3. Cost of Zero Coupon Bonds
4. Floating or Variable Rate Debt
Net Value or Net Proceeds
Face value xxx
Less: Discount xx
Issue Price xxx
Less: Floatation Cost xx
Net Value (NV) xxx
Face value xxx
Add: Premium xx
Issue Price xxx
Less: Floatation Cost xx
Net Value (NV) xxx
 Cost of Perpetual/Irredeemable Debt
 It
is the interest payable on debt.
 Cost of Debt Before tax
x 100

1  Cost of Debt After Tax

x 100

Kd : Cost of Debt
I : Annual Interest
NP : Net value or Net Proceeds
t : Rate of Tax
 Cost of Perpetual/Irredeemable Debt
From the following calculate Cost of Debt.
a. X Ltd. Issues ₹50,000 worth of 8% debentures at
par. The tax rate applicable to the company is 50%.
Y ltd. Issues ₹50,000 worth of 8% debentures at
1 b.
10% at premium. The tax rate applicable to the
company is 60%.
c. A Ltd. Issues ₹1,00,000 worth of 8% debentures at
a discount of 5%. The tax rate is 50%.
d. B Ltd. Issues ₹1,00,000 worth of 9% debentures at
a premium of 10%. The cost of floatation cost is
2%. Tax rate is 60%.
 Cost of Redeemable Debt
 The debt is issues to be redeemed after a certain period
during the life time of a firm.
 It is the discount rate which equates the present value of
sale proceeds with the present vale of interest payments
and principal repayments.
2

Kd : Cost of Debt
V0 : Current Value or the issue price of debt
It : Net Interest payments at the end of years
Vn : Redeemable value of debt
n : Term of debt
 Cost of Redeemable Debt
 Shortcut Method (Before Tax)

2 Kd : Cost of Debt
I : Annual Interest payment
NP : Net value or Net proceeds
RV : Redeemable Value
n : Term of Debt
 Cost of Redeemable Debt
 Shortcut Method (After Tax)

2 Kd : Cost of Debt
I : Annual Interest payment
NP : Net Value or Net Proceeds
RV : Redeemable Value
n : Term of Debt
 Example – 1

A company issues ₹10,00,000 10%

redeemable debentures at a discount of 5%.

2 The cost of floatation amount to ₹30,000.

The debentures are redeemable after 5
years. Calculate before tax and after tax
cost of debt assuming a tax rate of 50%.
 Example – 2

Prudhvi Industries Ltd. issued 12%

debentures of face value ₹10,000 for 10

2 years at discount of 5%. The company

incurred floatation costs of 2% of issue
price. If the debentures are redeemable at
par, calculate Kd. Tax rate is 35%.
 Example – 3
A five year ₹100 debenture of a firm can be
sold for a net price of ₹96.5. The coupon rate
of interest is 14% per annum, and the debenture
will be redeemed at 5 per cent premium on
maturity the firm’s tax rate is 40%. Compute
the yield to maturity and the after tax cost of
debenture.
 Cost of Zero Coupon Bonds

 Companies issue bonds or debentures at

a discount from their eventual maturity

3 value and having zero interest rate.

 No interest is payable on such

debentures before their redemption.
 Procedure to calculate Cost of Debt
 Prepare the cash flow table using an arbitrary
assumed discount rates.
 Find out the net present value by deducting the
present value of the outflows from the present value
3 of the inflow.
 Ifthe NPV is positive, apply the higher discount rate
up to discount rate is negative.
 Ifthe NPV is negative at this higher rate, the cost of
debt must be between these two rates.
 Example – 4
X Ltd has issued redeemable zero coupon
bonds of ₹100 each (at a discount rate of

3 40%) repayable at the end of fourth year.

Calculate the cost of debt.
 Cash flow table at various Assumed Discount Rates

Cash flow
Year discount PV at 12% Cash flows PV at 14% Cash flows
factor
0 60 1.000 (60) 1 (60)
4 100 0.636 63.6 0.592 59.2
3.6 -0.8

Low PV at Low discounting factor

Differences
Cost of Debt = discount
ing PV at Low discounting factor - in Rates
factor PV at High discounting factor
Example – 5
Consider a ₹1,000 zero-coupon bond
that has two years until maturity. The
bond is currently valued at ₹925, the
price at which it could be purchased
today. Calculate Cost of Debt.
 Floating or Variable Rate Debt

 The interest rate changes basing upon the market

rate of interest payable on the prime lending rate
of the bank.
4  If a company agreed to pay interest rate on
floatation rate basis at ‘bank rate plus 5%’, if the
bank rate prime lending rate is 8% pa, the
company will pay 13% (8%+5%). If prime
lending rate falls to 5%, it will pay only 10%
interest to the investor.
Example – 6

Dheeraj & Co. raised a debt of ₹500 on

the terms that interest shall be payable at
prime lending rate of bank plus three
percent. The prime lending rate of the
bank is 7 per cent. Calculate cost of debt
assuming that the corporate tax is 35%.
Example – 7
Pankaj & Co. raised a debt of ₹1500 on the
terms that interest shall be payable at prime
lending rate of bank plus four percent. The
prime lending rate of the bank is 8 per cent.
Calculate cost of debt assuming that the
corporate tax is 30%.
Cost of Preference Shares
Cost of Preference Shares
A fixed rate of dividend is payable on
preference shares.
Cost of Preference Share is
represented as Kp.
Preference shares are classified into
◦ Perpetual Preference Shares
◦ Redeemable Preference Shares
Cost of Perpetual Preference Shares
(Perpetual shares)

Kp : Cost of Preference Share

Dp : Annual Payment of Preference Shares
NP : Net value or Net proceeds
Example – 8
A company issues 10,000 10%
Preference shares of ₹100 each. Cost
of issue is ₹2 per share. Calculate
Cost of Preference capital if these
shares are issues
(a) at par
(b) at 10% premium
(c) at 5% discount
Cost of Perpetual Preference Shares
(Redeemable shares)

Kp : Cost of Preference Share

Dp : Annual Payment of Preference Shares
NP : Net value or Net proceeds
RV : Redeemable Value
Example – 9

RK Industries Ltd. issued 10% preference

shares of face value ₹100 for 8 years at a
discount of 5%. The company incurred
floatation costs of 3% of face value. If
the preference shares are redeemable at
par, calculate Kp.
Example – 10

A company issues 10,000 10%

Preference Shares of ₹100 each
redeemable after 10 years at a premium
of 5%. The cost of issue is ₹2 per
share. Calculate cost of preference
share.
Cost of Equity Shares
Cost of Equity Shares
Equity shares doesn’t carry any fixed
rate of dividend and there is no
obligation for the firm to pay dividend.
Payment of dividend is not a legal
binding.
It may or may not be paid.
 Ways to Computation of
Cost of Equity Shares
1. Dividend Yield Method
2. Dividend Yield Plus Growth in
Dividend Method
3. Earning Yield Method/Earning Price
Ratio
 Dividend Yield 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 of a
share.’
 Dividend Yield Method

or

Ke : Cost of Equity Shares

D : Expected dividend per share
NP : Net Proceeds per share
MP : Market Price
 Example – 11

A company issues 1000 equity shares of ₹120

each at a premium of 10%. The company has
been paying 20% dividend to equity shareholders
for the past five years and expects to maintain the
same in the future also. Compute the Cost of
Equity capital. Will it make any difference if the
market price of equity share is ₹150?
 Dividend Yield Plus Growth in Dividend
Method

Ke = =

Ke : Cost of Equity Shares

D1 : Expected dividend per share at the end
of the year
NP/MP: Net proceeds per share/current
market price per share
G : Rate of Grow in dividends
D0 : Pervious year’s dividend
 Example – 12
• A company plans to issue 1000 new shares of
₹100 each at par. The floatation costs are
expected 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.
• If the current market price of an equity share
is ₹175, calculate the cost of existing equity
share capital.
 Example – 13

The shares of a company are selling at ₹50 per

share and it had paid a dividend of ₹5 per share
last year. The investor’s market expects a growth
rate of 5 per cent per year.

a) Compute the company’s equity cost of capital.

b) If the anticipated growth rate is 7 per cent per

annum, calculate the indicated market price per
share.
 Earning Yield Method /
Earning Price Ratio
Ke = or

EPS =

NP = Net Proceeds
MP = Market Price Per Share
 Example – 14

A firm is considering an expenditure of ₹60 lakh for

expending its operations. The relevant info. is as follows.
Number of existing shares – 10 lakh
Market value of existing share – ₹60
Net earnings – ₹90 lakh

Compute the cost of existing equity share capital and of

new equity capital assuming that new shares will be issues
at a price of ₹52 per share and the cost of new issue will
be ₹4 per share.
Cost of Retained Earnings

Retained earnings accrue to a firm only

because of some sacrifice made by the
shareholders in not receiving the
dividends out of the available profits.
Cost of Retained Earnings
Or

Kr = Cost of Retained Earnings

D = Expected Dividend at the end of the Year
NP = Net Proceeds of share issue
G = Growth Rate
MP = Market Price
Kr with tax and cost adjustment

Kr = Cost of Retained Earnings

Ke = Rate of return available to Equity Share holders
t = Tax Rate
b = Brokerage cost
 Example – 15

A firms Ke is 20%, the average tax are of

shareholders is 40% and it is expected that
5% is brokerage cost that shareholders
will have to pay while investing their
dividends in alternative securities. What
is the cost of retained earnings?
Weighted Average Cost of Capital
The average cost of the cost of various
sources of financing.
It is also known as
◦ Composite cost of capital
◦ Overall cost of capital
◦ Average cost of capital
Weighted Average Cost of Capital
Kw =
Kw = Weighted average cost of capital
X = Cost of specific source of Capital
W = Weight, proportion of specific source
of finance
Example – 16

A firm has the following capital structure and after-tax

costs for the different sources of funds used.
Source of funds Amount (₹) Proportion (%) After-tax Cost (%)
Debt 15,00,000 25 5
Preference shares 12,00,000 20 10
Equity shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
Total 60,00,000 100 -

You are required to compute the weighted average

cost of capital.
Example – 17
A firm has the following capital structure and after-tax
costs for the different sources of funds used.
Source of Funds Amount (₹) After tax cost (%)
Debt 40,00,000 4.50
Preference Shares 20,00,000 9.00
Equity Shares 60,00,000 11.00
Retained Earnings 80,00,000 10.00
You are required to compute the weighted average
cost of capital.
Example – 18
Continuation to the example 2, If the firm
has 18000 equity shares of ₹100 each
outstanding and the current market price
is ₹300 per share, calculate the market
value weighted average cost of capital
assuming that the market values and book
values of the debt and preference are
same. Company does not maintain
retained earnings.
Source
Shashi K Gupata, RK Sharma & Neeti
Gupta, Financial Management, 9/e,
Kalyani Publishers, New Delhi, 2018.