Cost of Capital

Cost of Finance (Cost of Capital)

 The overall cost of funds based on various mix of sources
of funds.
 Useful for evaluation of projects.
 Helpful in designing the debt mix of the firm.
 Evaluation of financial performance of the top
management.

Cost of capital is called the “cut-off rate”, “target rate”,

“hurdle rate” and “required rate of return”.
Impact of Risk on Cost of Funds
Classification of Cost of Capital

+ Explicit Cost (Rate pays by the firm to procure finance)

+ Implicit Cost
+ Average Cost (Weighted Average Cost of Capital)
+ Marginal Cost (Weighted Marginal Cost of Capital)
+ Historical Cost
+ Future Cost
+ Specific Cost
+ Combined or Composite Cost
Measurement of Specific Cost

 Cost of Debt (Kd)

 Cost of Preference Shares (Kp)
 Cost of Equity (Ke)
 Cost of Retained Earnings (Kr)
Cost of Debt (Kd)
+ Cost of debt is the expected cost of funds raised through the
debentures, bonds etc. (fixed income securities).
+ Tax benefit is available on the interest payment under the Income
Tax Act.
+ Concept of Floatation cost
+ Issue of Debt at
 Par
 Premium
 Discount
+ Redemption (Repayment) of Debt at
 Par
 Premium
 Discount
Measurement of Cost of Debt (Kd)
 Perpetual/Irredeemable Debt

 Redeemable Debt
Measurement of Cost of Debt (Kd)
Supreme Packaging Limited is engaged in the business of manufacturing
of woolen cloths and planning to commence a new plant at Panipat.
The board of Directors has approved the raising of funds through 10%
Debentures of Rs. 500 Crores with the face value of Rs. 1000 each.
Following expenses has also been approved by the board related these
issues:
Underwriting Charges – 2.5%
Roadshow Cost – Rs. 10 per Debentures
Compliance Cost – 1%
Other Cost – 1%
Calculate the cost of debt of the company considering the availability
of Income Tax benefit.
Cost of Preference Shares (Kp)

 Perpetual/Irredeemable Preference Shares

 Redeemable Preference Shares

Cost of Preference Shares (Kp)
Supreme Packaging Limited is engaged in the business of
manufacturing of woolen cloths and planning to commence a new
plant at Panipat. The board of Directors has approved the raising of
funds through 10% Prefence Shares of Rs. 500 Crores with the face
value of Rs. 100 each. Following expenses has also been approved
by the board related these issues:
Underwriting Charges – 2.5%
Roadshow Cost – Rs. 10 per Shares
Compliance Cost – 1%
Other Cost – 1%
Calculate the cost of Preference Shares of the company.
Cost of Preference Shares (Kp)
Face Value – Rs. 100, Dividend – 10%, Fund Requirement – Rs. 500 Crores
Calculation of Net Proceeds (Per Preference Shares)
Net Proceeds = Face Value ± Premium/Discount – Flotation Cost
Flotation Expenses (Cost)
Underwriting Charges – 2.5% Rs. 2.50
Roadshow Cost – Rs. 10 per Shares Rs. 10
Compliance Cost – 1% Rs. 1.00
Other Cost – 1% Rs. 1.00
Total Rs. 14.50

Net Proceeds = Rs. 85.50 (Rs. 100 – Rs. 14.50)

Preference Dividend – 10% of Rs. 100 i.e. Rs. 10
Cost of Preference Shares (Kp)

Kp = 11.70%
Cost of Preference Shares (Kp)
If the company decided to redeem the preference shares at the end of five
years and the issue has been decided at 5% premium.
Flotation Expenses (Cost)
Underwriting Charges – 2.5% Rs. 2.625 (2.5% of Rs.
105)
Roadshow Cost – Rs. 10 per Shares Rs. 10
Compliance Cost – 1% Rs. 1.05 (1% of
Rs. 105)
Other Cost – 1% Rs. 1.05 (1% of
Rs. 105)
Total Rs.
14.725

Net Proceeds = Rs. 90.275 (Rs. 105 – Rs. 14.725)

Cost of Preference Shares (Kp)

Kp = 12.55%
 Cost of Equity Shares (Ke)
Cost of Equity
Shares (Ke)

Dividend Yield Capital Assets

Earning Yield Dividend Yield
with Growth Pricing Model

𝐸𝑃𝑆 𝐷 𝑃𝑆 𝐷 𝑃𝑆
𝐾 𝑒=
𝑀𝑃𝑆
𝑥100 𝐾 𝑒=
𝑀𝑃𝑆
𝑥100 𝐾 𝑒=
𝑀𝑃𝑆
𝑥100+𝐺 𝐾𝑒=𝑅𝑓+β(𝑅𝑚−𝑅𝑓)
Cost of Retained Earnings (Kr)
The cost of retained earnings is equal to the cost of equity.
Cost of retained earnings are not being calculated where the cost
of equity has been measured on market value basis.

Growth Measurement:
Retention Ratio x Return on Equity
(EPS – DPS)/EPS x ROE
(1 – Payout Ratio) x ROE
Calculation of Average Cost of Capital
 Proportionate Basis Cost of the firm
 Book Value Basis
 Debenture/Bonds/Term Loans
 Preference Shares
 Equity Shares
 Retained Earnings
 Market Value Basis
Suitable only for the who has listed all the financial
instruments through which the funds has been raised.
Weighted Average Cost of Capital (WACC)

Process of measurement of WACC:

Consider the overall sources of funds
Calculate weighted contribution of each source of funds
Calculate cost of each sources
Sum total of overall cost of funds
Weighted Average Cost of Capital (WACC)
Equity Share (FV = Rs. 100) Rs. 100 (CMP –
Rs. 15,000)
Retained Earnings Rs. 10,000
10% Preference Share Capital (FV = Rs. 10) Rs. 1000
10% Bonds (FV = Rs. 1000) Rs. 900
8% Term Loan Rs. 3,000
Total Rs.
15,000
EPS – Rs. 10, Dividend Payout Ratio – 40%, ROE = 15%
The company is having the policy for redemption of fixed income securities to 5 years
at 10% premium.
Applicable Tax Rate – 25%
Calculate WACC and advice the company for cut off rate related to acceptance or
rejection of project.
Marginal Cost of Capital
+ It is the cost of additional funds
+ Suitable for measuring the break even point of new projects
+ Cost of marginal cost shall be higher if retained earnings has
been fully used for financing the new project.
+ It is used for evaluate the project feasibility of new project.
+ Components of Marginal Cost of Capital
 Marginal Cost of Equity
 Marginal Cost of Debt
 Marginal Cost of Preference Shares
+ Marginal cost of capital is being measured using the concept of
WACC for additional funds only.
Marginal Cost of Capital
The existing capital structure of the company is
Sources Amount (In Lacs) Weight (%) Cost (After Tax)
Equity Shares 500 50 13%
Preference Shares 300 30 10%
Debt 200 20 8%
Total 1,000 WACC = 11%

The company is planning to expand the business through introducing a new project.
Rs. 500 Lacs is required for the new projects. The company wants to raise the funds
only through Equity and Debt using the debt equity ratio of 2:3.
Calculate the WMCC.