Cost Capital

By Monika Verma
 Cost of Capital
The cost of capital is the rate of return the company has to
pay to various suppliers of funds in the company.

Cost of capital is defined ‘as the minimum rate of return

that a firm must earn on its investments so that market
value per share remains unchanged’.

It is also referred to as cut off rate, target rate, hurdle rate,

minimum required rate of return and standard return etc.

Any investment which does not cover the firm’s cost of

funds will reduce shareholder wealth (just as if you
borrowed money at 10% to make an investment which
earned 7% would reduce your wealth)
Three Viewpoints regarding cost of capital

From Investor’s point of view

(e.g. An investor invested in a company’s shares amount
Rs. 1,00,000 instead of investing in a bank at the rate of
7% interest. He has sacrificed 7% for not having invested in
bank)
Firm’s point of view
(e.g. A firm raised Rs.10 lakh through issue of 10%
debentures for justifying this issue, a minimum rate of retun
it has to earn is 10%)
Capital Expenditure point of view
(minimum required rate of return or hurdle rate or
discounting rate to value cash flows)
Basic Aspects
(i) Rate of Return not cost
(ii) Minimum Rate of Return that will at least maintain the
market value of the shares
(iii)Cost of Capital comprises
- the risk less cost
- the business risk premium
- the financial risk premium

Ko  r  b  f
 The long-term funds requirement of the firm is
generally met from the following sources:
 Equity share capital
 Preference share capital
 Retained earnings
 Debentures and bonds
 Term loans from financial institutions and

banks
A firm should accept investment proposals
whose internal rate of return is above its
cost of capital.
 Cost of capital acts as a minimum benchmark
return, a firm should earn enough profits to meet
its cost of capital. The cost of capital consists of
the following elements:
 Cost of Equity Capital (Ke)
 Cost of Retained Earnings (Kr)
 Cost of Preferred Capital (Kp)
 Cost of Debt, includes both Debentures, Bonds
and Term Loans (Kd)
Cost of Debt (Kd)
An important point to be remembered that dividends
payable to equity shareholders and preference
shareholders is an appropriation of profit, whereas the
interest payable on debt is a charge against profit.

To gain the full tax shield, the following conditions apply:

- The company must be able to show a taxable profit
ever year to take full advantage of the tax shield.
- If the company makes loss, the tax shield goes
down and cost of borrowing increases.
 The debt may be perpetual debt or redeemable debt and for
calculation of cost of debt the following information is
required:
- Net cash inflow from each source of debt and cost of
raising debt.
- The amount of periodic interest payment and principal
repayment on maturity.
- Corporate taxation rate
Cost of perpetual/Irredeemable Debt
where, K d = Cost of Debt
I (1  t )
Kd  I = Annual interest payment
NP
t = Company’s effective corporate tax rate
NP = Net proceeds of the issue
# R & Co. has 15% irredeemable debentures of Rs.100 each for Rs.10,00,000. The tax rate
is 35%. Determine cost of debenture assuming it issued at (i) face value(ii) 10%
premium and (iii) 10% discount.

Issued at Pre-tax Post-tax

Face value 15/100=15% 15(1-0.35)/100=9.8%
10% Premium 15/110=13.7% 15(1-0.35)/110=8.9%

10% Discount 15/90=16.67% 15(1-0.35)/90=10.9%

Cost of Redeemable Debt (PV method)

n
INT (1  t ) RV
SV   
t 1 (1  k d ) t
(1  k d ) n

# A co. issues a new 10% debentures of Rs. 1,000 face value to be redeemed after 10
years. The debenture is expected to be sold at 5% discount. It will also involve flotation
cost of 5 % of face value . The company’s tax rate is 35%. What would the cost of debt
be?
Cost of redeemable debt (shot cut method)
RV  SV
( I (1  t )  ( ))
Kd  N
Where, Kd = cost of debt RV  SV
I = Annual interest payment
( )
2
Rv = Redeemable value of debt at maturity time
Sv = Sale value less discount and flotation expenses
N = Number of years to maturity
t = Company’s effective tax rate
# A co. issues Rs.100 par value of debentures carrying 15%interest. The debentures are
repayable after 7 years at face value. The cost of issue is 3% and tax rate is 45%.
Calculate the cost of debenture.
# S industry raised funds through issue of debentures of Rs.150 each at a discount of
Rs.10 per debenture with ten year maturity. The coupon rate is 16%. The flotation cost
is Rs. 5 per debenture. The debentures are redeemable with a 10% premium. The
corporate tax rate is 40% . Calculate the cost of debt.
 Cost of debt redeemable in installments

Int1 (1  t )  Pr incipal Int2 (1  t )  Pr incipal Intn (1  t )  Pr incipal

NP     
(1  k d )1 (1  k d ) 2 (1  k d ) n
n
I t (1  t )  Pt

t 1 (1  k d ) t

To calculate Kd steps to be followed:

(1) Calculate total present value of cash outflows during the maturity period at two
discount rates so as to have positive and negative NPVs
(2) Find Kd by interpolation technique:

NPVL
K d  Ld   ( H d  Ld )
NPVL  NPVH
# Bharti Ltd. issues Rs.100 Lakhs, 12% debentures of Rs.100 each at
par redeemable at par. The flotation cost being 10%. The corporate tax
rate is 40%. Calculate the cost of debt if 20% debentures are
redeemable each year beginning with the end of year 1
 Cost of Preferred Capital (Kp)
 The cost of preference share capital is the rate of return
that must be earned on preference capital financed
investments, to keep unchanged the earnings available to
the equity shareholders.
Irredeemable Preference Shares
where, K p = Cost of irredeemable pref. shares
Dp DP = Preference dividend
Kp  NP = Net proceeds from issue of pref.
shares
NP

# A co. issue 11% irredeemable preference shares of face value of Rs.100 each.
Floatation cost are estimated at 5% of expected sale price : (a) what is Kp if
the preference shares are issued at (i) par value, (ii) 10% premium (iii) 5%
discount? Also compute Kp in these situations assuming 13.125% dividend
tax.
 Redeemable Preference Shares
n
Dt (1  dt ) RV
SV   
t 1 (1  k p ) (1  k p ) n
t

# ABC Ltd has issued 11% preference shares of face value of Rs.100 each to
be redeemed after 10 years. Flotation cost is expected to be 5%. Determine
the cost of preference shares.

RV  SV
D (1  dt )  ( )
KP  N where,K P = Cost of preference shares
R  SV D = Constant annual preference dividend
( V ) N = Number of years to redemption
2 RV = Redeemable value at redemption time
SV = Sale value of preference shares (NP)
 X Ltd. Issues Rs.100 Lakhs, preference sharesof Rs.100 eachat par
redeemable at 5% premium. The flotation cost being 10%. The dividend tax
rate is 20%. The yearly coupon rate of preference dividend is as :
Year Coupon rate of preference dividend
1-2 10%
3-4 11%
5 12%
Calculate the cost of preference shares in each of the following alternative cases;
(a) If preference shares are redeemable after five years
(b) If 1/5th preference shares are redeemable each year beginning with the end of
year 1.
Cost of Equity Capital (Ke)
The cost of equity may be defined as the minimum rate of return that a
company must earn on the equity share capital financed portion of an
investment project so that market price of the shares remain unchanged.

Terms useful to study cost of equity

Retention ratio
P/E ratio
Growth rate
Expected dividend
Current market price
Risk of security
Dividend Yield Method

This method is based on the assumption that the market value of equity
shares is directly related to the future dividends on those shares; and
Future dividend per equity share is expected to be constant and the
company is expected to earn at least this yield to keep the equity
shareholders content.
D1
K =
P0
Where K e is cost of equity capital
e
D 1 is annual dividend per share on equity capital in period 1
P is current market price of equity share/net proceeds per
0
share

→It does not allow for any growth rate.

# R Ltd. Is expected to disburse a dividend of Rs. 30 on each equity
share of Rs.10. The current market price of share is Rs.80. Calculate
the cost of equity capital as per dividend yield method.

# F Ltd. Issued 10,000 shares of Rs.10 each at a premium of Rs. 2. The

company has incurred issue expenses of Rs. 5,000. the equity
shareholders expect the rate of dividend to 18% p.a. Calculate the
cost of equity share capital.
Dividend Growth Model (Gordon growth model)
D1 Dn 1
g Pn 
Ke=
P0 Ke  gn
g = Growth rate by which dividends are expected to grow per year at a constant compound rate.

→Future growth pattern is difficult to predict.

g = br
Where b = Retention ratio=(1-dividend payout ratio)
r = Rate of return on equity

Suppose that dividend per share of a firm is expected to be Re.1

per share next year and is expected to grow at 6% per year
perpetually. Determine the cost of equity capital assuming
market price per share is Rs.25.
 The shares of a company are selling at Rs.40 per share and it had paid
a dividend of Rs.4 per share last year. The investor’s market expects a
growth rate of 5% per year.
(a) Compute the company’s equity cost of capital;
(b) if the anticipated growth rate is 7% per annum, calculate the indicated
market price per share.
Earning Price Method
(Firm follows a policy of 100% payout) E
Ke 
M
Where, E = Current earnings per share

M = Market price per share/Net proceeds

A firm is considering an expenditure of Rs.60 Lakhs for expanding
its operations. The relevant information as as follows: Rs.
Number of existing equity shares 10 Lakh
Market value of existing shares 60
Net earnings 90 Lakh
Compute the cost of existing equity share capital and of new equity
capital assuming the new shares will be issued at a price of Rs. 52
per share and the costs of new issue will be Rs. 2 per share.
Earning Price plus growth Method
E
Ke  g
M
Capital Asset Pricing Model
Where,
K e  R f  bi ( Rm  R f )
R f = Risk-free rate of return
Rm
= Average market return
bi = Beta of the investment

Risk free rate of return (Rf): The yields on the government treasury
securities are used as the risk free rate. Returns may be either on short
term or long term treasury bills. Common practice is to use return on short
term treasury bills as risk free rate. Many analyst prefer to use long term
government bonds as risk free rate. One should always use current risk free
rate rather than historical average.
The market risk premium (Rm-Rf): market risk premium is measured as
difference between long term historical arithmetic averages of market return
and the risk free rate. Some use market risk premium base on returns of
most recent years.
The Beta of firm’s share (b): Systematic risk in relation to market.
 Risk free rate of return on 10 years Govt. of India bonds is 5.5%. Rate
of return on market portfolio is 13.5%. Beta of the company is 1.1875.
Here the required rate of return on security will be…….

From the following information, calculate the cost of equity according

to (a) Dividend price approach; (b) Dividend price plus growth
approach; (c) Earning Price ratio approach; (d) Earning price plus
growth approach; and (e) CAPM approach.
 Current market price of equity share Rs.100
 Expected earnings per share at the end of year Rs.10
 Dividend pay out ratio 80%
 Growth rate 6%
 Rate of return on risk free investment 8%
 Rate of return on market portfolio 18%
 Volatility of securities return relative to the return of a broad basesd
market portfolio 1.275
 Cost of Retained Earnings (Kr)
(Major sources of finance for the established companies to finance it
expansion and diversification programs)
 These are the funds accumulated over years of the
company by keeping a part of the funds generated without
distribution.
 Some argue that retained earnings are cost free funds
available with the company, on which no return is payable.
 Cost of retained earnings may be considered equivalent to
the return forgone by the equity shareholders and it is the
opportunity cost of funds not available for reinvestment by
the individual shareholders.
 A firm should earn a return on retained funds equal to Ke to
ensure growth of dividends and share price.
 D1
Kr  g
NP
Kr
Where, =Cost of retained earnings
D1 =Expected dividend at the end of year
g =rate of growth

 D 
K r    g   (1  t )  (1  b)
 NP 
Weighted Average Cost of Capital

 Weighted average cost of capital (WACC) is defined as

the weighted average of the cost of various sources of
finance, weight being the market value/book value of
each source of finance outstanding.
 A firm may procure long-term funds from various sources
like equity share capital, preference share capital,
debentures, term loans etc. at different costs depending
on the risk perceived by the investors. When all these
costs of different forms of long-term funds weighted by
their relative proportions to get overall composite cost of
capital termed as ‘weighted average cost of capital
(WACC)’.
Simple WACC
 The simple WACC is calculated without consideration to
the impact of tax on cost of capital. In case of geared
companies, the WACC can be stated as follows:
 WACC =(Cost of Equity × % Equity) + (Cost of Debt × %
Debt)
 The weighted average cost of capital of a company is
calculated in two ways.
- Based on weight of costs by the book value of the
different forms of capital.
- Based on weight of market value of each form of capital.