VIVEK COLLEGE OF COMMERCE

CHAPTER: 1
COST OF CAPITAL

1.1. DEFINITION:
The cost of capital is the return that must be provided for the use of an investors funds. If
the funds are borrowed, the cost is the interest that must be paid on the loan. If the funds
are equity, the cost is the return that investors expect, both from the stocks price
appreciation and dividends, considering the risk in providing the funds.
In financial economics, the cost of capital is the cost of a company's funds, or, from an
investor's point of view "the shareholder's required return on a portfolio company's
existing securities. It is used to evaluate new projects of a company. It is the minimum
return that investors expect for providing capital to the company, thus setting a
benchmark that a new project has to meet.
Following are some formal definitions of the term:
1. According to John Hampton Cost of capital is the rate of return of the firm required
from investments in order to increase the value of the firm in the market place.
2. According to Ezra Soloman Cost of capital is the minimum required rate of earnings
or the cut-off rate for capital expenditures.
3. According to Milton H. Spencer Cost of capital is the minimum rate of return which
a firm requires as a condition for undertaking an investment.
4. According to Van Horne Cost of capital is a cut off rate for the allocation of capital to
investments of projects. It is the rate of return on a project that will leave unchanged the
market price of the stock.

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1.2 SIGNIFICANCE:
Cost of capital is considered as a standard of comparison for making different business
decisions. Such importance of cost of capital has been presented below:
1. Making Investment Decision:
Cost of capital is used as discount factor in determining the net present value. Similarly,
the actual rate of return of a project is compared with the cost of capital of the firm. Thus,
the cost of capital has a significant role in making investment decisions.
2. Designing Capital structure:
The proportion of debt and equity is called capital structure. The proportion which can
minimize the cost of capital and maximize the value of the firm is called optimal capital
structure. Cost of capital helps to design the capital structure considering the cost of each
sources of financing, investor's expectation, effect of tax and potentiality of growth.
3. Evaluating the Performance:
Cost of capital is the benchmark of evaluating the performance of different departments.
The department is considered the best which can provide the highest positive net present
value to the firm. The activities of different departments are expanded or dropped out on
the basis of their performance.
4. Formulating Dividend Policy:
Out of the total profit of the firm, a certain portion is paid to shareholders as dividend.
However, the firm can retain all the profit in the business if it has the opportunity of
investing in such projects which can provide higher rate of return in comparison of cost
of capital. On the other hand, all the profit can be distributed as dividend if the firm has
no opportunity investing the profit. Therefore, cost of capital plays a key role formulating
the dividend policy.

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5. Capital Budgeting:
The primary purpose of measuring the cost of capital is the evaluation of new investment
projects. In the Net Present Value (NPV) method an investment project is accepted if it
has a positive NPV. The projects NPV is calculated by discounting its cash flows by the
cost of capital. In this sense, the cost of capital is the discount rate used for evaluating the
desirability of an investment project. In the Internal Rate of Return (IRR) method, the
investment project is accepted if it has an internal rate of return greater than the cost of
capital. In this context, the cost of capital is the minimum required rate of return on an
investment project. It is also known as the cutoff rate, or the hurdle rate.
6. Capital Structure Decisions:
Measurement of cost of capital from various sources is essential in planning the capital
structure of any firm. While designing an optimal capital structure, the management aims
at maximizing the firm value by minimizing the overall cost of capital.
7. Performance Evaluation:
Capital cost is the minimum rate of return that a firm must earn on its total investment
which will maintain the market value of share at its current level. The concept of cost of
capital can be used to evaluate the financial performance of top management. Such an
evaluation will involve a comparison of actual profitability of the investment projects
undertaken by the firm with the projected overall cost of capital, and the appraisal of the
actual costs incurred by management in raising the required funds.
8. Value Creation and Management:
The fundamental goal of management is creating value for shareholders. This is only
possible when management is focused on investing shareholders funds in such a way that
it generates returns that are higher than the cost of capital. Value-creation has two
aspects- finding attractive investment opportunities in which to invest and measuring the
expected returns of a project against an appropriate hurdle rate or the cost of capital. The
investment process is either organic, whereby the management constantly evaluates
projects in which to invest; or organic, where the management makes investment through
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M&A activities. In either of the cases, the measurement of the cost of capital remains a
fundamental part of the value-creation process. Therefore, the cost of capital or the
discounting rate used for evaluating projects or M&A targets plays an important role in
measuring shareholders value.
9. Other Financial Decisions:
The cost of capital is also used in making other financial decisions such as dividend
policy, capitalization of profits, making the rights issue and working capital management.
The cost of capital is used to evaluate alternative policies with regard to receivables or
inventories.
1.3 CLASSIFICATION:
The cost of capital defines as the minimum rate of return a firm must earn on its
investment in order to satisfy investors and to maintain its market value. It is the investors
required rate of return. Cost of capital also refers to the discount rate which is used while
determining the present value of estimated future cash flows.
The major classification of cost of capital is:
1. Historical Cost and future Cost:
Historical Cost represents the cost which has already been incurred for financing a
project. It is calculated on the basis of the past data. Future cost refers to the expected
cost of funds to be raised for financing a project. Historical costs help in predicting the
future costs and provide an evaluation of the past performance when compared with
standard costs. In financial decisions future costs are more relevant than historical costs.
2. Specific Costs and Composite Cost:
Specific costs refer to the cost of a specific source of capital such as equity shares,
Preference shares, debentures, retained earnings etc. Composite cost of capital refers to
the combined cost of various sources of finance. In other words, it is a weighted average
cost of capital. It is also termed as overall costs of capital. While evaluating a capital
expenditure proposal, the composite cost of capital should be as an acceptance/ rejection
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criterion. When capital from more than one source is employed in the business, it is the
composite cost which should be considered for decision-making and not the specific cost.
But where capital from only one source is employed in the business, the specific cost of
those sources of capital alone must be considered.
3. Average Cost and Marginal Cost:
Average cost of capital refers to the weighted average cost of capital calculated on the
basis of cost of each source of capital and weights are assigned to the ratio of their share
to total capital funds. Average cost of capital is the weighted average of the cost of each
component of funds invested by the concern. Marginal cost of capital may be defined as
the Cost of obtaining another dollar of new capital. When a firm raises additional capital
from only one sources, than marginal cost is the specific or explicit cost. Marginal cost is
considered more important in capital budgeting and financing decisions. Marginal cost
tends to increase proportionately as the amount of debt increase.
4. Explicit Cost and Implicit Cost:
Explicit cost refers to the discount rate which equates the present value of cash outflows
or value of investment. Thus, the explicit cost of capital is the internal rate of return
which a firm pays for procuring the finances. If a firm takes interest free loan, its explicit
cost will be zero percent as no cash outflow in the form of interest are involved. On the
other hand, the implicit cost represents the rate of return which can be earned by
investing the funds in the alternative investments. In other words, the opportunity cost of
the funds is the implicit cost. Implicit cost is the rate of return with the best investment
opportunity for the firm and its shareholders that will be forgone if the project presently
under consideration by the firm were accepted. Thus implicit cost arises only when funds
are invested somewhere, otherwise not. For example, the implicit cost of retained
earnings is the rate of return which the shareholder could have earn by investing these
funds, if the company would have distributed these earning to them as dividends.
Therefore, explicit cost will arise only when funds are raised whereas implicit cost arises
when they are used.

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1.4 COMPONENTS:
The items on the financing side of the balance sheet are called capital components. The,
major capital components are equity, preference and debt. A companys cost of capital is
the average cost of the various capital (or securities) employed by it.
Such components of cost of capital have been presented below:
(i)Cost of debt:
* Cost of perpetual or irredeemable debt
* Cost of non-perpetual or redeemable debt
* Cost of debt issued on redeemable condition
* Cost of callable debt
(ii)Cost of preference shares:
* Cost of perpetual preference Share
* Cost of redeemable preference Share
(iii)Cost of equity:
*Cost of ordinary/equity shares or common stock
(iv)Cost of retained earnings:
A firms overall cost of capital will reflect the required return on the firms assets as a
whole. Given that a firm uses debt and equity capital, this overall cost of capital will be a
mixture of the returns needed to compensate its creditors and those needed to compensate
its shareholders.
The individual cost of each source of financing is called component of cost of capital.
The component of cost of capital is also known as the specific cost of capital which
includes the individual cost of debt, preference shares, ordinary shares and retained
earnings.
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CHAPTER: 2
COST OF DEBT

2.1 MEANING:
When companies borrow funds from outside or take debt from financial institutions or
other resources the interest paid on that amount is called cost of debt. The cost of debt is
computed by taking the rate on a risk-free bond whose duration matches the term
structure of the corporate debt, then adding a default premium. This default premium will
rise as the amount of debt increases (since, all other things being equal, the risk rises as
the amount of debt rises). Since in most cases debt expense is a deductible expense, the
cost of debt is computed as an after tax cost to make it comparable with the cost of equity
(earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax
rate.
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest
paid. In practice, the interest-rate paid by the company can be modeled as the risk-free
rate plus a risk component (risk premium), which itself incorporates a probable rate of
default (and amount of recovery given default). For companies with similar risk or credit
ratings, the interest rate is largely exogenous (not linked to the cost of debt), the cost of
equity is broadly defined as the risk-weighted projected return required by investors,
where the return is largely unknown. The cost of equity is therefore inferred by
comparing the investment to other investments (comparable) with similar risk profiles to
determine the "market" cost of equity. It is commonly equated using the capital asset
pricing model formula (below), although articles such as Stulz 1995 question the validity
of using a local CAPM versus an international CAPM- also considering whether markets
are fully integrated or segmented (if fully integrated, there would be no need for a local
CAPM).

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2.2 COST OF DEBENTURES ISSUED AND REDEEMABLE AT PAR:
The cost of debentures issued and redeemable at par is the contractual interest rate
adjusted further for the tax liability of the company. In calculating weighted average cost
of capital, cost of debt after tax should be used. It is calculated by the formulakd = I (1-t)
Where,

kd = Cost of debt after tax

I = Annual interest rate
t = Tax rate

The amount of tax saved due to deduction of interest from taxable income (Interest x Tax
rate) is known as the Tax Shield.
ILLUSTRATION 1:
T Ltd. has Rs 300000, 10% Debentures. The tax rate is 50%. Calculate the cost of
debentures and the tax shield.
SOLUTION:
Cost of debentures, kd = (1-t) =10% (1-50%)= 5%
Tax shield = Interest x Tax rate= 300000 x 10% x 50% = Rs. 15000.
2.3 COST OF DEBENTURES ISSUED AT PREMIUM/DISCOUNT:
Cost of debentures issued at premium or discount:
Kd = I

x (1-t)

NP
Where, Kd = Cost of debt after tax
I

= Annual interest rate

NP = Net proceeds of debentures (FV + Premium Disc. Flotation Costs)

T = Tax rate

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2.4 COST OF DEBENTURES ISSUED AND / OR REDEEMABLE AT
PREMIUM/DISCOUNT:
If the debentures are redeemable after the expiry of a fixed period, the cost of debentures
would be,

kd = I (1-t) + (RV NP) / N

RV + NP
2

Where, I = Annual interest payment

NP = Net proceeds of debentures
RV = Redemption value of debentures
t = tax rate
N = Life of debentures
ILLUSTRATION 2:
A company issues Rs. 1000000 12% debentures of Rs. 100 each. The debentures are
redeemable after the expiry of fixed period of 7 years. The company is in 35% tax
bracket. The discount/ premium/ flotation cost is to be amortized.
Required:
(i) Calculate the cost of debt after tax, if debentures are issued at
(a) Par
(b) 10% discount
(c)10% Premium
(ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?
SOLUTION:
(i) (a)Cost of debentures issued at par
kd = I (1-t)
= 12% (1- 35%)
= 7.8%

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Cost of other debentures
kd = I (1-t) + (RV NP) / N
RV + NP
2
Where, I = Annual interest payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
t = tax rate
N = Life of debentures
(b) Cost of debentures issued at 10% discount:
kd = 120000 x (1- 0.35) + (1000000 - 900000 ) / 7
1000000 + 900000
2
= 78000 + 14286
950000
= 9.71%
(c) Cost of debentures issued at 10% premium
kd = 120000 x (1- 0.35) + (1000000 - 1100000 ) / 7
1000000 + 1100000
2
= 78000 - 14286
1050000
= 6.07%
(ii) Cost of debentures, if brokerage is paid at 2% and debentures are issued at par
kd = 120000 x (1- 0.35) + (1000000 - 980000 ) / 7
(1000000 20000) + 1000000
2
= 80857

= 8.17%

990000
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2.5 VALUE/ ISSUE PRICE ON BASIS OF NPV:
When the company intends to make a fresh issue of bonds, the issue price may be needed
to be determined by discounting the expected cash flows at the rate of return expected by
investors. Such Net Present Value (NPV) indicates:
(i) Likely price at which the company can issue new bonds; or
(ii) the fair value at which an investor may purchase a bond listed on stock exchange.
NPV, in short, is the fair value.
ILLUSTRATION 3:
A company intends to make a new issue of bonds with par value of Rs. 1000 bearing a
coupon rate of 12 % and a maturity period of 10 years. The required rate of return or
yield on this bond is 13%. What is the present/fair value of the bond on Discounted Cash
Flow (DCF) basis at which the company may make the new issue?
SOLUTION:
Value of Bond/ issue price can be found out by the following formula:
t

P= EC/ (1 + r) + M / (1 + r)

P= (C x PVIFAr.n) + (M x PVIFr.n)
Where, P= Value of the bond (in rupees)
n=Number of years to maturity
C= Annual coupon interest (in rupees)
R=Periodic required return
M= Maturity value
I= Time period when payment is received
PVIFA=Present Value Interest Factor of Annuity)
PVIF = Present Value Interest Factor
P = (C x PVIFAr.n) + (M x PVIFr.n)
= (120 x PVIFA13%.10 yrs) + (1000 x PVIF13%.10

yrs

= (120 x 5.426) + (1000 x 0.295) = 651.12 + 29 = Rs. 946.12

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CHAPTER 3
COST OF PREFERNCE SHARES

3.1 INTRODUCTION:
Cost of preference share capital is apparently the dividend which is committed and paid
by the company. This cost is not relevant for project evaluation because this is not the
cost at which further capital can be obtained. To find out the cost of acquiring the
marginal cost, we will be finding the yield on the preference share based on the current
market value of the preference share.
Preference share is issued at a stated rate of dividend on the face value of the share.
Although the dividend is not mandatory and it does not create legal obligation like debt, it
has preference of payment over equity for dividend payment and distribution of assets at
the time of liquidation. Therefore, without paying dividend to preference shares, they
cannot pay anything to equity shares. In that scenario, management normally tries to pay
regular dividend to the preference shareholders.
Cost of preference share capital is that part of cost of capital in which we calculate the
amount which is payable to preference shareholders in the form of dividend with fixed
rate. Even, dividend to preference shareholder is on the desire of board of directors of
company and preference shareholder cannot pressurize for paying dividend but it doesnt
mean that calculation of cost of pref. share capital is not necessary because, if we dont
pay the dividend to pref. shareholders, it will affect on capability to receive funds from
this source.
The cost of preference share capital is the dividend payable to its holders plus amortized
premium/discount/floatation costs. Though payment of dividend is not mandatory, nonpayment may results in exercise of voting rights by them. The payment of preference
dividend is not adjusted for taxes as they are paid after taxes and is not deductible.
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3.2 COST OF REDEEMABLE PREFERENCE SHARES ISSUED:
Redeemable preference share is very commonly seen preference share which has a
maturity date on which date the company will repay the capital amount to the preference
shareholders and discontinue the dividend payment thereon. These shares are issued for a
particular period and at the expiry of that period, they are redeemed and principal is paid
back to the preference shareholders. The characteristics are very similar to debt and
therefore the calculations will be similar too.
Those preference shares, which can be redeemed or repaid after the expiry of a fixed
period or after giving the prescribed notice as desired by the company, are known as
redeemable preference shares. Terms of redemption are announced at the time of issue of
such shares. These are preference shares that the company will buy back at an agreed date
in the future. They are classified as non-current liabilities in the statement of financial
position of a company.
The cost of redeemable preference shares is calculated by the following formula:
Kp = PD + (RV NP) / N
RV + NP
2
Where,
PD = Annual preference dividend
RV = Redemption value of preference shares (Face Value + Premium Discount)
NP = Net proceeds on issue of preference shares
(Face Value + Premium - Discount Flotation Expenses)
N = Life of preference shares

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ILLUSTRATION 4:
XYZ Ltd. issues 2000, 10% Preference Share of Rs.100 each at a premium of Rs. 5 each,
redeemable after 10 years at a premium of Rs.10 each. The flotation cost of each share is
Rs. 2. You are required to calculate cost of preference share capital ignoring dividend tax.
SOLUTION:
Calculation of Coat of Preference Share (kp)
Preference Dividend (PD) = 0.12 x 40000 x 100 = 480000
Flotation Cost = 40000 x 2 = 80000
Net Proceeds (NP) = 4200000 80000 = 4120000
Redemption Value (RV) = 40000 x 110 = 4400000
Cost of Redeemable preference shares = PD + (RV NP) / N
RV + NP
2
Kp = 480000 + (4400000 4120000) / 10
4400000 + 4120000
2
= 480000 + (280000) / 10
8520000 / 2
= 480000 + 28000
4260000
= 508000
4260000
= 0.1192 = 11.92%
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3.3 COST OF IRREDEEMABLE PREFERENCE SHARES:
Irredeemable preference shares is little different from other types of preference shares. It
does not have any maturity date which makes this instrument very similar to equity
except that the dividend of these shares is fixed and they enjoy priority in payment of
both dividend and capital over the equity shares. Since there is an absence of maturity,
they are also known as perpetual preference share capital.
These are preference shares that will not be bought back by the company. Shareholders
will continue to earn dividends as long as profit is earned. They are listed under heading
equity in the statement of financial position of a company. Those preference shares,
which cannot be redeemed during the life time of the company, are known as nonredeemable preference shares. The amount of such shares is paid at the time of
liquidation of the company.

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CHAPTER 4
COST OF EQUITY

4.1 INTRODUCTION:
In finance, the cost of equity is the return (often expressed as a rate of return) a firm
theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk
they undertake by investing their capital. Firms need to acquire capital from others to
operate and grow. Individuals and organizations who are willing to provide their funds to
others naturally desire to be rewarded. Just as landlords seek rents on their property,
capital providers seek returns on their funds, which must be commensurate with the risk
undertaken.
Firms obtain capital from two kinds of sources: lenders and equity investors. From the
perspective of capital providers, lenders seek to be rewarded with interest and equity
investors seek dividends and/or appreciation in the value of their investment (capital
gain). From a firm's perspective, they must pay for the capital it obtains from others,
which is called its cost of capital. Such costs are separated into a firm's cost of debt and
cost of equity and attributed to these two kinds of capital sources.
While a firm's present cost of debt is relatively easy to determine from observation of
interest rates in the capital markets, its current cost of equity is unobservable and must be
estimated. Finance theory and practice offers various models for estimating a particular
firm's cost of equity such as the Capital Asset Pricing Model, or CAPM. Another method
is derived from the Gordon Model, which is a discounted cash flow model based on
dividend returns and eventual capital return from the sale of the investment. Another
simple method is the Bond Yield Plus Risk Premium (BYPRP), where a subjective risk
premium is added to the firm's long-term debt interest rate. Moreover, a firm's overall
cost of capital, which consists of the two types of capital costs, can be estimated using
the weighted average cost of capital model.
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According to finance theory, as a firm's risk increases/decreases, its cost of capital
increases/decreases. This theory is linked to observation of human behavior and logic:
capital providers expect reward for offering their funds to others. Such providers are
usually rational and prudent preferring safety over risk. They naturally require an extra
reward as an incentive to place their capital in a riskier investment instead of a safer one.
If an investment's risk increases, capital providers demand higher returns or they will
place their capital elsewhere.
In cost of capital, calculating of cost of equity capital is not so easy like calculation of
cost of debt because there are many approaches in cost of equity capital. These are just
like different methods of cost equity methods which have been developed after
developing the outlook of company.
Knowing a firm's cost of capital is needed in order to make better decisions. Managers
make capital

budgeting decisions

while

capital

providers

make

decisions

about lending and investment. Such decisions can be made after quantitative analysis that
typically uses a firm's cost of capital as a model input.
In financial theory, the return that stockholders require for a company. The
traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange
for owning the asset and bearing the risk of ownership.
4.2 DIVIDEND PRICE APPOROACH:
According to dividend price approach, we can calculate cost of capital just dividing
dividend per share with market value of per share. This cost shows direct relationship
between price of equity shares and price of dividend. Its % value shows what amount, we
are giving per $ 100 share.
Ke = D/P

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This model assumes that dividends shall be paid at a constant rate to perpetuity. It ignores
taxation. Assume a $ 10/- share quoted at $ 25/-, dividend just paid of $ 2/Ke= 2/25 = 0.08 or 8%
Above is simple approach, but these days, we also include inflation adjustment in
calculating cost of equity capital with dividend price approach.
Ke = D (1+ growth rate/100)(1+inflation rate/100) / Price of per share + (growth rate +
inflation rate)
Suppose, if in above example, growth rate is 5% and inflation rate is 6% , then
Ke = Rs. 2 (1.05 X 1.06)/$ 25 + ( 5% + 6% ) = 2 (1.113)/25 + 0.11 = 20.2%
ILLUSTRATION 5:
A company offers equity shares of Rs. 10 each for public subscription at a premium of
5%. The company pays 2% of the issue price as underwriting commission. The rate of
dividend expected by equity shareholders is 30%. You are required to compute the cost of
equity capital. Will your cost of capital be different if it is calculated on the basis of
present market value of equity share which is only Rs. 13?
SOLUTION:
(a) Cost of New Equity Capital
D = Dividend per share = Rs.3
P = Net Proceeds per share = 10.00 + 0.50 0.21 = Rs. 10.29
Ke = Cost of Equity share capital = D/P
Ke =

= 0.29 or 29%

10.29
(b) Cost of Existing Equity Capital

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When Market Price of each share (P) is Rs.13
Ke =

= 0.2307 or 21.07%

13
4.3 EARNING/ PRICE APPROACH:
This approach tells that we should not co-relate dividend per share with market value per
share but we should use total earning and try to co-relate it with market value of shares.
We have to just write earning per share of company instead writing dividend per share. It
will be helpful to void the effect of dividend policy on calculation of working capital.
The price-to-earnings ratio, or P/E ratio, is an equity valuation multiple. It is defined as
market price per share divided by annual earnings per share.
There are multiple versions of the P/E ratio, depending on whether earnings are projected
or realized, and the type of earnings.
"Trailing P/E" uses net income for the most recent 12 month period, divided by
the weighted average number of common shares in issue during the period. This is
the most common meaning of "P/E" if no other qualifier is specified. Monthly
earnings data for individual companies are not available, and in any case usually
fluctuate seasonally, so the previous four quarterly earnings reports are used and
earnings per share are updated quarterly. Note, each company chooses its own
financial year so the timing of updates varies from one to another.
"Trailing P/E from continued operations" uses operating earnings, which exclude
earnings from discontinued operations, extraordinary items (e.g. one-off windfalls
and write-downs), and accounting changes.
"Forward P/E": Instead of net income, this uses estimated net earnings over next
12 months. Estimates are typically derived as the mean of those published by a
select group of analysts (selection criteria are rarely cited).
As an example, if stock A is trading at $24 and the earnings per share for the most recent
12-month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the
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purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses
(negative earnings) or no profit have an undefined P/E ratio (usually shown as "not
applicable" or "N/A"); sometimes, however, a negative P/E ratio may be shown.
Some people mistakenly use the formula market capitalization / net income to calculate
the P/E ratio. This formula often gives the same answer as market price / earnings per
share, but if new capital has been issued it gives the wrong answer, as market
capitalization = market price current number of shares whereas earnings per share= net
income / weighted average number of shares.
Variations on the standard trailing and forward P/E ratios are common. Generally,
alternative P/E measures substitute different measures of earnings, such as rolling
averages over longer periods of time (to attempt to "smooth" volatile or cyclical earnings,
for example) or "corrected" earnings figures that exclude certain extraordinary events or
one-off gains or losses. The definitions may not be standardized. For companies that are
loss-making, or whose earnings are expected to change dramatically, a "primary" P/E can
be used instead, based on the earnings projections made for the next years to which a
discount calculation is applied.
This approach co-relates the earnings of the company with the issue/ market price of its
share. Accordingly, the cost of ordinary share capital would be based upon the expected
rate of earnings of a company. The argument is that each investor expects a certain
amount of earnings, whether distributed or not from the company in whose shares he
invests. This approach seeks to nullify the effect of changes in the dividend policy.
However, this approach ignores the factor of capital appreciation or depreciation in the
market value of shares. The earnings/price ratio is calculated by dividing the earnings per
share by the average price per share. Thus, the cost of equity (Ke) is measured by:
Ke = E
P
Where, E = Earnings Per Share
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P = Net Proceeds per share/ Current Market Price per Share
ILLUSTRATION 6:
XYZ Ltd. is planning for an expenditure of Rs. 120 lakhs for its expansion programme.
Number of existing equity shares are 20 lakhs and the market value of equity shares is
Rs. 60. It has net earnings of Rs. 180 lakhs. Compute the cost of existing equity share and
the cost of new equity capital assuming that new share will be issued at a price of Rs. 52
per share and the costs of new issue will be Rs. 2 per share.
SOLUTION:
(a)Cost of existing equity capital = (Ke) = E/P
Earnings per share (E)

= 180 / 20 = Rs.9

Ke = E/P = 9 / 60 = 0.15 or 15%

(b) Cost of new equity capital (Ke) = E/P = 9 / (52-2) = 9 / 50 = 0.18 or 18%
4.4 CAPITAL ASSET PRICING MODEL (CAPM)
In finance, the Capital Asset Pricing Model (CAPM) is used to determine a
theoretically appropriate required rate of return of an asset, if that asset is to be added to
an already well-diversified portfolio, given that asset's non-diversifiable risk. The model
takes into account the asset's sensitivity to non-diversifiable risk (also known
as systematic risk or market risk), often represented by the quantity beta () in the
financial industry, as well as the expected of the market and the expected return of a
theoretical risk-free asset. CAPM suggests that an investors cost of equity capital is
determined by beta.
The CAPM was introduced by Jack Treynor (1961, 1962), William Sharpe(1964), John
Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work
of Harry Markowitz on diversification and modern. Sharpe, Markowitz and Merton
Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution
to the field of financial economics. Fischer Black (1972) developed another version of
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CAPM, called Black CAPM or zero-beta CAPM that does not assume the existence of a
riskless asset. This version was more robust against empirical testing and was influential
in the widespread adoption of the CAPM.
Despite its empirical flaws and the existence of more modern approaches to asset pricing
and portfolio selection, the CAPM still remains popular due to its simplicity and utility in
a variety of situations. The idea behind CAPM is that investors need to be compensated
in two ways- time value of money and risk. The time value of money is represented by
the risk-free rate in the formula and compensates the investors for placing money in any
investment over a period of time.
Symbolically, the cost of equity capital can be computed using the following formulaKe = Rf + (Rm - Rf )
Where, Ke = Cost of Equity capital
Rf = Risk free rate of return
Rm = Return on market portfolio
= Beta Co-efficient (Risk Factor) of Security
The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat the
required return, the investment should not be undertaken.
The shortcomings of this approach are:
(a) Estimation of betas with historical data is unrealistic: and
(b) Market imperfections may lead investors to unsystematic risk.
Despite these shortcomings, the capital asset pricing approach is useful in calculating cost
of equity, even when the firm is suffering losses.

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CHAPTER 5
COST OF RETAINED EARNINGS AND COST OF DEPRECIATION

5.1 COST OF RETAINED EARNINGS

Cost of retained earnings (ks) is the return stockholders require on the company's
common stock. The cost of retained earnings is slightly less than the cost of common
stock, as it excludes transaction costs and taxes associated with dividends.
Retained earnings refer to the portion of net income (or loss) that is retained by a
company rather than distributed to its owners as dividends. We can think of the cost of
retained earnings in relation to the opportunity cost of how we can use these funds
elsewhere. When deciding how to finance a new project, companies have a tendency to
follow the pecking order of finance, preferring internal sources of capital to external
sources of capital.
Retained earnings and losses are cumulative from year to year, with losses offsetting
earnings. Retained earnings can be expressed as a ratio known as the "retention rate. "The
retention rate also can be expressed in terms of the dividend payout ratio: . The retention
rate and the dividend payout rate are opposites, as are retained earnings and dividends
paid out. Therefore, we also can calculate retained earnings by subtracting dividends paid
out from total net income.
The cost of retained earnings or internal funds within a capital structure is similar to the
cost of common stock, since it is a component of equity. We can think of the cost of
retained earnings in relation to the opportunity cost of how we can use these funds
elsewhere. Generally, the cost of retained earnings is slightly less than the cost of
common stock.
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It is the opportunity cost of dividends foregone by shareholders. If it is assumed that the
retained earnings are reinvested in the firm itself, retained earnings may be treated at par
with the equity share capital. In other words, the cost of retained earnings may be
measured in exactly the same way as equity share capital. However, while calculating
cost of retained earnings, two adjustments should be made: (a) Income-tax adjustment as
the shareholders are to pay some income tax out of dividends, and (b) adjustment for
brokerage cost as the shareholders would incur some brokerage cost while investing
dividend income. Therefore, after these adjustments, cost of retained earnings is
calculated as:
Kr=Ke (1-t)(1-b)
Where, Kr= Cost of retained earnings
Ke= Cost of equity
t= Rate of tax
b= Cost of purchasing new securities or brokerage cost
ILLUSTRATION 7
Y Ltd. retains Rs.750000 out of its current earnings. The expected rate of return to the
shareholders, if they had invested the funds elsewhere is 10%. The b5rokerage is 3% and
the shareholders come in 30% tax bracket. Calculate the cost of retained earnings.
SOLUTION:
Computation of Cost of Retained Earnings (Kr)
Kr=Ke (1-t) (1-b)
Kr=0.10 (1-0.30) (1-0.03)
=0.10 (0.70) x (0.97)
=0.0679 or 6.79%
Cost of Retained Earnings=6.69%
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5.2 COST OF DEPRECIATION
Depreciation cost is a term used to account for the loss of value in an item over time.
There are four methods of depreciation that are approved for use under the generally
accepted accounting principles or GAAP. The most commonly used methods are straightline depreciation, declining balance and percentage of use.
The depreciation cost must be listed as a separate item on the companys financial
statements. The method of calculation will provide in the notes to the financial statement.
If the method used is changed, this must be clearly noted in the notes, as it has a
significant impact on the financial statements. There are two costs for a fixed asset:
purchase price or book value and the adjusted or depreciated cost. The purchase price is
the amount of the original equipment cost. This is used as the dollar value of the
equipment. However, it is necessary to adjust this value to indicate the amount that could
actually be realized if the equipment was to be sold. This is the depreciated or adjusted
value.
Depreciation provisions may be considered in a similar manner to retained earnings
they have an opportunity cost and represent an increased stake in the firm by its
shareholders. However, a distribution of depreciation provisions would produce a capital
reduction, probably requiring outstanding debts to be repaid due to the depletion of the
capital base, the security against which the debt was obtained. Depreciation is an
allocation of the expired cost of fixed assets. Therefore, the funds derived from
depreciation should be considered to be derived from funds previously invested in fixed
assets. Since these funds have already been individually costed and a weighted average
cost derived, it would be reasonable to assume that the cost of capital for depreciation
funds is the same as the weighted average cost of capital. It is, therefore, not necessary to
separately calculate the cost of funds represented by depreciation. Since the cots of
deprecation-generated funds are equal to the weighted average cost of capital,
depreciation does not enter in to the calculation of the weighted average cost of capital.

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CHAPTER 6
WEIGHTED AVG. COST OF CAPITAL (WACC)

6.1 MEANING:
The Weighted Cost of Capital (WACC) is used in finance to measure a firm's cost of
capital. The total capital for a firm is the value of its equity plus the cost of its debt.
Notice that the "equity" in the debt to equity ratio is the market value of all equity, not
the shareholders' equity on the balance sheet. To calculate the firms weighted cost of
capital, we must first calculate the costs of the individual financing sources: Cost of Debt,
Cost of Preference Capital and Cost of Equity Cap.
Calculation of WACC is an iterative procedure which requires estimation of the fair
market value of equity capital.

CALCULATION OF WACC:
A three-step approach is taken to calculating the cost of the pool of long-term funds used
to finance operations (the weighted average cost of capital or WACC).
Step 1: Isolate the companys sources of longterm funds.
Step 2: Use appropriate models to calculate the cost of each source individually.
Step 3: Calculate the weighted average cost of capital by weighting each source
according to market value.

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ILLUSTRATION 8:
S plc has the following summarized balance sheet at 31 December 2013.
Particulars

Ordinary shares of 50p nominal value

10

Reserves

20

10% irredeemable debentures

10

Net assets

40

The current share price is 1.20 ex div and a dividend of 15p per share has been paid for
many years. The debentures are trading at 90 cum int. Interest is paid annually and the
corporation tax rate is 30 percent. You are required to calculate the traditional weighted
average cost of capital at 31 December 20X3.
SOLUTION
Step 1 Isolate source of longterm funds.
The only sources relevant to X plc are the ordinary shares and the irredeemable
debentures.
Step 2 Calculate cost of each source
Ke = 15p = 12.5% per annum
120p
Kd = 10 (1 0.3 ) = 8.375% per annum
90-10
Step 3 Weight out according to market value.
Sources

MV

Cost

WACC

Equity

10m 2 1.20

= 24

12.5%

9.375

Debt

10m 80

=8

8.375%

2.094

100
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= 32

11.469

WACC = 11.47%
This represents the overall annual cost of servicing the pool of funds the company uses to
finance its operations in the long run.
6.2 LIMITATIONS OF WACC
The main limitation of using WACC is that it does not take into consideration the
floatation cost of raising the marginal capital for new projects. Another problem with
WACC is that it is based on an impractical assumption of same capital mix which is very
difficult to maintain.
If we use the existing WACC as the hurdle rate in NPV computations (benchmark), we
are assuming that when new funds are raised to finance new projects, the cost of capital
will be unchanged, i.e.:
The proportion of debt and equity remain unchanged.
The operating risk of the firm is unchanged.
The finance is not project specific.

CHAPTER 7
PROBLEMS IN DETERMINING COST OF CAPITAL

7.1 PROBLEMS IN DETERMINING COST OF CAPITAL:

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1. Problems in computation of cost of equity:
The computation of cost of equity capital depends upon the expected rate of return by its
investors. But the quantification of the expectations of equity shareholders is very
difficult task because there are many factors at play. The debt cost of the company is
easier to calculate, since it is paid in cash in the form of interest. The equity cost is not so
obvious and can only be estimated by taking into consequence the factors encapsulated in
a specific approach, e.g., the risk-free rate, the market risk premium, the beta factors in
the Capital Asset Pricing Model (CAPM), the expectations of investors in a behavioral
finance model, etc. Furthermore, the debt equity ratio (D/E ratio) is also not a
straightforward calculation, since rations can vary at different stages of a project or
acquisition and also from company to company and industry to industry.
2. Problems in computation of cost of retained earnings:
It is sometimes argued that retained earnings do not involve any cost but in reality, it is
the opportunity cost of dividends foregone by its shareholders. Since different
shareholders may have different opportunities for investing their dividends, it becomes
very difficult to compute the cost of retained earnings.
3. Problems in assigning weights:
For determining the weighted average cost of capital, weights have to be assigned to the
specific cost of individual source of finance. The choice of using the book value of the
source or the market value of the source poses another problem in the determination of
capital.
4. Problem in Estimation:
Conditions which are present now while computing the WACC may not continue in
future. Therefore, howsoever cost of capital is determined now, it is dependent on certain
conditions or situations which are subject to change.

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* Firstly, the firms internal structure and character change. For instance, as the firm
grows and matures, its business risk may decline resulting in new structure and cost of
capital.
* Secondly, capital market conditions may change, making either debt or equity more
favorable that the other.
* Thirdly, supply and demand for funds may vary from time to time leading to change in
cost of different components of capital.
* Fourthly, the company may experience subtle change in capital structure because of
retained earnings unless its growth rate is sufficient to call for employment of debt on a
continuous basis.
5. Conceptual controversies regarding the relationship between the cost of capital
and the capital structure:
Different theories have been developed by different authors explaining the relationship
between capital structure, cost of capital and the value of the firm. This has resulted into
various conceptual difficulties. According to the Net Income Approach and the traditional
theories both the cost of capital as well the value of the firm have a direct relationship
with the method and level of financing. In their opinion, a firm can minimize the
weighted average cost of capital and increase the value of the firm by using debt
financing. On the other hand, Net Operating Income and Modigliani and Miller Approach
argue that the cost of capital is not affected by changes in the capital structure or say that
debt equity mix is irrelevant in determination of cost of capital and the value of a firm.

BIBLIOGRAPHY

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Websites:
www.google.com

Books:

Advanced Financial Management

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Dr. Varsha M.Ainapure

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