Unit 2 Cost of Capital

Cost of Capital:
A firm raises funds from various sources, which are called the components
of capital. Different sources of fund or the components of capital have
different costs. For example, the cost of raising funds through issuing equity
shares is different from that of raising funds through issuing preference
shares. The cost of each source is the specific cost of that source.

The firm invests the funds in various assets. So, it should earn returns that
are higher than the cost of raising the funds. In this sense the minimum
returns a firm earns must be equal to the cost of raising the fund. So, the
cost of capital may be viewed from two viewpoints—acquisition of funds and
application of funds. From the viewpoint of acquisition of funds, it is the
borrowing rate that a firm will try to minimize.

On the other hand, from the viewpoint of application of funds, it is the

required rate of return that a firm tries to achieve. The cost of capital is the
average rate of return required by the investors who provide long-term
funds. In other words, cost of capital refers to the minimum rate of return a
firm must earn on its investment so that the market value of company’s
equity shareholders does not fall.

The cost of capital is also referred to as the discounting rate to determine

the present value of return. Cost of capital is also referred to as the
breakeven rate, minimum rate, cut-off rate, target rate, hurdle rate,
standard rate, etc. Hence cost of capital may be defined according to the
operational as well as the economic sense.

According to Khan and Jain, cost of capital means “the minimum rate of
return that a firm must earn on its investment for the market value of the
firm to remain unchanged”.

Ezra Solomon defines “Cost of capital is the minimum required rate of

earnings or cut-off rate of capital expenditure”.

An investor provides long-term funds (i.e., Equity shares, Preference Shares,

retained earnings, Debentures etc.) to a company and quite naturally he
expects a good return on his investment.

In order to satisfy the investor’s expectations, the company should be able to

earn enough revenue.
Thus, to the company, the cost of capital is the minimum rate of return that
the company must earn on its investments to fulfil the expectations of the
investors.

If a company can raise long-term funds from the market at 10%, then 10%
can be used as cut-off rate as the management gains only when the project
gives return higher than 10%. Hence 10% is the discount rate or cut-off
rate.

Significance of Cost of Capital:

The concept of cost of capital plays a vital role in decision-making process of
financial management. The financial leverage, capital structure, dividend
policy, working capital management, financial decision, appraisal of
financial performance of top management etc. are greatly influenced by the
cost of capital.

The significance or importance of cost of capital may be stated in the

following ways:

1. Maximisation of the Value of the Firm:

For the purpose of maximisation of value of the firm, a firm tries to minimise
the average cost of capital. There should be judicious mix of debt and equity
in the capital structure of a firm so that the business does not to bear
undue financial risk.

2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking capital
budgeting decisions. Generally, cost of capital is the discount rate used in
evaluating the desirability of the investment project. In the internal rate of
return method, the project will be accepted if it has a rate of return greater
than the cost of capital.

In calculating the net present value of the expected future cash flows from
the project, the cost of capital is used as the rate of discounting. Therefore,
cost of capital acts as a standard for allocating the firm’s investible funds in
the most optimum manner. For this reason, cost of capital is also referred to
as cut-off rate, target rate, hurdle rate, minimum required rate of return etc.

3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions of
business concern.
4. Management of Working Capital:
In management of working capital, the cost of capital may be used to
calculate the cost of carrying investment in receivables and to evaluate
alternative policies regarding receivables. It is also used in inventory
management also.

5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The dividend
policy of a firm should be formulated according to the nature of the firm—
whether it is a growth firm, normal firm or declining firm. However, the
nature of the firm is determined by +comparing the internal rate of return (r)
and the cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth
firm, normal firm and decline firm, respectively.

6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In designing
optimum capital structure that is the proportion of debt and equity, due
importance is given to the overall or weighted average cost of capital of the
firm. The objective of the firm should be to choose such a mix of debt and
equity so that the overall cost of capital is minimised.

7. Evaluation of Financial Performance:

The concept of cost of capital can be used to evaluate the financial
performance of top management. This can be done by comparing the actual
profitability of the investment project undertaken by the firm with the
overall cost of capital.

Basic costs of capital

1. Cost of Equity

2. Cost of Preference Shares

3. Cost of Debt

4. Cost of Retained Earnings

Measurement of Cost of Capital:

Cost of capital is measured for different sources of capital structure of a
firm. It includes cost of debenture, cost of loan capital, cost of equity share
capital, cost of preference share capital, cost of retained earnings etc.

The cost of debenture is calculated in the following ways:

 A. Cost of Debentures:

 Debt is the cheapest form of long-term debt from the company’s point
of view as: It’s the safest form of investment from the point of view of
creditors because they are the first claimants on the company’s assets
at the time of its liquidation. Likewise, they are the first to be paid
their interest. Another, more important reason for debt having the
lowest cost if the tax- deductibility of interest payments.

 Cost of perpetual/irredeemable debt

 Cost of redeemable debt

1. Irredeemable Bond / perpetual Bond: (years is not Given)

Kd= INT (1-t)/SP*100

Where,
INT= FV*Int Rate
T = tax rate
SP= selling price
SP= FV+Premiume-Discount-Cost

Example:
A 12% perpetual debt of nominal value of Rs.100000. Tax rate is
50%. Cost of debt when issued at
i. Par,
ii. ii. At discount of 5% and
iii. iii. premium of 10%.

2. Redeemable Bond: (year is given)

Kd= INT (1-t) + Rv-Sp/n

Rv+Sp/2

Rv= Redeemable Bond/ Face value

N= no of year

Example: K ltd issued 10000000 at 12% debenture of Rs. 100 Each

redeemable at Par after 5 years find out the cost of debt in following case
assuming tax rate is 40%

1. No flotation cost
2. 5 % Flotation cost
 3. 10% premium at 5% flotation cost
4. 10% discount rate with 5% flotation cost.

2.Flotation cost is 5%

Kd= int (1-t)+ Rv-Sp/N

Rv+Sp/2

SP= FV+P-D-F 100*5% flotation cost is 5 RS

100+0-0-5

Sp= 95

Kd= 12(1-0.40) + 100-95/5

100+95/2

8.41 %

3. 6.16 %

4. 10.89 %

B. Cost of Preference Share Capital:

1. Perpetual/ irredeemable (years is not Given)

Kp= PDIV(1+dt)/SP*100

PDIV= Fv* Dividend Rate

Dt= dividend Tax
SP= selling price
SP= FV+Premiume-Discount-cost

Example: 16 % P. share of rs. 100 find out cost of p. share dividend tax is
20%

1 0 % flotation cost

2 10 % flotation cost

3 10 Premium and 10% flotation cost

4 15% discount and 10% flotation cost

1. Kp= PDIV(1+dt)/sp 19.2/100 19.2%

PDIV= fv*Div rate

100*16%

16

2. 21.33 %
3. 19.39 %
4. 25.09 %

5. Redeemable Preference share

Kp= PDIV (1+dt) + RV-SP/n

RV+SP/2

Example: 16 % P.share of rs. 100 isuued for 5 year and it redeemable at par
find out cost of p. share dividend tax is 20%

1 0 % flotation cost

2 10 % flotation cost

3 10 Premium and 10% flotation cost

4 15% discount and 10% flotation cost

C. Cost of Equity or Ordinary Shares:

1. Dividend Model.

Ke= (DIV1/Po-f)+g

DIV1= Expected Dividend at the end of year/ Next year Dividend

DiV1= DIV0(1+g)

Do= current year dividend/present year dividend/past paid dividend

g= growth rate

PO= Market price of share

F = Flotation cost or any other cost

2 CAPM model (Capital Assets pricing Model)

Ke= Rf+B(Rm-Rf)

Rf= Risk free return/ T bill

B= Beta

Rm= return of market

D. Cost of Retained Earnings:

Kr= (D1/Po) +g

WACC: Weighted average cost of capital

Example:1

Cost of equity:

Ke= (DIV1/PO-f)+g DIv1= 20% of FV 10*20% 2rs

(2/25-0)+0.10

Ke= 18 %

Kr= 18%-3% =

Kr= 15%

Cost of preference share:

Kp= PDIV(1+DT)/SP

11% p.share PDIV= 100*11% 11RS

Kp= 11(1+0)/100

11%

Cost of debenture
kd= int (1-T)/sp

15(1-0.60)/100

6%

WACC (book value)

Source BV Mv
Euity 1000000 2000000
10(100000)
P,share 100 200000 400000
Reserve 1800000
Debenture 100 2000000 40000000
Total 5000000

WACC (market value)

Market price of equity

25(1000000/10)

2500000 market value 1000000:1800000 10:18

2500000*10/28 2500000*18/28

892857 1607143

Market price of preference share

60*(200000/100)

120000

Market price of debenture

69*(2000000/100)

1380000

Source Market Portion cost Wacc

value
E 892857 892857/4000000= 0.22 18 3.96
P 120000 120000/4000000= 0.03 11 0.33
R 1607143 1607143/4000000 = 15 6
0.40
D 1380000 1380000/4000000=0.35 6 2.1
Total 4000000 12.39

Example 2

Ke= (div1/po-f)+g

(3.60/ 40-0)+0.07

0.16= 16%

Kp= pdiv(1+dt) + Rv-SP/n

RV+SP/2

12+ 100-75/10

100+75/2

14.5/87.5

16.57%

Kd= int (1-t)+ RV-SP/n

RV+Sp/2

11.5 (1-0.40) + 100-80/6

100+80/2

11.37%

Kr= (d1/po)+g

(3.60/40)+0.07

16%
Kl= int (1-t)/sp

11(1-0.40)/100

6.6 %

WACC (book value)

source Book value proportion cost Wacc

E 150000000 0.26 16 4.16
P 10000000 0.02 16.57 0.33
R 200000000 0.34 16 5.44
D 100000000 0.17 11.37 1.93
Tl 125000000 0.21 6.6 1.39
total 585000000 13.25 %

WACC (market value)

Market value of equity share

40* 150000000/10

600000000 1500000000:200000000

Equity market value 600000000*150000000/350000000= 257142857

Retain earning market value 60000000*20000000/350000000= 342857143

Market value of p.share

75*10000000/100

7500000

Market value of debenture

80*100000000/100

80000000

WACC (market value)

 sources Market value Proportion Cost wacc
E 257142857 0.32 16 5.12
P 7500000 0.01 16.57 0.17
R 342857143 0.42 16 6.72
D 80000000 0.10 11.37 1.14
tl 125000000 0.15 6.6 0.99
812500000 14.14

Example 3

Ke= (d1/po-f)+g

(2/22-2)+0.07

0.17

17%

Example no.5

Kd = int (1-t)/sp

14(1-0.50)/100

7%

Ke = (div/po-f)+g

(12/105-0)0.06

17.43%

Revised share:

Sources
E 1000000 0.33 17.43
P 400000 0.13 10
D 600000 0.21 6
New debenture 1000000 0.33 7
 3000000 10.42

Ke= (div/po-f)+g (9/102-0)+0.05 13.82

Kp= pdiv(1+DT)/sp 9(1+0)/100 9%

Kd= int(1-tax)/sp 10(1-0.30)/100 7%

Sources Book proportion Cost Wacc

value
E 500000 0.50 13.82 6.91
P 200000 0.20 9 1.80
D 300000 0.30 7 2.10
1000000 WACC 10.81

Kl= int(1-T)/sp 12(1-0.30)/100 8.40

G = 14.19/10.60

1.34

Fine third value in compound value factor

(6-1)

5 year

6%

G = 6%

Ke= (div/po-f)+g

(15/123-3)+0.06 18.5

Sp=fv+p-d-f

970*1.5= 14.55
970-14.55

Sp

955.45

Kp pdiv/sp 15/108 13.89%

Sp=fv+p-d-f

100+10+0-2

108

1930000

520000

10000000

Eq 6000000 re 1500000 total 7500000

10000000*60/75

8000000

10000000* 15/75

2000000

GROWTH RATE = LAST YEAR DIV/FIRST YEAR DIV

14.03/10.70

1.311

YEAR= 5-1

4 YEAR

WE WILL SEE IN COMPOUND VALUE FACTOR

G=7%

D6= D5(1+G)

14.03(1+0.07)

D6 =15.01

KE= (15.01/125-0)+0.07 19.01%

NEW COST OF EQUITY

KE= (DIV/PO-F)+G

(15.01/121.25)+0.07== 19.38% 125*3/100 3.84 125-3.84 121.25

APRIL 2015

KE= (DIV/PO-F) (11/120) + 0.05

14.17

KP= 10/98 10.20%

KD= 3000 PAR

3000*10% 300

300(1-0.35)+ 3150-3000-2940/15

3000+2940/2

6.86 %

KR= (11/125)+0.05 13.80%

E 2000000 0.40 14.17

R 500000 0.10 13.80
P 500000 0.10 10.20
D 2000000 0.40 6.86
5000000 10.81%

SP=FV+P-D-F
3000+0-0-60

2940

Plan A

Total fund 1000000

EQUITY 1000000*50% 500000

7% debenture 1000000*25% 250000

10% p, share 1000000*25% 250000

Cost equity

D0= 2

D1= D0(1+G) 2(1+0.05)

2.1

Ke= (Div1/PO-f)+g

(2.1/200-5)+0.05

6.08

Kd= 7(1-0.35)+ 90-100/5

90+100/2

4.55-2/95

2.68

Kp= 10+100-100/10

100

10%

Wacc as per plan A

E 500000 6.1 3.04

D 250000 2.68 0.67
p 250000 100 2.5
WACC 6.21