INTRODUCTION Cost of capital is an extremely important input requirement for capital budgeting decision.
Without knowing the cost of capital no firm can
evaluate the desirability of the implementation of new projects.
Cost of capital serves as a benchmark for evaluation.
2 COST OF DEBT Companies may raise debt capital through issue of debentures or through loans from financial institutions or accept deposits from public.
All these resources involves a specific rate of interest.
The interest paid on these sources of funds is charged to the
profits of the company.
Interest payment made by the firm on debt issue qualify
tax deduction in determining net taxable income.
Computation of Cost of Debenture or debt capital depends
on their nature. The debenture/debt can be irredeemable or 3 redeemable. COST OF IRREDEEMABLE DEBT Perpetual funds provide permanent funds to the firm, because the funds will remain in the firm till liquidation.
Bonds or Debentures can be issued at
Par/Face Value Discount Premium
4 Following formula is used to compute cost of debt: 1. Pre-tax cost:
2. Post Tax:
Where, Kd = Cost of Debt P = Principle amount or face value NP = Net sales proceeds 5 T = Tax rate Q.1.Rama & Company has issued 15% irredeemable debentures of Rs.10,00,000 @ Rs.100each. Determine cost of debt if tax rate is 35% assuming it is issued at i) At par ii) 10% premium iii) 10% Discount.
6 COST OF REDEEMABLE DEBT Redeemable debenture are those having a maturity period or repayable after certain given period of time.
In other words these type of debenture are under
legal obligation to repay the principal amount to its holder at the end of the maturity period.
Cost of Redeemable Debt is calculated using following
formula: P NP I (1 T ) Kd n P NP 7 2 Q.2. BE Company issues debentures carrying 15% coupon rate at a par value of Rs.100. The debentures will be redeemed after 7 years at face value. The cost of issue is 3% and tax rate is 35%. Calculate cost of Debentures.
8 Q.3. A company issues debentures of Rs. 100,000 and allows 2% commission to brokers. Debenture carries interest rate @12%. The debentures are due to maturity at the end of 10th year. You are required to calculate the effective cost of debt if tax rate is 50%.
9 If the debentures are redeemed at premium or discount:
Where, Kd = Cost of Debt RV = Redemption value of the debenture. P = Principle amount or face value NP = Net sales proceeds T = Tax rate n = no of years 10 Q.4. A company is planning to raise Rs.50 lakhs by issue of 5 year repayable public deposits at 10% interest. The issue involves 3% brokerage, 2% printing and stationery and 2% advertising expenditure. The company’s tax rate is 40%. Calculate cost of public deposits capital if it is to be repaid at 5% premium.
11 COST OF PREFERENCE CAPITAL Preference share is one of the types of shares issued by the companies to raise funds from public.
Preference share is the share that has two
preferential right over equity shares: Preference in payment of dividend from distributable profits Preference in the payment of capital at the time of liquidation of the company.
There are various types of preference shares but for
the computation of cost of preference capital shall only be for irredeemable and redeemable. 12 COST OF IRREDEEMABLE PREFERENCE SHARE
Where, Kp = Cost of preference share
D = Dividend per share
NP = Net proceeds
13 Q.5. Sai Ram co. is planning to issue 14% perpetual preference shares, face value of Rs.100 each. Floatation cost is estimated to be 4%. Compute cost of preference shares if it is issued at i) face value, ii) 10% premium and iii) 5% discount
14 COST OF REDEEMABLE PREFERENCE SHARES
Shares that are issued for a specific maturity period or
redeemable after specific period are known as redeemable preference shares.
Cost of Redeemable Preference shares is calculated
using following formula:
P NP D Kp n P NP 2 15 Q.6. Dell Ltd. wants to issue Rs.100 par value preference shares redeemable after 15 years. The coupon rate offered is12% and floatation cost is 5%. Calculate cost of preference shares if it is to be redeemed at premium of 10%.
16 COST OF EQUITY Cost of equity may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment project.
Cost of equity capital is most difficult to determine
because It is not directly observable There is no legal binding to pay any compensation, and It is not explicitly mentioned.
17 APPROACHES COST OF EQUITY Cost of equity is determined by Dividend capitalization approach CAPM based approach.
Both approaches are driven by market conditions
and measure the cost of equity in an indirect manner.
The price to be used in any of the model is the
market determined.
18 Dividend capitalization approach: Dividend capitalization approach determines the cost of equity by equating the stream of expected dividends to its market price.
19 Capital Asset pricing model: CAPM based determination of cost of equity considers the risk characteristics that dividend capitalization approach ignores.
Ke = Rf + β(Rm- Rf)
20 Q.7. Equity share of a paper manufacturing company is currently selling at Rs.100. It wants to finance its capital expenditure of Rs.1,00,000 either by retaining earnings or selling new shares. If company seeks to sell shares, the issue price will be 95. The expected dividend for the next year is 4.75 and it is expected to grow at 6% perpetually. Calculate the cost of new equity capital.
21 Q.8. A company plans to issue 10,000 new shares of Rs. 100 each at a par. The floatation cost is expected to be 4% of the share price. The company would pay a dividend of Rs. 12 per share and 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 Rs. 120. Calculate the cost of existing equity share capital.
22 COST OF RETAINED EARNING Retained earnings is one of the internal sources of funds to raise equity funds.
Retained earnings are those part of net earnings
which is retained by the firm for investing in capital budgeting proposals instead of paying them as dividends to shareholders.
The cost of retained earning (Kr) is equal to cost of
Equity (Ke).
23 WEIGHTED AVERAGE COST OF CAPITAL WACC is a composite figure reflecting cost of each component multiplied by the weight of each component. WACC = Wd X Kd + Wp X Kp + We X Ke + Wr X Kr
We = Proportions of Equity Ke = Cost of Equity Wp = Proportion of Preference Capital Kp = Cost of Preference Capital Wd = Proportion of Debt Kd = Cost of Debt Wr = Proportion of Retained Earnings 24 Kr = Cost of Retained Earnings BOOK VALUE VS MARKET VALUE The weights for computation of WACC can either be based on
Book Values Market Values
Though book value weights appear convenient
and practical it lacks conviction ignoring current trends.
Use of market value based weights is technically
superior reflecting the current expectations of investors. 25 Q.9. A firm’s after-tax cost of capital of the specific sources is as follows: Cost of Debt is 8%
Cost of Preference shares is 14%
Cost of Equity funds is 17%
Calculate WACC using book value weights and market
value weights from following is the capital structure:
26 Q.10. The following data presents the book value capital structure of a particular company: Particulars Amount Debenture (Rs. 100 per debenture) 7,00,000 Preference Shares (Rs. 100 per share) 3,00,000 Equity Shares (Rs. 10 per share) 10,00,000
All these securities are traded on capital market and their recent market prices are: Debentures Rs.110 per debenture, Preference Share Rs. 120 per share and Equity share Rs.20 per share. Further details are given below: Face value of a debenture Rs. 100, redeemable after 8 years, 13% interest rate and 4% flotation cost. 14% Preference shares redeemable after 5 years, flotation cost of 5% and face value is Rs. 100. Equity share selling price of Rs. 20 per share; in addition, the dividend expected on equity share at the end of the year is Rs.2 per share. The anticipated growth rate in dividends is 6% and the firm has the practice of paying all its earnings in the form of dividends. The corporate tax rate is 35%. You are required to calculate WACC 27 based on book value weights and market value weights. Q.11. Citrus Ltd, has following book value capital structure:
Particulars (Rs crores)
Equity capital (in shares of Rs. 10 each, fully paid up—at par) 25 11% Preference capital (in shares of Rs. 100 each, fully paid 2 up—at par) Retained Earnings 40 14% Debentures (of Rs. 100 each, issued at par) 10 12% Term loans 10
The next expected dividend on equity shares is Rs 5 per share; the
dividend per share is expected to grow at the rate of 8 per cent. The market price per share is Rs 50. The Income- tax rate for the company is 30 per cent. Preference stock, redeemable after ten years, is currently selling at Rs. 90 per share. Debentures, redeemable after five years, are selling at Rs 95 per debenture. You are required to calculate the weighted average cost of capital using: 28 (a) Book value proportions (b) Market value proportions.
