Cost of Capital

Cost of Capital & Capital Structure Decisions

Decisions Cost of Capital
Major consideration in capital structure planning
Selection of an appropriate capital structure is dependent on number of factors. These are:
(1) Risk : Financial Risk
(2) Control : Right to vote
(3) Cost : jiski cost kam ho waha se fund le aao.

COST:
What is return for investor is the cost for company. Means cost of any source of finance is nothing
but expectation of investors (IRR). Besides expectation of investors cost is also affected by issue
expenses (named as floatation cost) and tax effect.

Cost of Debt:

Question A Bond having face value of Rs.100 and coupon of 12% p.a. will mature in 3 years. If Current
market price of bond is Rs.98. If issue expenses are Re.1 per bond and tax rate is 30% what is cost of
debt for the company?

Answer:
Year Cash Flow
0 +97
1 -8.4
2 -8.4
3 -108.4
IRR 9.60%

-12 + 12*30% = -12 + 3.6 = -8.4

Shortcuts
1) Redeemable debt:
𝑅−𝑃 100−97
𝐼(1 − 𝑡) + 12 × 0.7 + 8.4 + 1
𝑛 3
𝐾𝑑 = 𝑅+𝑃 = 100+97 = = 9.54%
98.5
2 2
2) Irredeemable or perpetual debt:
𝐼(1 − 𝑡)
𝐾𝑑 =
𝑃
here Kd = Cost of Debt
I = Amount of Interest (not the rate of interest)
P = Net proceeds from debt (issue price – issue expenses)
R = Redemption Price
t = Tax Rate bookmark

Cost of Preference Shares:

Calculation of cost of preference shares is mostly same as that of cost of debt .The only difference is
that dividend of preference shares is not an allowable expenditure for the purpose of income tax
while interest is deductible. Also dividend tax is payable on preference dividend but not on interest.
Cost of Capital
Shortcuts
1) Redeemable Preference Shares:
𝑅−𝑃
𝐷+
𝑛
𝐾𝑃 = 𝑅+𝑃
2
2) Irredeemable or perpetual* Preference shares:
𝐷
𝐾𝑃 =
𝑃
* Issue of irredeemable preference shares is not permissible as per Companies Act, 2013.

here: Kp = Cost of Preference Shares

D = Dividend (including dividend tax, if any – removed from 1st April, 2020 )
R = Redemption price
P = Proceeds from issue (Issue price – issue expenses)
t = tax Rate

Question Calculate the cost of capital for Outdated Co. Ltd. in the following situations :
5000 10% Preference shares of Rs.100 each, issued at par. Issue expenses amount to 4% in total. The
shares are redeemable @ Rs.105 per share after 9 years.
Answer
R=105, P = 96, D=10, n=9

105−96
10 +
9
𝐾𝑝 = 105+96 = 10.94%
2
105-96 ÷ 9 +10 = M+
105+96 ÷ 2 = ÷=
x MRC =

Cost of Equity Share Capital:

Measurement of cost of equity shares is somewhat different from cost of debt & preference shares
because unlike debt & preference shares there is no fixed payment to equity shareholders.

There may be different dividend patterns hence there are many approaches regarding calculation of
cost of equity shares as follows:
𝑝𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒 𝑅𝑠. 6
𝑉𝑎𝑙𝑢𝑒 = = = 𝑅𝑠. 60
𝑒𝑥𝑝𝑒𝑐𝑡𝑎𝑡𝑖𝑜𝑛 𝐾𝑒

(1) Dividend Capitalization Approach Dividend Constant

(2) Earning Capitalization Approach EPS Constant
(3) Growth Approach growth rate constant
(4) Capital Asset Pricing Model (CAPM) The Best Approach

(1) Dividend Capitalization Approach :-

𝐷
𝑃0 = 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑓𝑜𝑟𝑚𝑢𝑙𝑎
𝐾𝑒
𝐷
𝐾𝑒 = 𝐽𝑢𝑔𝑎𝑑 𝑓𝑜𝑟𝑚𝑢𝑙𝑎
𝑃
Cost of Capital
Ke = Cost of Equity
D = Dividend (including dividend tax if any)
P = Net proceeds realized (issue price - issue expenses)

Question A company's shares are presently quoted in the market at Rs.50 per share. Dividend
declared by the company is Rs.4 and it is expected to maintain the same . What is the cost of Equity
Share Capital?

Answer
𝐷 4
𝐾𝑒 = = = 8%
𝑃 50

(2) Earning Capitalization Approach : -

𝐸
𝐾𝑒 =
𝑃

Question Find out the cost of equity in the following case:

Earning per share Rs.6, Market price per share Rs.50.

Answer
𝐸 6
𝐾𝑒 = = = 12%
𝑃 50

(3) Growth Approach :-

𝐷1
𝑃0 = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑓𝑜𝑟𝑚𝑢𝑙𝑎
𝐾𝑒 − 𝑔

𝐷1
𝐾𝑒 = + 𝑔 𝐽𝑢𝑔𝑎𝑑 𝐹𝑜𝑟𝑚𝑢𝑙𝑎
𝑃0

D1 = Dividend for the first year (including dividend tax if any) = D 0(1+g)
D0 = Rs.5 g = 6% D1 = 5 x (1.06) = 5.30
g = growth rate.

Question Calculate cost of equity for Evergrowing Financial Ltd. if the dividend paid last year was Rs.2
per share, growth rate is 6% p.a. and current market price is Rs.40 per share.

Answer
𝐷1 2.12
𝐾𝑒 = +𝑔 = + 0.06 = 11.3%
𝑃0 40

Examples of D0: Examples of D1:

• Company has paid dividend • Company will pay dividend
• Company is paying dividend • Dividend at the end of current year
• Company is about to pay dividend • Dividend at end of 1st year
• Dividend for the last year • Next expected dividend
Cost of Capital
How to calculate growth rate:
Growth rate = Return on equity x Retention ratio
= 15% x 40% = 6%

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 30𝑐𝑟

𝑅𝑂𝐸 = ′
= = 15%
𝐸𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑 200𝑐𝑟

𝐷𝑃𝑆 3
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = = = 60%
𝐸𝑃𝑆 5

Retention ratio = 100 – dividend payout ratio = 100 – 60 = 40%

(4) Capital Asset Pricing Model :-

In all the above approaches we calculated cost of equity (expectation of equity shareholders) as a
balancing figure. But CAPM calculates expectation of investors based on risk.
𝐸(𝑅𝑃 ) = 𝐾𝑒 = 𝑅𝑓 + (𝑅𝑚 − 𝑅𝑓 )𝛽
𝐸(𝑅𝑃 ) = 6 + (14 − 6) × 2
=6+8x2
= 6 + 16
= 22

Here:
E(Rp) = Ideal expectation of investors, i.e., cost of capital
Rf = Risk free rate of return (say return on Govt. bonds)
Rm= Return on market portfolio (say return on BSE Sensex)
Rm – Rf= Risk premium on market portfolio
β = Risk Index (Regression coefficient)

Overall Cost of Capital: -

A firm's overall cost of capital is the weighted average of the cost of various sources of finance used
by it. The weights assigned to various sources of funds may be Book Value Weights, Market Value
Weights or Marginal Weights. Symbolically,
𝐾𝑑 × 𝐷 + 𝐾𝑃 × 𝑃 + 𝐾𝑒 × 𝐸 + 𝐾𝑟 × 𝑅
𝐾𝑂 =
𝐷+𝑃+𝐸+𝑅

Here, Ko, Ke, Kp, Kd & Kr are Overall cost of capital, cost of equity, cost of preference shares, cost of
debt and cost of Reserves respectively and D,P,E &R are weight of Debt, Preference, equity and
reserves respectively.

Question Compute the overall cost of capital for Doughtful Ltd. in the following cases using book
value weights:
(i) Cost of Debt :- Balance outstanding Market Value
Debentures 7% 10,00,000 10,50,000
Bank Loans 7.5 % 3,50,000 3,50,000
Cost of Preference Share 11 % 2,50,000 2,25,000
Cost of Equity (no.50000) 16 % 5,00,000 6,25,000
Cost of Retained earnings 15 % 15,00,000 18,75,000
Cost of Capital
𝐾𝑑 × 𝐷 + 𝐾𝑃 × 𝑃 + 𝐾𝑒 × 𝐸 + 𝐾𝑟 × 𝑅
𝐾𝑂 =
𝐷+𝑃+𝐸+𝑅

7% × 10 + 7.5% × 3.5 + 11% × 2.5 + 16% × 5 + 15% × 15

𝐾𝑂 =
10 + 3.5 + 2.5 + 5 + 15

428.75
= = 𝟏𝟏. 𝟗𝟏%
36

7% × 10.5 + 7.5% × 3.5 + 11% × 2.25 + 16% × 6.25 + 15% × 18.75

𝐾𝑂 =
10.5 + 3.5 + 2.25 + 6.25 + 18.75
505.75
=
41.25
= 𝟏𝟐. 𝟐𝟔%
Cost of Capital

Capital Structure Decisions

EBIT-EPS analysis
Till the point we have been simply calculating cost of various sources of finance. But to arrive at a
decision regarding capital structure we need to consider income also. For this we start with EBIT and
calculate EPS of all the given capital structures and chose the one with highest EPS.

EPS depicts performance. To calculate value we should go a step further. We will divided EPS by cost
of equity to calculate fair price of the share. Alternatively we can multiply EPS by P/E (because P/E =
1/Ke).

If the cost of equity or P/E is not given in the question, we can assume is to be same for all the options
hence ignore it and take decision on the basis of EPS only.
y
EPS Debt
Equity

Financial EBIT
Indifference
BEPs Point
Indifference Point: EBIT keeps on changing hence EPS and MPS will also change. Therefore it is not
fair to chose capital structure on the basis of a single EBIT only. We need to know the behavior of EPS
with change in EBIT. Indifference point may help us on this issue.

Indifference point is the level of EBIT at which EPS is same for two capital structures. To calculate
indifference point, we should assume EBIT to be “X” and put EPS of two option equal.

(𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡)(1 − 𝑡) − 𝐷𝑃
𝐸𝑃𝑆 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

Financial Break Even Point: It is the level of EBIT at which EPS is zero. Higher the Financial BEP higher
the financial risk and vice versa.

Financial Break Even Point:

(𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡)(1 − 𝑡) − 𝐷𝑃
0=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
Cost of Capital
Question A company which is presently growing and packing tea now planning to enter into jute
industry. To establish the new project it requires Rs.2 crore. It has three options as under :
1) 12% Debentures Rs.1 crore
Equity Shares Rs.1 crore

2) Equity Shares Rs.2 crore

Calculate the indifference point and the financial breakeven points. Tax rate may be assumed as
50%.

Answer
Indifference point between option 1 & 2 : Rs.24 lakhs
(𝐸𝐵𝐼𝑇 − 1200000) × 0.5 (𝐸𝐵𝐼𝑇) × 0.5
=
1000000 2000000
E – 1200000 = 0.5 E
EBIT = 1200000/0.5 = 24,00,000
Can’t calculate indifference point because debt plan is better than preference plan at all levels of
EBIT.

EPS Debt (1)

Equity (2)

EBIT
Indifference
Point = 24

Just keep in mind that if amount of equity share capital is same under two financial plans then one of
the following two situations will arise:
1) No indifference point: if after tax cost of the source other than equity shares is not same
under both plans then there will be no indifference point between the two. Because one
plan will be better than other at all levels of EBIT. For example if two plans have equity
shares of `1,00,000 each. Plan 1 has 10% debentures of `50,000 while plan 2 h as 8% Term
loan of `50,000. Then plan 2 will be better than plan 1 at any level of EBIT and there will
be no indifference point
Cost of Capital

EPS Debt

Preference

EBIT

2) Many indifference points: if after tax cost of the source other than equity shares
is same under both plans then each EBIT will be an indifference point.

EPS Plan 1

Plan 2

Both lines will

coincide

EBIT

Question X Ltd., a widely held company is considering a major expansion of its production facilities
and the following alternatives are available:

Alternatives (Rs. in Lakhs)

A B C
Share Capital (Rs.10) 50 20 10
14% Debentures - 20 15
Loan from a Financial Institution
@ 18% p.a. Rate of Interest - 10 25

Expected rate of return before tax is 25%. The rate of dividend of the company is not less than 20%.
The company at present has low debt. Corporate taxation 50%. Which of the alternatives you would
choose?
Cost of Capital
Answer
𝐸𝐵𝐼𝑇
𝑅𝑂𝐼 = → 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 ∗ 𝑅𝑂𝐼 = 𝐸𝐵𝐼𝑇 = 50 ∗ 25% = 𝟏𝟐. 𝟓
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Particulars A B C
EBIT 1250000 1250000 1250000
Interest 0 -460000 -660000
PBT 1250000 790000 590000
Tax@50% -625000 -395000 -295000
PAT 625000 395000 295000
No. 500000 200000 100000
EPS 1.25 1.98 2.95
÷ Ke 20.00% 20.00% 20.00%
MPS 6.25 9.88 14.75

EBIT = 50 x 25% = 12.5 lakh

Decision:
1) Plan C is the best to raise Rs.50 lakhs
2) Accept this business proposal because value of share is rising from Rs.10 to Rs.14.75 per share