cf_7_2024

COST OF CAPITAL
What does it mean?

 The cost of capital is the rate of return required by the
suppliers of capital (bondholders and shareholders).
 Cost of funds for a company

 Or
 Required rate of return by the bondholders and owners

Significance of the Cost of Capital
 Evaluating investment decisions
 Thefirm creates value when it provides a return
greater than its cost of capital
COST OF PREFERENCE CAPITAL
 For REDEEMABLE preference shares

n Dt M
P0 =  +
t=1 (1 + kp)t (1 + kp)n
kp is the cost of preference capital

P0 = price of the preference shares
Dt = annual preference dividend
n = number of years left to maturity
M = maturity value
ILLUSTRATION
 Face value : Rs.100
 Dividend rate : 11 percent
 Maturity period : 5 years
 Issue price : Rs.95
Approximate answer
 100 - 95 
  11 
 
5
kp
 100  95 
= 12.31 percent
 
 2 
Using trial and error approach
 At 12%, PV =96.4
 At 13%, PV =92.97
 Using interpolation,
(96.4 − 95 )
12% + 𝑥1
(96.4−92.97)
 =12.408%
 Exact answer 12.40%
COST OF IRREDEEMABLE PREFERENCE SHARES
𝐷𝑝
 kp =
𝑃0
 kp is the cost of preference share
 𝐷𝑝 is the preference dividend given
 P0 is the price
 A company issues 10% preference share (with a
face value of 100) at Rs 97 per share.
10
 Cost = = 10.31%
97
Cost of Equity Shares
 Cost of Equity Shares is difficult to assess as it

is the return required by the investors on their
investment in shares.
 Cost of Equity finance has to be calculated for:
 Existing equity capital
 Retained earnings (Reserves & Surplus)
APPROACHES TO ESTIMATE COST OF EQUITY
 CAPM
 Or
 Dividend Growth Model (Gordon)

 ke = Rf +  (RM – Rf)
 or
 ke = Rf +  [Market Risk Premium]
 ke is cost of equity or the required rate of return on equity

shares by shareholders
 Rf = risk-free rate
  = beta
 RM = expected return on the market portfolio
Illustration
 Rf = 7%,  = 1.2, Market Risk Premium = 8%
 ke = 0.07 + 1.2 [0.08]
 = 0.166 or 16.6%
 --------------------------------
 Rf = 7%,  = 1.2, Rm = 15%
 ke = 0.07 + 1.2 (0.15 - 0.07)
 = 0.166 or 16.6%
DIVIDEND GROWTH MODEL APPROACH
(Gordon Model)
 Gordon model assumes the dividend per share
grows at a constant rate of g
D1
P0 
ke  g
 So,
𝐷1
 𝑘𝑒 = +g
𝑃0
EXAMPLE
The dividend just given is Rs 4.19; The price of the shares in the
market is Rs 50; Growth expected in the long term is 5%.
Find the cost of equity
D1 D0(1+g)
ke = +g= +g
P0 P0
= 4.19*(1.05)
+ 0.05
50
= 0.0879 + 0.05
= 13.79%
COST OF RETAINED EARNINGS
 Retained Earnings are mentioned as ‘Reserves and
Surplus’
 Cost is SAME as Cost of Equity

COST OF DEBT (before tax)
n Ct M
 P0 =  +
t=1 (1 + kd)t (1 + kd)n
 kd = cost of debt (before tax)
 P0 = price of the debenture / bond
 Ct = annual interest payment
 n = number of years left to maturity
 M = maturity value
 kd may be computed through trial-and-error
 Or, a very close approximation is
M-P
 Ct
n
kd = MP
2
M = Maturity Value
P = Bond Price
C = the annual coupon interest (in Rupees)
n = number of years
ILLUSTRATION
 Face value = Rs 1000

 Coupon rate = 12 percent
 Period to maturity = 4 years
 Issue price = Rs 1040
 The approximate yield to maturity of this
debenture is :
 1000 - 1040  
  120 
 
kd 4
 1000  1040  
 
 2 
= 10.78 %
Using trial and error approach
 At 10%, PV =1063.39
 At 11%, PV =1031.02
 Using interpolation,
(1063.39 − 1040)
10% + 𝑥1
(1063.4−1031.02)
 =10.72%
 Exact answer 10.72%
COST OF DEBT (after tax)
 = (Cost of debt before tax)*(1-tax rate)
 If the tax rate in the previous example is 30%, the

after tax cost of debt is:
= 0.1072 * (1-0.3)
= 7.504%
Why after tax?

Company ABC
No loan
EBIT 75000
Interest 0
PBT 75000
Tax (20%) 15000
PAT 60000
ABC company borrows Rs 2,00,000 at 6%. Interest
payment for the year is Rs 12,000.
With loan
EBIT 75000
Interest 12000
PBT 63000
Tax (20%) 12600
PAT 50400
A company borrows Rs 2,00,000 at 6%. Interest
payment for the year is Rs 12,000.
No loan With loan
EBIT 75000 75000
Interest 0 12000
PBT 75000 63000
Tax (20%) 15000 12600
PAT 60000 50400

Taxes reduced by 15000-12600 = 2400
 After tax interest payment
 = 12000-2400
 = 9600
 After tax interest cost
 = 9600/2,00,000
 = 4.8%
 Or
 Before tax cost of debt 6%

 After tax cost of debt
 = 6*(1-0.2) = 4.8%
WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
 WACC = weke + wpkp + wdkd (1 – tc)
 we = proportion of equity in the capital structure

 ke = cost of equity
 wp = proportion of preference in the capital structure
 kp = cost of preference
 wd = proportion of debt in the capital structure
 kd = pre-tax cost of debt
 tc = corporate tax rate
Problem on WACC
 A company has the following capital structure:

Equity Capital: Rs 40 crores
Reserves and Surplus: Rs 20 crores
Preference Capital: Rs 5 crores
Long term debt: Rs 35 crores
The after-tax costs of individual sources have been calculated by the

Finance department as:
Equity Capital and Reserves & Surplus : 16%
Preference Capital: 14%
Long term debt: 8.4%
Calculate the WACC for the company.

Source of Capital Proportion Cost Weighted Cost
(1) (2) [(1) x (2)]
Equity 0.40 16.0% 6.40%
Reserves & Surplus 0.20 16.0% 3.20%
Preference 0.05 14.0% 0.70%
Debt 0.35 8.4% 2.94%
WACC = 13.24%
Book Value Versus Market Value Weights
 Market-value weights are theoretically superior to

book-value weights:
 They reflect economic values and are not influenced by
accounting policies.
 The difficulty in using market-value weights:

 The market prices of securities fluctuate widely and
frequently.
 A market value based target capital structure means that
the amounts of debt and equity are continuously adjusted
as the value of the firm changes.
WACC using market weights
A company has the following capital structure:
Reserves and Surplus: Rs 20 crores
Debentures: Rs 30 crores
The value of equity shares in the market is Rs 100 crores
and market value of debentures is Rs 35 crores
The after tax costs of individual sources have been calculated by the Finance
department as:
Equity Capital: 16%
 Calculate the WACC using market weights
Calculation of weights
 Total = 100 + 5 + 35 = 140
 Equity and R&S = 100/140 = 0.714286

 Preference = 5/140 = 0.035714
 Debt = 35/140 = 0.25
WACC using market weights
Weighted
Source of Capital Cost Weight Cost
Equity and R&S 100 0.16 0.714286 0.1143
Preference 5 0.14 0.035714 0.005
Debt 35 0.084 0.25 0.021
140 14.03%
Marginal Cost
 Weighted Marginal Cost of Capital (WMCC) is
the weighted average cost of new / incremental
capital given the firm’s target capital structure.
 A company is proposing to have the following capital
structure:
Reserves and Surplus Rs 20 crores
Long term debt: Rs 25 crores
The after tax costs of individual sources have been calculated by

the Finance department as:
Equity Capital: 16%
WMCC
Source of Capital Proportion Cost Weighted Cost
(1) (2) [(1) x (2)]
Equity 0.50 16.0% 8.0%
Reserves and Surplus 0.20 16.0% 3.2%
Preference 0.05 14.0% 0.7%
Debt 0.25 8.4% 2.1%
WMCC = 14.0%
 Suppose the cost of capital of the Gadget
Company is 10 percent. If Gadget has a capital
structure that is 50 percent debt and 50 percent
equity, its before-tax cost of debt is 5 percent, and
its marginal tax rate is 20 percent, then its cost of
equity capital is ?
 0.1 = 0.5 (.05)(1-0.2) + 0.5 (ke)

 Ke = .16 or 16%
Cost for new issues
 Floatation or issue costs consist of items like
underwriting costs, brokerage expenses, fees of
investment bankers, advertisements etc.
 One can adjust floatation costs with the specific
sources of capital

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COST OF CAPITAL

What does it mean?

 Cost of funds for a company

 Required rate of return by the bondholders and owners

 For REDEEMABLE preference shares

kp is the cost of preference capital

 Cost of Equity Shares is difficult to assess as it

 Dividend Growth Model (Gordon)

 ke is cost of equity or the required rate of return on equity

 Cost is SAME as Cost of Equity

 Face value = Rs 1000

 = (Cost of debt before tax)*(1-tax rate)

 If the tax rate in the previous example is 30%, the

Why after tax?

Tax (20%) 15000

Tax (20%) 12600

No loan With loan

EBIT 75000 75000

PBT 75000 63000

Tax (20%) 15000 12600

PAT 60000 50400

 Before tax cost of debt 6%

 WACC = weke + wpkp + wdkd (1 – tc)

 we = proportion of equity in the capital structure

 A company has the following capital structure:

The after-tax costs of individual sources have been calculated by the

Calculate the WACC for the company.

 Market-value weights are theoretically superior to

 The difficulty in using market-value weights:

 Equity and R&S = 100/140 = 0.714286

Equity and R&S 100 0.16 0.714286 0.1143

Preference 5 0.14 0.035714 0.005

Debt 35 0.084 0.25 0.021

The after tax costs of individual sources have been calculated by

 0.1 = 0.5 (.05)(1-0.2) + 0.5 (ke)

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