Dr.

Amit Gupta
Concept and Measurement
of Cost of Capital
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Cost of Capital
In operational terms, it is defined as the weighted average cost of capital
(k
0
) of all long-term sources of finance. The major long-term sources of
funds are
1) Debt,
2) Preference shares,
3) Equity capital, and
4) Retained earnings.
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Explicit and Implicit Costs
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Measurement of Specific Costs
There are four types of specific costs
1) Cost of Debt
2) Cost of Preference Shares
3) Cost of Equity Capital
4) Cost of Retained Earnings
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Cost of Debt
Cost of debt is the after tax cost of long-term funds
through borrowing. The debt carries a certain rate of
interest. Interest qualifies for tax deduction in
determining tax liability. Therefore, the effective cost
of debt is less than the actual interest payment made
by the firm by the amount of tax shield it provides.
The debt can be either
1) Perpetual/ irredeemable Debt
2) Redeemable Debt
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Perpetual Debt
In the case of perpetual debt, it is computed dividing effective interest
payment, i.e., I (1 t) by the amount of debt/sale proceeds of debentures or
bonds (SV). Symbolically
k
i
= Before-tax cost of debt
k
d
= Tax-adjusted cost of debt
I = Annual interest payment
SV = Sale proceeds of the bond/debenture
t = Tax rate

) 4 (
SV
t 1 I
k
) 3 (
SV
1
k
d
t

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Solution
(i) Debt issued at par
Before-tax cost, k
i
= (Rs 10,000 / Rs 1,00,000) = 10 per cent
After-tax cost, k
d
= k
i
(1 t) = 10% (1 0.35) = 6.5 per cent
(ii) Issued at discount
Before-tax cost, k
i
= (Rs 10,000 / Rs 90,000) = 11.11 per cent
After-tax cost, k
d
= 11.11% (1 0.35) = 7.22 per cent
(iii) Issued at premium
Before-tax cost, k
i
= (Rs 10,000 / Rs 1,10,000) = 9.09 per cent
After-tax cost, k
d
= 9.09% (1 0.35) = 5.91 per cent
Example
A company has 10 per cent perpetual debt of Rs 1,00,000.
The tax rate is 35 per cent. Determine the cost of capital
(before tax as well as after tax) assuming the debt is issued
at (i) par, (ii) 10 per cent discount, and (iii) 10 per cent
premium.
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Redeemable Debt
Dr. Amit Gupta
where I = Annual interest payment
RV = Redeemable value of debentures/debt
SV = Net sales proceeds from the issue of debenture/debt
(face value of debt minus issue expenses)
N
m
= Term of debt
f = Flotation cost
d = Discount on issue of debentures
pi = Premium on issue of debentures
pr = Premium on redemption of debentures
t = Tax rate

/2 SV RV
m
/N pi pr d f t 1 I
d
k

Yield to Maturity
n Yield to maturity (YTM) is a rate of return that measures the
total return of a bond/debenture (coupon/interest payments
as well as capital gain or loss) from the time of purchase
until maturity. The calculation of YTM takes into account
the current market price, the par value, coupon interest rates
and the time to maturity. It is also assumed in yield to maturity that
all coupons are reinvested at the same rate.
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Yield to Maturity (Contd)
In the formula,
P
0
= issue price of debt
I
t
= the interest paid on debt
P
n
= repayment of debt on maturity
Y = yield or return to maturity
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Yield to Maturity (Contd)
We can also use the shortcut formula to calculate yield to maturity:
where YTM = yield to maturity
I
t
= interest paid on debt
M = par or maturity value of debt or redemption value
P
b
= debts issue price or its purchase price or net realized value
M P
b
= Debt premium
N = life of debt or number of years to maturity
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Yield to Maturity: An Example
ABC Ltd issues bonds of par value INR 2000 at 12 per cent interest,
on 8 per cent discount for 10 years, calculate its yield to maturity.
Solution
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Dr. Amit Gupta
Cost of Preference Shares
The cost of preference share (k
p
) is akin to k
d
.
However, unlike interest payment on debt, dividend
payable on preference shares is not tax deductible
from the point of view assessing tax liability. On the
contrary, tax (D
t
) may be required to be paid on the
payment of preference dividend.
n Irredeemable Preference Shares
n Redeemable Preference Shares
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Irredeemable Preference Shares
The cost of preference shares in the case of irredeemable
preference shares is based on dividends payable on them and the
sale proceeds obtained by issuing such preference shares, P
0
(1
f ). In terms of equation:
where k
p
= Cost of preference capital
D
p
= Constant annual dividend payment
P
0
= Expected sales price of preference shares
f = Flotation costs as a percentage of sales price
D
t
= Tax on preference dividend


f P
D D
k
f P
D
K
t p
p
p
p

1
1
1
0
0
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Example
A company issues 11 per cent irredeemable preference shares of the face
value of Rs 100 each. Flotation costs are estimated at 5 per cent of the
expected sale price. (a) What is the k
p
, if preference shares are issued at (i)
par value, (ii) 10 per cent premium, and (iii) 5 per cent discount? (b) Also,
compute k
p
in these situations assuming 13.125 per cent dividend tax
Solution



% 2 . 12
05 . 0 1 95 Rs
11 Rs
) iii (
% 5 . 10
05 . 0 1 110 Rs
11 Rs
) ii (
% 6 . 11
05 . 0 1 100 Rs
11 Rs
) i ( ) a (

p
p
p
k
Discount at Issued
k
Premium at Issued
k
par at Issued
% 8 . 13
25 . 90 Rs
44 . 12 Rs
) iii (
% 9 . 11
5 . 104 Rs
44 . 12 Rs
) ii (
% 1 . 13
95 Rs
44 . 12 Rs ) 13125 . 1 ( 11 Rs
) i ( ) b (

p
p
p
k
Discount at Issued
k
Premium at Issued
k
par at Issued
Cost of Redeemable Preference Shares
Where k
p
is the cost of preference share, D
t
is the dividend, P
0
is the
issue price of preference share, P
n
is the redemption price, n is the
maturity period.
Like redeemable debt we can also use the shortcut formula for
calculating cost of preference shares:
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Cost of Redeemable Preference Shares
(Contd)
In the formula,
k
p
= cost of preference shares,
M = par or maturity value of preference shares or redemption value,
P
b
= preference shares issue price or its purchase price or net
realized value,
M - P
b
= share premium,
N = life of preference shares or no. of years to maturity
Dr. Amit Gupta
Dr. Amit Gupta
The computation of cost of equity capital (k
e
) is
conceptually more difficult as the return to the equity-
holders solely depends upon the discretion of the
company management. It is defined as the minimum
rate of return that a corporate must earn on the
equity-financed portion of an investment project in
order to leave unchanged the market price of the
shares. There are two approaches to measure k
e
:
1) Dividend Valuation Model Approach
2) Capital Asset Pricing Model (CAPM) Approach.
Cost of Equity Capital
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As per the dividend approach, cost of equity capital is defined as the
discount rate that equates the present value of all expected future
dividends per share with the net proceeds of the sale (or the current
market price) of a share.
The cost of equity capital can be measured with the following equation:
(A) When dividends are expected to grow at a uniform rate perpetually:
where D
1
= Expected dividend per share
P
0
= Net proceeds per share/current market price
g = Growth in expected dividends
Dividend Valuation Approach
g
P
D
k
0
1
e

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(B) Under different growth assumptions of dividends over the
years:




years later in growth Constant g
years earlier in growth of Rate whereg
k 1
g 1 D
k 1
g 1 D
P
c
b
n
1 t 1 n t
t
e
1 t
c n
t
e
1 t
b 0
0

Dr. Amit Gupta
Example 6
Suppose that dividend per share of a firm is expected to be Re 1 per share
next year and is expected to grow at 6 per cent per year perpetually.
Determine the cost of equity capital, assuming the market price per share is
Rs 25.
Solution: This is a case of constant growth of expected dividends. The k
e
can
be calculated by using Equation
The dividend approach can be used to determine the expected
market value of a share in different years. The expected value of a
share of the hypothetical firm in Example 6 at the end of years 1 and
2 would be as follows
% 10 06 . 0
25 Rs
1 Rs
g
0
P
1
D
e
k
28 Rs
0.06 0.10
1.124 Rs
g
e
k
3
D
2
P (ii)
26.50 Rs
0.06 0.10
1.06 Rs
g
e
k
2
D
)
1
(P year first the of end the at Price (i)

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Example 7
From the undermentioned facts determine the cost of equity shares of
company X:
(i) Current market price of a share = Rs 150.
(ii) Cost of floatation per share on new shares, Rs 3.
(iii) Dividend paid on the outstanding shares over the past five years:
Year Dividend per share
1
2
3
4
5
6
Rs 10.50
11.02
11.58
12.16
12.76
13.40
(iv) Assume a fixed dividend pay out ratio.
(v) Expected dividend on the new shares at the end of the current year is Rs
14.10 per share.
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Solution
As a first step, we have to estimate the growth rate in
dividends. Using the compound interest table (Table A-1), the
annual growth rate of dividends would be approximately 5 per
cent. (During the five years the dividends have increased from
Rs 10.50 to Rs 13.40, giving a compound factor of 1.276, that is,
Rs 13.40/Rs 10.50. The sum of Re 1 would accumulate to Rs
1.276 in five years @ 5 per cent interest).

% 6 . 14 % 5
3 Rs 150 Rs 147 Rs
10 . 14 Rs
k
e

Dr. Amit Gupta

CAPITAL ASSET PRICING MODEL
(CAPM) APPROACH
The CAPM describes the relationship between the required rate of return or
the cost of equity capital and the non-diversifiable or relevant risk of the
firm as reflected in its index of non-diversifiable risk, that is, beta.
Symbolically,
K
e
= R
f
+ b (K
m
R
f
)
R
f
= Required rate of return on risk-free investment
b = Beta coefficient**, and
K
m
= Required rate of return on market portfolio, that is, the average rate or
return on all assets
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Example 8
The Hypothetical Ltd wishes to calculate its cost of equity
capital using the capital asset pricing model approach. From
the information provided to the firm by its investment advisors
along with the firms own analysis, it is found that the risk-free
rate of return equals 10 per cent; the firms beta equals 1.50
and the return on the market portfolio equals 12.5 per cent.
Compute the cost of equity capital.
Solution
K
e
= 10% + [1.5 (12.5% 10%)] = 13.75 per cent
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Example 9: As an investment manager you are given the following
information
Investment in equity
shares of
Initial
price
Dividends Year-end
market price
Beta risk
factor
A Cement Ltd
Steel Ltd
Liquor Ltd
B Government of India
Bonds
Risk-free return, 8 per cent
Rs 25
35
45
1,000
Rs 2
2
2
140
Rs 50
60
135
1,005
0.80
0.70
0.50
0.99
You are required to calculate (i) expected rate of returns of market portfolio,
and (ii) expected return in each security, using capital asset pricing model
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Solution
(i) Expected Returns on Market Portfolio
Security Return Investment
Dividends Capital
Appreciation
Total
A Cement Ltd
Steel Ltd
Liquor Ltd
B Government
of India Bonds
Rs 2
2
2
140
146
Rs 25
25
90
5
145
Rs 27
27
92
145
291
Rs 25
35
45
1,000
1.105
Rate of return (expected) on market portfolio = Rs 291/Rs 1,105 = 26.33 per
cent
(ii) Expected Returns on Individual Security (in percent)
k
e
= R
f
+ b(k
m
R
f
)
Cement Ltd = 8% + 0.8 (26.33% 8%) 22.66
Steel Ltd = 8% + 0.7 (26.33% 8%) 20.83
Liquor Ltd = 8% + 0.5 (26.33% 8%) 17.16
Government of India Bonds = 8% + 0.99 (26.33% 8%) 26.15
Capital Asset Pricing Model
Assume that R
f
is 9 per cent and R
m
is 18 per cent. If a
security has a beta factor of: (a) 1.4, (b) 1.0 and (c) 2.3,
determine the expected return of the security.

Solution
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Capital Asset Pricing Model
Using the information in the table below, calculate the market
portfolio return and the expected return on security using CAPM.
The risk-free return is 14 per cent.
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Capital Asset Pricing Model
Solution
The table below shows the returns on the portfolio:
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Capital Asset Pricing Model
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Dr. Amit Gupta
The capital assets pricing model (CAPM) approach to calculate the
cost of equity capital is different from the dividend valuation
approach in some respects. In the first place, the CAPM approach
directly considers the risk as reflected in beta in order to determine
the K
e
. The valuation model does not consider the risk; it rather uses
the market price as a reflection of the expected risk-return preference
of investors in the market.
Secondly, the dividend model can be adjusted for flotation cost to
estimate the cost of the new equity shares. The CAPM approach is
incapable of such adjustment as the model does not include the
market price which has to be adjusted.
Both the dividend and CAPM approaches are theoretically sound. But
major problems are encountered in the practical application of the
CAPM approach in collecting datawhich may not be readily
available or in a country like India may be altogether absent
regarding expected future returns, the most appropriate estimate of
the risk-free rate and the best estimates of the securitys beta.
Cost of Retained Earnings
n Cost of retained earnings is the required rate of return on
equity.
n Retained earnings is the earnings left after deducting
dividend payments and other provisions from profit after tax
(PAT).
n The cost of retained earnings (internal funds) is similar to the
cost of equity.
n Because shareholders forego their current income when they
allow the company to use the retained earnings in profitable
investments
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Cost of Retained Earnings (Contd)
Generally, the cost of retained earnings is slightly less than the cost of
equity since no issuance costs are incurred. Floatation cost is
considered when determining the cost of equity. Retained earnings is
the residual earnings of a firm.
where k
e
is cost of equity, k
re
is the cost of retained earnings and
f is the floatation cost.
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Weighted Average Cost of
Capital (WACC)
n The capital that a company procures is derived from
various sources.
n Each source of capital has a distinct cost attached
to it.
n The overall cost of capital is termed as weighted
average cost of capital (WACC).

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Weighted Average Cost of Capital (Contd)
WACC is calculated by multiplying the cost of each capital
component by its proportional weighting and then
summing them.
Thus,

WACC = w
d
(cost of debt) + w
s
(cost of equity) + w
p
(cost
of preferred stock)+ w
re
(cost of retained earnings)

Where w
d
is weight of debt, w
s
is weight of equity, w
p
is
weight of preference shares, w
re
is weight of retained
earnings.
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Weighted Average Cost of
Capital: An Example
Calculate the weighted average cost of capital from the figures
shown in the table below:
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Weighted Average Cost of
Capital: An Example (Contd)
Solution
Market prices are INR 1,050 for bonds, INR 65.00 for common stock and
INR 35.00 for preferred stock. Total market values are calculated as follows:
Long-term debt = 5,000 INR 1,050 INR 5,250,000
Common stock = 62,500 INR 65.00 INR 4,062,500
Preferred stock = 20,000 INR 35.00 INR 7,00,000
Since retained earnings have a market value closely tied to the common
stock, we will allocate the common stock market value between the
common stock and the retained earnings based on the book values.
Common stock = INR 40,62,500 (INR 2,500,000/INR 3,250,000)
= INR 3,125,000
Retained earnings = INR 40,62,500 (INR 7,50,000/INR 3,250,000)
= INR 9,37,500

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Weighted Average Cost of
Capital: An Example (Contd)
The weighted average cost of capital is calculated as shown in the
table below:
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