Cost of capital

• A firm needs funds for its’ various capital

budgeting proposals.
• These funds are procured from different types of
investors
– Equity shareholders
– Preference shareholders
– Debenture holders
• These investors provides funds to the firm with
expectation of receiving a minimum return from
the firm.
• The returns payable to investors would be
earned out of revenues generated by the
proposals wherein funds are used.

• The minimum rate of return which a firm must

earn in order to satisfy the ‘expectations of
investors’ is cost of capital of the firm.
 Significance
• If firm’s rate of return > cost of capital
then,
• the goal of wealth maximization will be achieved.
• the investor will not have any doubt of receiving
their expected rate of return from firm.
• Excess portion of return will be used:
– For distribution of higher than expected dividends
– For reinvestment within firm for further increasing
returns
• Cost of capital can be used as discount rate in
capital budgeting as it helps in accepting
proposals whose rate of return is higher than
cost of capital.
• Helps in deciding the capital structure of firm,
as the funds raised from different sources
must be raised at minimum cost
 Cost of equity share capital
• It is required rate of return on equity share
capital.
• The following models are used to calculate Ke
– Earning / Price Model
– Dividend growth model
– Earning growth model
– Realized yield approach
 Earning/price model
• It is calculated by dividing EPS by current
market price per share
• Ke= E/P
 Problem solving
• The share capital of company is represented
by 20000 shares of Rs. 10 each. The current
market price of share is Rs. 40.
• The earnings available to equity shareholders
amounts to Rs. 100,000 at end of period.
• Calculate cost of equity capital using
earning/price ratio.
 Dividend growth model
• Cost of equity is calculated as
• Ke = D/P + g
• Where D = dividend per share
• P = current market price
• g = growth in dividend
 Problem solving
• If the rate of current dividend to equity
shareholders = 30%
• Price of one share = Rs. 10
• Growth rate in dividend = 5%
• Market price per share Rs. 40
• Calculate cost of equity capital
 Earnings growth model
• Cost of equity is calculated as
• Ke = E/P + g
• Where E = earnings per share
• P = current market price
• g = growth in dividend
 Problem solving
• If earnings per share = Rs. 5
• Growth rate in dividend = 10%
• Market price per share Rs. 40
• Calculate cost of equity capital
 Problem Solving
• A firm is considering an expenditure of Rs. 75
lakhs for expanding its operations.
• The relevant information is as follows :
– Number of existing equity shares =10 lakhs
– Market value of existing share =Rs.100
– Net earnings =Rs.100 lakhs
• Compute the cost of existing equity share capital
and of new equity capital assuming that new
shares will be issued at a price of Rs. 92 per share
and the costs of new issue will be Rs. 2 per share.
 Realized Yield Approach
• Under this method, cost of equity is calculated
on the basis of return actually realized by the
investor in a company on their equity capital.
• Formula is ;
• Ke = PVf ×D
– Ke = Cost of equity capital.
– PVƒ = Present value of discount factor.
– D = Dividend per share.
 Cost of preference share capital
• It is the dividend expected by the preference
shareholders.
• Preference share capital can be redeemable or
irredeemable.
 Cost of irredeemable Preference
Dividend
• Kp= D/I
Where D= Dividend Per Share (Fixed)
I= Net proceeds of the preference share issue
(Per Share)
(Used for irredeemable preference shares)
 Problem solving
• A company issues 1000 9% preference shares
of Rs. 50 each at a discount of 5%. Calculate
the cost of preference share capital.
Cost of Redeemable Preference Shares
• Kp= [D+ 1/n (FV-IP)] / [1/2 (FV+IP)]

Where D= Annual Dividend Payable

FV = Face Value of Preference Shares
IP = Issue Price of Shares
 Problem solving
• X Ltd issues 1000 10% preference shares of Rs.
100 each at Rs. 95 each, redeemable at the
end of the 10th year from the year of issue.
• You are required to calculate the cost of
preference shares.
 Cost of Retained Earnings
• Although these funds do not cost anything, there is a
definite opportunity cost involved and that is the
dividend foregone by the shareholders. Two
methods:
1. Reinvestment Assumption- Kr=Ke(1-t)(1-C),
Where Ke= Cost of equity capital
t= Tax rate
C= Commission, brokerage etc expressed as a
percentage
 Problem solving
• Cost of equity= 15%
• Tax Rate= 40%
• Commission= 1.5%
2. External Yield Criterion- Same as equity share
capital
Kr= Ke = (E/P) + g
Or
Kr= Ke = (D/P) + g
 Cost of debt
• Cost of debt is after tax long term funds
through borrowing.
• Debt may be issued at par, at premium or at
discount and also it may be perpetual or
redeemable.
 Debt issued at par
• It means debt issued at face value.
• Formula Kd= (1-t) I/P
• Where,
Kd = Cost of debt capital
t = Tax rate
I = Debenture interest rate
 Problem solving
• A company raises Rs. 1,00,000 by the issue of
1000 10% debentures of Rs. 100 each payable
at par after 10 years.
• If the rate of the company’s tax is 50%,
• What is the cost of debt capital to the firm?
 Debt Issued at Premium or Discount
• If the debt is issued at premium or discount,
the cost of debt is calculated with the help of
the following formula.
• Kd = I/Np (1-t)
• Where,
– Kd = Cost of debt capital
– I = Annual interest payable
– Np = Net proceeds of debenture
– t = Tax rate
 Problem solving
a) A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax
rate applicable to the company is 50%. Compute the cost
of debt capital.
b) B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of
10%. The tax rate applicable to the company is 60%.
Compute the cost of debt capital.
c) A Ltd. issues Rs. 1,00,000, 8% debentures at a discount of
5%. The tax rate is 60%, compute the cost of debt capital.
d) B Ltd. issues Rs. 10,00,000, 9% debentures at a premium
of 10%. The costs of floatation are 2%. The tax rate
applicable is 50%. Compute the cost of debt-capital.
 Cost of Perpetual Debt and
Redeemable Debt
Kdb = I + 1/n (P- Np) / (P +Np) / 2
Where,
• I = Annual interest payable
• P = Par value of debt
• Np = Net proceeds of the debenture
• n = Number of years to maturity
• Kdb = Cost of debt before tax
 Cost of debt after tax
• Cost of debt after tax can be calculated with
the help of the following formula:
• Kda =Kdb ×(1–t)
• Where,
Kda = Cost of debt after tax
Kdb = Cost of debt before tax
t = Tax rate
 Problem solving
• AB Ltd issues 100 10% Rs. 1000 debentures at
a discount of 2% redeemable after 10 years. If
the tax rate is 50%, find out the after tax cost
of debentures.
 Weighted Average Cost of Capital

• It is the average cost of the costs of various sources

of financing.
• It is also known as the composite cost of capital,
overall cost of capital or average cost of capital.
• Kw= ƩXW/ ƩW
Where X=Cost of Specific Source of Finance
W= Weight or proportion of specific source of finance
 Case analysis - I
• Nike India has the following capital structure and
after-tax costs for the different sources of funds
used. Calculate the weighted average cost of capital.

Sources of Funds Amount (Rs.) Proportion (%) After-Tax Cost

(%)
Debt 1500000 25 5
Preference Shares 1200000 20 10
Equity Shares 1800000 30 12
Retained Earnings 1500000 25 11
Total 6000000 100
 Case analysis – I (Cont.)
• Continuing with the above case, if Nike Co. has
18000 equity shares of Rs. 100 each outstanding
and the current market price is Rs. 300 per share,
• Calculate the market value weighted average cost
of capital.
Assumption:-
• Market values and book values of the debt and
preference capital are same and no retained
earnings.
 Case Analysis - II
• The following is the capital structure of Bata India as on 31-12-2016:

Rs.
Equity Shares- 20000 shares of Rs. 100 each 20,00,000

10% Preference Shares of Rs. 100 each 800,000

12% Debentures 12,00,000
Total 40,00,000

• The market price of the company’s share is Rs. 110 and it is

expected that a dividend of Rs. 10 per share would be
declared after 1 year. The dividend growth rate is 6%.
• If the company is in the 50% tax bracket, compute the
weighted average cost of capital.
 Case analysis - III
• The following information is available
regarding the capital structure of a company:
Sources Amount (in Rs.) Before tax cost (in %)

Equity share capital 400000 15

Preference share capital 50000 7

Long term debt 300000 10

 Case analysis – III (Contd.)
• The company wants to undertake an expansion
project costing Rs. 250,000 which can be arranged at
11% from a financial institution.
• What is the minimum acceptable rate of return in
case of proposed expansion project?
• The applicable tax rate is 40%
 Case Analysis – III (Contd.)
• The company intends to borrow a fund of Rs. 20
lakhs bearing 14% rate of interest in order to finance
an expansion plan,
• What will be the company’s revised weighted
average cost of capital?
• This financing decision is expected to increase
dividend from Rs. 10 to Rs. 12 per share.
• However, the market price of equity share is
expected to decline from Rs. 110 to Rs. 105 per
share.
 News Analysis
• Restructuring Plans of Food Corporation of
India (FCI) capital
• Idea allots shares worth Rs 3,250 crore to
promoter entities
 Case Analysis – IV
• A company has the following capital structure (in Rs. Million):
Equity capital (10 million shares, Rs. 10 par) = Rs. 100
Preference Capital, 11% (100,000 shares, Rs. 100 par) = Rs. 10
Retained earnings = Rs. 120
Debentures, 13.5% (500,000 debentures, Rs. 100 par) = Rs. 50
Term Loans, 12% = Rs. 80
• The next expected dividend (on equity) per share is Rs. 1.50
and it is expected to grow at the rate of 7%. The market price
per equity share is Rs. 20.
• Preference share is redeemable after 10 years, is currently
selling at Rs. 75 per share.
• Debentures is redeemable after 6 years, are selling for Rs. 80
per share. The tax rate is 50%. Calculate the WACC.
 Problem solving
• A company’s share is quoted in the market at Rs. 20
currently. The company pays a dividend of Re. 1 per
share and the investor’s market expects a growth
rate of 5% per year.
1. Compute the company’s equity cost of capital
2. If the anticipated growth rate is 6% p.a, calculate
the indicated market price per share.
 Problem solving
• X is a shareholder in ABC Company Ltd. Although
earnings for this company have varied considerably, X
has determined that long run average dividends for
the firm have been Rs. 2 per share.
• He expects a similar pattern to prevail in the future.
• Given the volatility of the ABC’s dividends, X has
decided that a minimum rate of 20% should be
earned on his share.
• What price would X be willing to pay for the
company’s shares?
 Problem solving
In considering the most desirable capital structure for company,
the following estimates of the debt and equity capital (after-tax)
have been made at various levels of debt-equity mix.
You are required to determine the optimal debt equity mix for
the company by calculating composite cost of capital.
Debt as a percentage of total Cost of debt (%) Cost of equity (%)
capital employed
0 5 12
10 5 12
20 5 12.5
30 5.5 13
40 6 14
50 6.5 16
60 7 20
 Problem solving
• Excellent Fans Ltd. needs Rs. 500000 for the expansion of its
activities and it is expected to earn a rate of return of 10% on
its investment.
• The management of the company is considering to finance
this amount by retaining profits which otherwise shall be
distributed to the shareholders.
• The shareholders, on an average, are in 60% tax bracket.
• If the shareholders reinvest their dividends, they will earn
12% on new investment but have to incur 2% brokerage cost
on the purchase of new securities.
• What is your recommendation to the management keeping in
view the shareholders?