UNIT-V

LESSON

20
COST OF CAPITAL
CONTENTS
20.0 20.1 20.2 20.3 20.4 20.5 20.6 20.7 20.8 20.9 Aims and Objectives Introduction Meaning and Assumptions of Cost of Capital Measurement of Cost of Debt Cost of Preference Share Capital Cost of Retained Earnings Weighted Average of Cost of Capital Let us Sum up Lesson-end Activity Keywords

20.10 Questions for Discussion 20.11 Suggested Readings

20.0 AIMS AND OBJECTIVES

The purpose of this lesson is to discuss about the cost of capital which is used as a phenomenon for the decision criterion in the case of studying the worth of long-term assets. After studying this lesson you will be able to: (i) (ii) understand meaning and assumptions of cost of capital describes measurement of cost of debt

(iii) solve problems on cost of debt (iv) solve problems on cost of preference share of capital (v) describe cost of retained earnings.

20.1 INTRODUCTION
It is imperative to study the importance of cost of capital to the tune of financing decision of the firm. The financing decision of the firm normally facilitates the firm to raise the financial resources to the requirements of the firm. The raising of the financial resources should be carried out not only to the tune of financial requirements but also it should mind about the cost of availing the resource; which means that the cost of raising and applying the resources in and of the organization. The cost is the most limiting factor of influence for the success of the firm, the reason is that the cost of capital is the major determinant of success of the business firm. The firm must be facilitated to raise the financial resources at cheaper cost in order to earn more and more.

Accounting and Finance for Managers

The cost of capital is used as a phenomenon for the decision criterion in the case of studying the worth of long-term assets, which have got greater importance in the success of the firm. The cost of capital is instrumented in the Net present value method and Internal rate of return method of studying the worth of long-term assets under the capital budgeting decisions of the enterprise.

20.2 MEANING AND ASSUMPTIONS OF COST OF CAPITAL

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It is the Minimum rate of return which the firm should or must earn only in order to maintain the value of the shareholders. Classification of the cost of capital: The cost of capital can be classified into two categories viz specific cost of capital and weighted cost of capital.

Assumptions
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It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothing but determinant of influence is Fixed Cost of Operations. The cost of capital is subject to the volume of fixed cost of operations of the firm. On the basis of Financial Risk i.e., with reference to Financial Commitments of the firm which in other words as financial Risk. The Interest on debenture, Preference Dividend on Preference share capital should be paid without fail irrespective of the firms' earnings according to the terms and conditions of the issue. The greater the fixed financial commitments require the firm to earn more and more in order to retain the interest of the shareholders of the firm. Operational Terms - capital structure remain unchanged; unless the cost of capital of the firm would change. For new projects, funds are raised only at same proportion.

l l

How the cost of capital is to be denominated in terms ? Whether the cost of capital is to be denominated in terms of after tax or before tax. Why it has to be expressed in terms of after tax ? Why not the before tax cost should be taken into consideration? For appraising the projects, the return of the investments are considered for comparison which are nothing but the resultant of earnings of the firm immediately after the payment of tax. To study the quality of the projects, both factors must be at common at parlance for comparison. While computing the cost of capital, the cost of specific sources should be to the tune of after tax only in order to have an effective comparison.
v v

Then, the cost of capital is further bifurcated into two categories viz Explicit cost of capital and Implicit cost of capital. Explicit cost of capital: The discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.

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It is further explained that rate of return of cash flow of the financing opportunity. It normally takes place only at the moment of raising of financial resources. l Implicit cost of capital: It is nothing but the Opportunity cost of capital of the firm to earn through investing elsewhere by the shareholders themselves or by the company itself. It is rate of return which is associated with the best investment opportunity for the firm and its shareholders that would have to be forgone, which were presently considered by the firm. l Specific cost of specific source of capital: Each source of capital has its own cost at the moment of raising which form part of the computation of total cost of capital of the firm.

20.3 MEASUREMENT OF COST OF DEBT

The cost of the perpetual debt is nothing but the cost of raising the debt financial resource, in which the time period of repayment of the principal is not known. This particular specific source has two different classifications viz cost of interest and cost of debt.
Cost of interest (Ki) = Interest Sale value

Cost of Capital

Cost of Debt (Kd) =

Tax adjusted Interest Sale value

Problem on Cost of Debt

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A company has 10 percent 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) at par ii) at 10% discount iii) at 10% premium.
At par Cost of Interest Ki= Rs.10,000/Rs.1,00,000=10% Cost of Debt Kd= Rs.10,000(1-.35)/Rs.1,00,000= 6.5% At Discount Cost of Interest Ki=Rs.10,000/ Rs.90,000= 11.11% Cost of Debt Kd= Rs.6,500/90,000= 7.22% At Premium Cost of Interest Ki= Rs.10,000/Rs.1,10,000=9.09% Cost of Debt Kd=Rs 6,500/Rs.1,10,000=5.90%

Check Your Progress

1.

A company is considering raising Rs 100 lakh by one of the two alternative methods. viz 14 percent institutional term loan and 13 percent non - convertible debentures. The term loan option would attract no major incidental cost. The debentures would have to be issued at a discount of 2.5 per cent and would involve Rs. 1 lakh as cost of issue. Advise the company as to the better option based upon the effective cost of capital in each case. Assume tax rate of 35 per cent.

The next method of computing the cost of debt is only for the debt finance which knows the repayment period of the principal and the payment of the interest periodicals. This process of computation could be divided into two categories First one is the periodical repayment of the principal along with the periodical payment of interest periodicals.

CIo =

COIt + COPn (1 + kd) t

The second one is the lump sum repayment of the principally only at the end of the term of the debenture.

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Accounting and Finance for Managers

CIo =

COIt COPn + (1+kd)t (1+Kd)n

Problem on cost of debt

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A company issues a new 10 percent debentures of Rs.1,000 face value to be redeemed after 10 years. The debenture is expected to be sold at 5 percent discount. It will also involve flotation cost of 5 per cent of face value. The companys tax rate is 35 per cent what would be the cost of debt be ? Illustrate the computations i) trial and error approach and ii) shortcut method.

Trial Error approach: The first step is to determine the cash flows involved in the process of the debentures issue
Years 0 Particulars Rs.900 at the moment of raising i.e., cash in flow during the issue of debentureRs.1,000Rs.50 Rs.50 Regular flow interest payment The interest outflow which is subject to the adjustment of taxation Rs100(1 0.35)=Rs.65 Final repayment of the principal The last payment is nothing but the repayment of the principal Rs.1,000

1-10

10

Rs. 900 =

Rs 65 Rs. 1,000 + t T =1 (1+kd) (1+Kd) n

10

The present value of the future cashflows should be found out one after the another. The determination of present value at 7% and 8%
Years Cash Present value @ 7% 1-10 10 Rs.65(Annuity Table) 1,000(Single flow table) 7.024 0.508 @ 8% 6.710 .463 Total Present value @7% Rs.456.56 Rs.508.00 964.56 @ 8% Rs.436.15 Rs.463.00 899.15

The value of Cost of debt is 8% The short cut method is as follows

l

Kd =

I(1 t) + (f + d + pred - pi)/N (RV + SV)/2

I=Annual interest payment T=tax rate F=Flotation cost d=Discount on debentures pred=premium on redemption pi=premium on issue of debentures RV=Realisable value SV=Sale value Kd= 7.9%
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Check Your Progress

Cost of Capital

A company issues 11 percent debentures of Rs.100 for an amount aggregating Rs.1,00,000 at 10 percent premium, redeemable at par after five years. The companys tax rate is 35 per cent. Determine the cost of debt using the shortcut method.

20.4 COST OF PREFERENCE SHARE CAPITAL

The next specific source of cost is cost of preference share capital l Cost of preference share capital - From the angle of interest on the amount of debentures it is also like a fixed in charge but not contractual obligation, but the interest payment is contractual in obligation in accordance with the terms and conditions of the issue agreement reached earlier with the company, irrespective of the profits earned. l Preference dividend is to be paid only with reference to availability of profits. Normally the Expectations of the preference shareholders are nothing but the preference dividends. The preference shares are classified into two categories viz Redeemable and Irredeemable l Let us discuss at first about the Irredeemable preference shares during the issue The first one is the methodology for the computation of the cost of irredeemable preference share
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Kp =

Dividend preference share P0 (1f)

The second methodology incorporates the dividend taxation which is normally borne by the company during the moment of declaration.

Kp =

Kp=Dividend prefernce(1+Dt) P0 (1f)

ABC company issues 11 percent 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) par value b) 10% premium c) 5% discount and also compute the Dividend tax at 13.125%
At par Cost of Preference share capital Kp= Rs11./Rs 95.=11.57% Cost of preference share with dividend tax Kp = Rs.11(1+.13125) = 13.09% Rs.95 At Discount Cost of Preference share capital Kp=Rs.11/ Rs.110(.95).= 10.5% Cost of preference share with dividend tax Kp = Rs.11(1+.13125) = 13.81% Rs 110(.95) At Premium Cost of Preference share capital Ki= Rs.11/Rs.95(.95)=12.2% Cost of preference share capital with dividend tax Kd = Rs.11(1+.13125) = 13.78% Rs 95(.95)

The next methodology under the preference share capital is the cost computation for redeemable preference share capital. Under this the period of payment of capital is known along with the payment periodical preference dividends.
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Accounting and Finance for Managers

Po (1-f) =

Dp Pn + t (1+kp) (1+kp)n

Problem on the preference share capital

l

Xion Ltd has issued 11% preference shares of the face value of Rs.100 each to be redeemed after 10 years. Floatation cost is expected to be 5% Determine the cost of preference shares Kp
10

Rs. 95 =
T =1

Rs 11 Rs. 1,000 + (1+kp) t (1+Kd)10

The value of the Kp is lying in between the two rates of discounts viz 11% and 12% Determination of present value in between 11% and 12%
Year 1 to 10 years 10th yr completion Cash outflow Rs11 Rs.100 Present value @ 5.889 .362 5.65 .322 Total Present value @ Rs 64.78 35.15 99.93 62.15 32.20 94.35

Cost of preference share capital is Kp= 11.9% The next important cost to be determined is that cost of equity share capital:
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Equity dividends is not at par with Interest and Preference dividends, these two are subject to fixed in principle. The payment of dividends are subject to the availability of earnings and the future prospects of the firm in the future to grow. Equity shareholders are the last claimants of the company not only in sharing the profits of the company at the end of every year immediately after anything paid to the preference shareholders. It never carries any fixed rate of dividends subject to the availability of profits to disburse. Market value of shares are determined by the Equity dividends which are nothing but the return expect to get. Ke= a minimum rate of return which the firm should earn from the equity portion of financing of the project in order to maintain the value of the share prices.

l l

There are many more models in the computation of cost of equity i) ii)
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Dividend valuation model Capital Asset Pricing Model Dividend valuation model: The Cost of equity capital Ke is in terms of required rate of return to the tune of future dividends to be paid to the investors.
v

It is discount rate which equates the present value of future dividends per share with sale proceeds of a share (after adjusting the expenses of flotation of a share)

Po =

Dividend of the first year1 Ke g

Dividend of the first year1 + G Po

Ke =
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Problem: Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25 What would be market price of a share after 1 year and 2 year Ke= Re.1/25+ 6%= 4%+ 6%= 10% The market price at the end of 1 year

Cost of Capital

P1 =

Rs.1.06 10%-6%

= Rs.26.5

The market price at the end of 2nd year

P2 =
l

Rs.1.12 = Rs.28 10%-6%

Capital Asset Pricing Model approach: The cost of equity share capital is computed by registering the Beta with reference to the non diversifiable risk in addition to the diversifiable risk of the equity share with reference to market responsiveness.

The basic assumptions of the CAPM approach (i) (ii) The efficiency of the security markets Investor preferences

The efficiency of the security markets is embedded with the following assumptions: (a) (b) (c) (d) (e) All investors are common expectations about the expected returns, variances and correlation of the expected returns among the various securities in the market All investors have equivalent amount of information All investors are rational No transaction costs No single investor influence the market (i) (ii) Highest level return at minimum level risk or Lowest level of risk for given level of return

The investors' preference with reference to two different types of returns

The above alternatives are subject to two different type of risk viz Systematic and Unsystematic risk. Systematic risk which cannot be reduced i.e., undiversifiable risk for which allowances are given to the investors. Unsystematic risk which can be reduced to the level of minimum for which no other allowances are given to the investors. The allowances are given to the investors only subject to the market responsiveness Beta coefficient Ke= Rf+ b(KmRf) Problem
l

The hypothetical ltd wishes to calculate the cost of equity capital using the CAPM approach. From the information that the risk free rate of return equals 10% ; the firms beta equals 1.50 and the return on the market portfolio equals 12.5% Compute the cost of equity capital Ke= 10% + 1.5(12.5%-10%)=13.75%
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Accounting and Finance for Managers

20.5 COST OF RETAINED EARNINGS

The next important cost of specific source of capital is cost of retained earnings. The cost of retained earnings is to be computed on the basis of opportunity cost. It does not have any direct cost, instead, the amount of retained earnings loses the opportunity of the investors to earn in the form of dividends due to retained earnings; which are foregone by them one side and on the other side the earnings which are retained are invested in some other investments, would be in a position to yield the return, is the cost of retained earnings. It could be defined as "cost of retained earnings is the opportunity cost in terms of dividends foregone by with held from the equity shareholders." The cost of retained earnings is nothing but the external criterion which is equal to the Ke. Practically speaking, Ke is more than the Kr due to the floatation cost involved in the process of issue of shares.

20.6 WEIGHTED AVERAGE OF COST OF CAPITAL

The term cost of capital is nothing but the overall cost of capital which is to be computed to the tune of the proportion of the funds in the mixture; should computed only to the tune of assignment of weights. The weight average cost of capital has its own steps to follow during the process of computation.
l l l l

Assigning the weights Multiplying the weights with the specific cost of the fund Dividing the total cost immediately after adding them together by the summation of weights It is denominated by Ko Marginal weights Historical weights

The weights are normally classified into two major classification viz
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Marginal weights: Assignment of weights to the specific cost by the proportion of the each fund to be raised to the total fund Historical weights: The weights are assigned to the specific source of fund to the tune of the proportion of the fund in the existing capital structure. This type of historical weight is further classified into two different categories viz:
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Book value weights and Market value weights. Book value weights are assigned to the tune of book values to measure the proportion of each type of capital.

Market value weights are assigned to the tune of market value to measure the proportion of each type of capital. Problem A company has on its books the following amounts and specific cost of each type of capital.
Type of capital Debt Preference Equity Retained earnings
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Book value Rs.4,00,000 1,00,000 6,00,000 2,00,000 13,00,000

Market value 3,80,000 1,10,000 12,00,000 16,90,000

Specific cost Rs 5 8 15 13

Determine the weighted average cost of capital using (a) Book value weights and (b) Market value weights. The determination of the weighted average cost of capital using book value weights
Type of capital Debt Preference Equity Retained earnings Market value 3,80,000 1,10,000 9,00,000 3,00,000 16,90,000 Specific cost Rs 5 8 15 13 Total costs BV* K Rs.20,000 8,000 90,000 26,000 1,44,000

Cost of Capital

Ko =

Rs.1,44,000 100 = 11.1% Rs.13,00,000

The determination of Market value weights

Type of capital Debt Preference Equity Retained earnings Book value Rs.4,00,000 1,00,000 6,00,000 2,00,000 13,00,000 Specific cost Rs 5 8 15 13 Total costs BV* K 19,000 8,000 1,35,000 39,000 2,01,000

Ko =

Rs.2,01,000 100=11.9% Rs.13,00,000

20.7 LET US SUM UP

The cost is the most limiting factor of influence for the success of the firm, the reason is that the cost of capital is the major determinant of success of the business firm. The cost of capital is used as a phenomenon for the decision criterion in the case of studying the worth of long-term assets. Cost of capital is the minimum rate of return which the firm should or must earn only in order to maintain the value of the shareholders. The cost of the perpetual debt is nothing but the cost of raising the debt financial resource, in which the time period of repayment of the principal is not known. This particular specific source has two different classifications viz cost of interest and cost of debt. The term cost of capital is nothing but the overall cost of capital which is to be computed to the tune of the proportion of the funds in the mixture; should computed only to the tune of assignment of weights. The weight average cost of capital has its own steps to follow during the process of computation.

20.8 LESSON-END ACTIVITY

A company has issued 15% preference shares of the face value of Rs.100 each to be redeemed after 20 years. Flotation cost is expected to be 5% of the expected sales price. Determine the cost of preference shares.

20.9 KEYWORDS
Cost of capital: It is the minimum rate of return to be earned at which the capital is raised Implicit cost of capital: It is the minimum rate of return to be earned by the firm, at the moment of retaining the earnings, towards the investment decision
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Accounting and Finance for Managers

Explicit cost of capital: It is the cost incurred by the firm at the moment of raising Specific cost of capita: It is the cost incurred at every moment for raising the specific resource of capital Book value weights: Weights assigned to the tune of the book value of the capital Weighted average cost of capital: The aggregate of the weighted specific resources cost of capital is weighted average cost of capital

20.10 QUESTIONS FOR DISCUSSION

1. 2. 3. 4. Define cost of capital. Explain the various types of cost of capital. Explain the methodology involved in the process of computing the weighted average cost of capital. Explain the meaning of assigning the weights on the specific sources of capital.

20.11 SUGGESTED READINGS

R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. M.P. Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi. S. Bhat Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

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