Introduction

•Important input in the capital budgeting

•It helps in determining present value
•Called weighted average of the cost
•Major long term sources of funds are
1)Debt , 2) preference shares, 3)retained
earnings, and 4) equity capital
•Each source of fund has its cost called
the specific cost of capital
SPECIFIC COST OF
CAPITAL
 SPECIFIC COSTS OF CAPITAL
COST OF DEBT
1)Perpetual debt
Ki= I/SV
Kd= I/SV (1-t)
where Ki= before tax cost of debt
Kd= after tax cost of debt
I= annual interest payment
SV= amount of debt
t= tax rate
COST OF PREFERENCE SHARES

IRREDEEMABLE SHARES

REDEEMABLE SHARES
IRREDEEMABLE SHARE CAPITAL
CALCULATION:-
Kp = Cost of preference share capital

D p = Annual dividend

Po = Sale price

f = Flotation cost

FORMULAE:
K p = D p / P o (1-f)
REDEEMABLE SHARE CAPITAL

Po (1-f) = ∑N Dt/ (1+Kp)+ Pn/(1+Kn)n

t=1

Pn =repayment of principal
EQUITY CAPITAL
COST OF EQUITY CAPITAL
DIVIDEND APPROACH METHOD:-
Ke = cost of equity capital

D1 = expected dividend per share at the end of the year

Po = current market price

f = flotation cost

g = growth in expected dividends

FORMULAE-: Ke = [D1/Po (1-f)]+g

CAPITAL ASSET PRCING MODEL (CAPM)
APPROACH

Rf = required rate of return on risk free investment

b = beta coefficient

Km = required rate of return on market portfolio, i.e , the avg.

rate of return on all assets.

FORMULA:-

Ke = Rf + b(Km – Rf)
WEIGHTED AVERAGE COST OF CAPITAL
Ko = overall cost of capital

Wd = percentage of debt to the total capital

Wp = percentage of preference shares to the total capital

We = percentage of external equity to total capital

Wr = percentage of retained earnings to total capital

Formula

Ko = KdWd +KeWe+KrWr
 Problem
• A financial consultant of HPCL recommends that the firm
should estimate its cost of equity capital by applying the
capital asset pricing model rather than the dividend yield plus
growth model. He has assembled the following facts:
(i) Systematic risk of the firm is 1.4
(ii) 182 days Government treasury bills currently yields 8%
(iii)Expected yield on the market portfolio of assets is 13%

Determine the Cost of Equity Capital based on the above data

 Formula
Cost of equity capital
where

Rf = Required rate of return on risk free

investment
b = Beta coefficient
Km =Required rate of return on market portfolio, ie., the
average rate of return on all assets
 Solution To the Problem
Cost of Equity Capital
Ke =R f +b(Km-Rf)

= 8% + 1.4(13%- 8%)
= 15%

Note: Yield on treasury bills is considered a good proxy for risk

free required rate of return
 Indian oil corporation sold Rs 1,000 16%debentures
carrying no maturity date to the public 5 years ago.
Interest rate since have risen so that the debentures of
the quality represented by this company are selling at
14% yield basis.

i. Determine the current indicated market price of

debentures would you buy the debentures for Rs 12,00?
ii. Assuming that the debentures of the company are
selling at Rs 1,040 and if the debentures have 8 years to
run to maturity, compute the approximate effective
yield an investor would earn on his investment .
SOLUTION
i. Vd= Interest on debentures(I) =Rs 160 =Rs 1,143
Current interest rate (Kd) 14%
(No,the debenture is not worth purchasing for Rs 12,000)
ii. Rs 825 = ∑ Rs 120 + Rs 1000
(1 + Kd)t (1 +Kd)8
Let us try the discount rates of 15% and 16% as coupon
rate is 15%.
PV TOTAL
PV
Year Cashflow 15% 16% 15% 16%
1-8 Rs 160 4.487 4.344 Rs717.92 Rs 695.04
8 1000 0.327 0.305 327.00 305.00
1,044.92 1,000.04
Effective yield=15%
Essar Global Limited is a diversified business corporation with a balanced portfolio of
assets in the manufacturing and services sectors of Steel, Energy, Power,
Communications, Shipping Ports & Logistics, and Construction. Essar Global employs
over 40,000 people across offices in Asia, Africa, Europe and the Americas. With a firm
foothold in India, Essar Global has been focusing on global expansion with
projects/investments in Canada, USA, Africa, the Middle East, the Caribbean and
South East Asia. Privately owned and professionally managed, Essar is judiciously
invested in the commodity, annuity and services businesses. Forward and backward
integration, state-of-the-art technologies, in-house research and innovation have made
Essar Global a leading player in each of its businesses. Essar’s abiding philosophy is
to be a low cost, high quality, technology driven group with innovative customer
offerings.
 Work
Problems
1. Essar Global has issued 15% preference shares of the face value
of Rs 100 each to be redeemed after 10 years. Floatation cost is
expected to be 4%. We have to determine the cost of preference
shares of the company.

Formula : -- Cost of preference shares:

Redeemable: - P0 (1 - f) = nΣt=n D + Pn
(1+KP )t ( 1+KP )

KP = Cost of preference share capital

DP = Annual dividend
P0 = Sale Price
f = Floatation cost
 Solution
• Cost of preference shares (K p )

P0 (1 - f) = 10Σt=1 Rs. 15 + Rs.100

( 1+KP ) t (1+KP )10

Kp is likely to lie between 15 and 16% as rate of dividend is 15%.

Year Cash 15% PV 16% PV 15%PV 16%PV
Flow(Rs) Total(Rs Total(Rs
) )
1-10 15 5.019 4.833 75.28 72.50
10 100 0.247 0.227 24.70 22.50
99.80 95.20
Therefore Kp = 15% + 0.8 = 15.2%
4.78
 WORK
PROBLEM 2
2. Equity Shares of Essar Global are currently selling for Rs.
125 per share. The company expects to pay Rs. 15 per share
as dividend at the end of the coming year and the
estimated growth rate is 6%. It is expected that new equity
shares can be sold at Rs 123; the company expects to incur
Rs 3 per share as floatation cost. What is the cost of equity
capital?
SOL:

Ke = D1 + g = 15/120 + 0.06 = 18.5 %

Po (1-f)