Attribution Non-Commercial (BY-NC)

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Attribution Non-Commercial (BY-NC)

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Cost of Capital

return a firm must earn on its investment so that the

market value of company's equity shares does not fall.

This is an consonance with the overall firm's objective

of wealth maximization. This is possible only when the

firm earns a return on the projects financed by equity

shareholders' funds at a rate which is at least equal to

the rate of return expected by them. If a firm fails to

earn return at the expected rate, the market value of the

shares would fall and thus result in reduction of overall

wealth of the shareholders.

of return the firm requires from investment in order to

increase the value of the firm in the market place".

really the rate of return that it requires on the

projects available. It is merely a 'hurdle rate'. Of

course, such rate may be calculated on the basis of

actual cost of different components of capital.

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will result in at least maintaining (if not increasing)

the value of its equity shares.

of capital comprises of three components.

rate of return when a project involves no risk

whether business of financial.

refers to the variability in operating profit (EBIT)

due to change in sales. In case a firm selects a

project having more than the normal or average

risk, the suppliers of funds for the project will

expect a higher rate of return than the normal rate.

The cost of capital will thus go up. The business

risk is generally determined by the capital

budgeting decisions.

refers to the risk on account of pattern of capital

structure (or debt-equity mix). In general, it may be

said that a firm having a higher debt content in its

capital structure is more risky as compared to a

firm which has a comparatively low debt content.

This is because in the former case the firm requires

higher operating profit to cover periodic interest

3

maturity as compared to the latter. Thus, the

chances of cash insolvency are greater in case of

such firms. The suppliers of funds would therefore

expect a higher rate of return from such firms as

compensation for hither risk.

put in the form of the following equation:

K = r0 + b + f

where

K = Cost of capital,

r0 = return at zero risk level,

b = Premium for business risk;

f = Premium for financial risk.

important from the point of view of both capital

budgeting as well as capital structure planning

decisions.

decisions, the cost of capital is often used as a discount

rate on the basis of which the firm's future cash flows

are discounted to find out their present values. Thus, the

cost of capital is the very basis for financial appraisal of

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finance manger will be irrational and wrong I case of

cost of capital is not correctly determined. This is

because the business must earn at least at a rate which

equals to its cost of capital in order to make at least a

break-even.

also an important consideration in capital structure

decisions. The finance manager must raise capital from

different sources in a way that it optimizes the risk and

cost factors. The sources of funds which have less cost

involved high risk. Raising of loans may, therefore, be

cheaper on account of income tax benefits, but it

involves heavy risk because a slight fall in the earning

capacity of the company may bring the firm near to

cash insolvency. It is, therefore, absolutely necessary

that cost of each source of funds is carefully considered

and compared with the risk involved with it.

cost and implicit cost

defined as the discount rate that equates the present

value of the funds received by the firm net of

underwriting costs, with the present value of the

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payment, repayment of principal or dividend. This may

be calculated by computing value according to the

following equation:

C1 Cn Cn

Io = (1+K) + (1+K)2 + (1+K)n

where

Io = Net amount of funds received by the firm at

time zero

C = Cash Outflow in the period concerned

n = Duration or number of years for which the

funds are provided

K = Explicit cost of capital.

rate of return of the cash flows of financing

opportunity". It is, in other words the internal rate of

return the firm pays for financing. For example, if a

company raised a sum of Rs.l lakh by way of

debentures carrying interest at 9% and payable after 20

years, the cash inflow will be a sum of Rs.l lakh.

However, annual cash outflow will be Rs.9,000 for 20

years. The explicit cost will, therefore, be that rate of

internal return which equates Rs. 1 lakh, the initial cash

inflow with Rs.9,000 payable every year for 20 years

and Rs.l lakh at the end of 20 years.

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associated with the best investment opportunity for the

firm and its shareholders that will be forgone if the

project presently under consideration by the firm were

accepted". When the earnings are retained by a

company, the implicit cost is the income which the

shareholders could have earned if such earnings would

have been distributed and invested by them. As a matter

of fact explicit costs arise when the funds are raised,

while the implicit costs arise whenever they are used.

Viewed from this angle, funds raised from any source

have implicit costs once they are invested.

finance the project, while historical cost is the cost

which has already been incurred for financing a

particular project. In financial decision making, the

relevant costs are future costs and not the historical

costs. However, historical costs are useful in projecting

the future costs and providing an appraisal of the past

performance when compared with standard or

predetermined cost.

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known as specific cost of capital. In order to determine

the average cost of capital of the firm, it becomes

necessary first to consider the costs of specific methods

of financing. This concept of cost if useful in those

cases where the profitability of a project is judged on

the basis of the cost of the specific sources from where

the project will be financed. For example, if a

company's estimated cost of equity share capital is 11%,

a project which will be financed out of equity

shareholders' funds would be accepted only when it

gives a rate of return of at least 11%.

of all cost of capital from all sources, i.e., equity shares,

preference shares, debentures and other loans. In capital

investment decisions, the composite cost of capital will

be used as a basis for accepting or rejecting the

proposal, even though the company may finance one

proposal from one source of financing while another

proposal from another source of financing. This is

because it is overall mix of financing over time, which

is important in valuing the firm as an ongoing overall

entity.

the costs of each component of funds employed by the

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component of capital in the total capital structure.

problems:

specific source of capital,

(ii) It requires assigning of appropriate weights of each

component of capital.

(iii) It raises a question whether the average cost of

capital is at all affected by changes in the

composite of the capital. The financing experts

differ in their approaches. According to the

traditional approach, the firm's cost of capital

depends upon the method and level of financing,

while according to the modern approach as

propounded by Modigliani and Miller, the firm's

total cost of capital is independent of the method

and level of financing.

weighted average cost of new funds raised by the firm.

For capital budgeting and financing decision, the

marginal cost of capital is the most important factor to

be considered.

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1. Traditional Approach

depends upon the method and level of financing or its

capital structure. A firm can, therefore, change its

overall cost of capital by increasing or decreasing the

debt-equity mix. For example, if a company has 9%

debentures (issued and payable at par) the cost of funds

raised from this source comes to only 4.5% (assuming a

50% tax rate). Funds from other sources, such as equity

shares and preference shares, also involve cost. But the

raising of funds through debentures is cheaper because

of following reasons:

(ii) Interest is allowed as an expense resulting in a tax

benefit while dividend is not allowed as an expense

while computing taxable profits of the company.

weighted average cost of capital will decrease with

every increase in the debt content in the total capital

employed. However, the debt content in the total capital

employed should be maintained at a proper level

because cost of debt is a fixed burden on the profits of

the company, it may have adverse consequences in

periods when a company has low profitability.

Moreover, if the debt content is raised beyond a

particular point, the investors will start considering the

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shares will go up.

of capital is constant and it is independent of the

method and level of financing. In other words,

according to this approach a change in the debt equity

ratio does not affect the total cost capital. According to

traditional approach, as explained above, the cost of

capital is the weighted average cost of the debt and the

cost of equity. Each change in the debt-equity ratio

automatically offsets change in one with the change in

the other on account of change in the expectation of

equity shareholders. For example, the capital structure

of a company is as follows:

Equity Share Capital 1,00,000

has been paying dividend at the rate of 12% on equity

shares. In case, the debt equity ratio changes to say 60%

debt and 40% equity, the following consequences will

follows:

will come down.

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present dividend of 12%, will go up because they

will find the company now more risky.

be affected by change in the debt-equity ratio.

Modigliani and Miller, therefore, argue that within the

same risk class, mere change of debt-equity ratio does

not affect cost of capital. Their following observations

in their article. "Cost of Capital Corporation Finance

and Theory of Investment", need careful consideration:

(i) The total market value of the firm and its cost of

capital are independent of its capital structure. The

total market value of the firm can be computed by

capitalizing the expected stream of operating

earnings at discount rate considered appropriate for

its risk class.

(ii) The cut-off rate for investment purposes is

completely independent of the way in which

investment is financed.

following assumptions:

(i) Perfect capital market: The securities are traded in

perfect capital markets. This implies that:

(a) The investors are free to buy or sell securities.

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rational persons. All information and changes in

conditions are known to them immediately.

(c) The purchase and sale of securities involve no costs

such as broker's commission, transfer, fees, etc.

(d) The investors can borrow against securities

without restrictions on the same conditions as the

firms can.

(ii) Firms can be grouped in homogeneous risk

classes: Firms should be considered to belong to a

homogeneous class if their expected earnings have

identical risk characteristics. In other words, all

firms can be categorized according to the return

that they give and a firm in each class is having the

same degree of business and financial risk.

(iii) Same expectations: All investors have the same

expectation of the firm's net operating income

(EBIT) which is used for evaluation of a firm.

There is 100% dividend pay out, i.e., firms

distribute all of their net earnings to the

shareholders.

(iv) No corporate taxes: In the original formulation

Modigliani and Miller hypothesis assumes that

there are no corporate taxes. This assumption has

been removed later.

correctness of the basic reasoning of Modigliani and

Miller, the traditional approach is more realistic on

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therefore, due to tax effect, the cost of debt is lower

than cost of equity capital.

(ii) The basic assumptions of Modigliani and Miller

hypothesis that capital markets are perfect, is

seldom true.

Miller approach has come under severe criticism. Mr.

Ezra Solomon has observed. "The thesis that the

company's cost of capital is independent of its financial

structure is not valid. As far as the leverage effect alone

is concerned (and ignoring all other considerations that

might affect the choice between debt and equity) there

does exist a clearly definable optimum position-namely,

the point at which the marginal cost of more debt is

equal to or greater than a company's average cost of

more debt is equal to or greater than a company's

average cost of capital". However, Mr. E.W. Walker's

remarks very aptly explain the utility of Modigliani and

Miller's approach. According to him, "the criticisms

lodged against Modigliani and Miller's thesis are valid

thus limiting its use in actual situations. Nevertheless,

the propositions as well as their criticisms should be

carefully studied, since they will serve as an aid to

understanding capital structure theory".

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Problems in determination

of the most crucial factors in most financial

management decisions. However, the determination of

the cost of capital of a firm is not an easy task. The

finance manager is confronted with a large number of

problems, both conceptual and practical, while

determining the cost of capital of a firm. These

problems can briefly be summarized as follows:

capital upon the method and level of financing

There is a, major controversy whether or not the cost of

capital dependent upon the method and level of

financing by the company. According to the traditional

theorists, the cost of capital of a firm depends upon the

method and level of financing. In other words,

according to them, a firm can change its overall cost of

capital by changing its debt-equity mix. On the other

hand, the modern theorists such as Modigliani and

Miller argue that the firm's total cost of capital is

independent of the method and level of financing. In

other words, the change in the debt-equity ratio does not

affect the total cost of capital.

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market does not exist in practice, hence the approach is

not of much practical utility.

The determination of the cost of equity capital is

another problem. In theory, the cost of equity capital

may be defined as the minimum rate of return that a

company must earn on that portion of its capital

employed, which is financed by equity capital so that

the market price of the shares of the company remains

unchanged. In other words, it is the rate of return which

the equity shareholders expect from the shares of the

company which will maintain the present market price

of the equity shares of the company.

capital will require quantification of the expectations of

the equity shareholders. This is a difficult task because

the equity shareholders value the equity shares of a

company on the basis of a large number of factors,

financial as well as psychological. Different authorities

have tried in different ways to quantify the expectations

of the equity shareholders. Their methods and

calculations differ.

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depreciation funds

depend upon the approach adopted for computing the

cost of equity capital. Since there are different views,

therefore, a finance manager has to face difficult task in

subscribing and selecting an appropriate approach.

It is argued that for decision-making purposes, the

historical cost is not relevant. The future costs should be

considered. It, therefore, creates another problem

whether to consider marginal cost of capital, i.e., cost of

additional funds or the average cost of capital, i.e., the

cost of total funds.

5. Problem of weights

The assignment of weights to each type of funds is a

complex issue. The finance manager has to make a

choice between the risk value of each source of funds

and the market value of each source of funds. The

results would be different in each case.

calculate the cost of capital with precision. It can never

be a single given figure. At the most it can be estimated

with a reasonable range of accuracy. Since the cost of

capital is an important factor affecting managerial

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identify the range within which his cost of capital lies.

Computation of cost of each specific source of finance-

termed as computation of specific costs and (ii)

Computation of composite cost termed as weighted

average cost.

preference capital and equity capital, can be determined

as follows:

Cost of Debt

may be perpetual or redeemable. The technique of

computation of cost in each case has been explained

later.

issued at par is comparatively an easy task. It is the

explicit interest rate adjusted further for the tax liability

of the company. It may be computed according to the

following formula:

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Kd = (l-T)R

R = Debenture interest rate.

and the tax rate is 50%, the after tax cost of debt will be

4.5%, calculated as given below:

Kd = (l-T)R

= (1 -.5) 9 = .5x9 = 4.5%

interest is treated as an expense while computing the

firm's income for tax purposes. However, the tax

adjusted rate of interest should be used only in those

cases where the "earning of the firm before interest and

tax" (EBIT) is equal to or exceed the interest. In case,

EBIT is in negative, the cost of debt should be

calculated before adjusting the interest rate for tax. For

example, in the above cases, the cost of debt before

adjusting for tax effect will be 9%.

debentures are issued at premium or discount, the cost

of debt should be calculated on the basis of net proceeds

realized on account of issue of such debentures or

bonds. Such cost may further be adjusted keeping in

view the tax applicable to the company.

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debentures of Rs. 1,00,000. The company is in 55% tax

bracket. Calculate the cost of debt (before as well as

after tax) if the debentures are issued at (i) par; (ii) 10%

discount, and (iii) 10% premium.

Solution:

Cost of debentures can be calculated according to the

following formula:

Kd = I (1-T)

NP

where

Kd = Cost of debt after tax.

I = Annual interest payment.

NP = Net proceeds of loans or debentures.

T = Tax rate.

1000 (1-.55)

Kd = 1,00,00

= 1 x .45

10 = .045 or 4.5%

10,00 (1-.55)

Kd = 90,00

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= 1 x .45

9 = .05 or 5%

10,00 (1-.55)

Kd = 1,00,00

= 1 x .45

11 = .041 or 4.1%.

while calculating cost of debt we have presumed that

debentures/bonds are not redeemable during the lifetime

of the company. However, if the debentures are

redeemable after the expiry of a fixed period the

effective cost of debt before tax can be calculated by

using the following formula:

I + (P - NP)/n

Kd(before tax) = (N + NP)/2

where

I = Annual interest payment,

P = Par value of debentures,

NP = Net proceeds of debentures,

n = Number of years to maturity.

and realises Rs.98,000 after allowing 2% commission to

brokers. The debentures carry an interest rate of 10%.

The debentures are due for maturity at the end of the 1

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cost of debt before tax.

Solution

I + (P - NP)/n

Kd (before tax) = (P + NP)/2

10,000 + (1,00,000 - 98,000) / 10

= (1,00,000 + 98,000)72

10,000+200

= 99,000 =.103 or 10.30%.

debt after tax can be calculated as follows:

= 10.30(1 -.55)

= 10.30 x. 45 = 4.64%.

shareholders for maintaining their present value, the

company should see that it earns on the funds provided

by raising loans at least equal to the effective interest

rate payable on them. In case the firm earns less than

the effective interest rate, earnings available for the

equity shareholders will decrease. This would naturally

affect adversely the market price of the company's

equity shares.

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debt, not only the contractual interest rate but also

certain other imputed costs or raising funds from debts

should be considered. The more is the financing of

funds from the debt the higher is the expectation of the

equity shareholders on their capital because of increase

in the risk factor. Moreover, with increase in the amount

of borrowed funds, the interest rate is also likely to rise.

Thus, the imputed cost of raising funds through

borrowings includes the increase in the expectation of

the equity shareholders from their capital employed in

the business. If it had not been so, the management

would have at all times liked to finance their

requirements only by means of raising long-term debts.

however poses some conceptual problems. In case of

borrowings, there is legal obligation on the firm to pay

interest at fixed rates while in case of preference shares,

there is no such legal obligation. Hence, some people

argue that dividends payable on preference share capital

do not constitute cost. However, this is not true. This is

because, though it is not legally binding on the

company to pay dividends on preference shares, it is

generally paid whenever the company makes sufficient

profits. The failure to pay dividend may be better of

serious concern from the point of view of equity

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company because of the preference shareholders getting

the legal right to participate in the general meetings of

the company with equity shareholders under certain

conditions in the event of failure of the company to pay

them their dividends. Moreover, the accumulation of

arrears of preference dividends may adversely affect the

right of equity shareholders to receive dividends. This is

because no dividend can be paid to them unless the

arrears of preference dividend are cleared. On account

of these reasons the cost of preference capital is also

computed on the same basis as that of debentures. The

method of its computation can be put in the form of the

following equation:

Dp

Kp = NP

Dp = Fixed preference dividend

Np = Net proceeds of preference shares.

capital of Rs. 1,00,000 by issue of 10% preference

shares of Rs.10 each. Calculate the cost of preference

capital then they are issued at (i) 10% premium, and (ii)

at 10% discount:

24

Solution

(i) When preference shares are issued at 10%

premium:

Dp 10,000 X 100

Kp = NP = 1,10,000 =9.09%

Dp 10,000 X 100

Kp = NP = 90,000 =11.11%.

capital is the discount rate that equals the net proceeds

of sale of preference shares with the present value of

future dividends and principal repayments. Such cost

can be calculated according to the same formula which

has been given in the preceding pages for calculating

the cost of redeemable debentures.

preference shares redeemable at the end of the 10th year

from the year of their issue. The underwriting costs

came to 2%. Calculate the effective cost of preference

share capital:

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Solution:

Dp + (P - NP)/n

Kd (before tax) = (P + NP)/2

= (1,00,000 + 98,000) / 2

10,200

= 99,000 = 10.30%.

not adjusted for taxes, since dividend on preference

capital is taken as an appropriation of profits and not as

a charge against profits. Thus, the cost of preference

capital is substantially greater than the cost of debt.

difficult task. Some people argue, as observed in case of

preference shares, that the equity capital does not

involve any cost. The argument put forward by them is

that it is not legally binding on the company to pay

dividends to the equity shareholders. This does not

seem to be a correct approach because the equity

shareholders invest money in shares with the

expectation of getting dividend from the company. The

company also does not issue equity shares without

having any intention to pay them dividends. The market

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return expected by the shareholders.

defined as the minimum rate of return that a firm must

earn on the equity financed portion of an investment in

a project in order to leave unchanged the market price

of such shares. For example, in case the required rate of

return on equity shares is 16% and cost of debt is 12%,

and the company has the policy of financing with 75%

equity and 25% debt, the required rate of return on the

project could be estimated as follows:

12% x .25 = 3%

15%

involving an investment of Rs.l0,000, and giving an

annual return of Rs. l,500, the project would provide a

return which is just sufficient to leave the market value

unchanged of the company's equity shares. The rate of

return on equity financed portion can be calculated as

follows:

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Less: Interest on debentures 0.25 x 12 x 100 Rs. 300

7,500

= 16%

equals the required rate of return on investment. If the

project earns less than Rs. l,500 a year, it would provide

a return less than required by the investors. As a result,

the market value of the company's shares would fall.

Theoretically, this rate of return could be considered as

the cost of equity capital.

be divided into the following two categories:

2. The retained earnings.

explained below:

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order to find out the cost of equity capital, one must be

in a position to determine what the shareholders as a

class expect from their investment in equity shares. This

is a difficult proposition because shareholders as a class

are difficult to predict or quantify. Different authorities

have conveyed different explanations and approaches.

The following are some of the appropriate according to

which the cost of equity capital can be worked out:

market price of an equity shares by capitalizing the set

of expected dividend payments. Cost of equity capital

has therefore been 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".

rate of expected dividends which will maintain the

present market price of equity shares.

dividends, but it ignores the fact that the retained

earnings have also an impact on the market price of the

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be very logical.

equity shares of Rs.10 each at a premium of 10%. The

company pays 5% of the issue price as underwriting

commission. The rate of dividend expected by the

equity shareholders is 20%.

Will your cost of capital be different if it is to be

calculated on the present market value of the equity

shares, which is Rs.15?

Solution:

The cost of new equity can be determined according to

the following formula:

D

Ke = NP

where

Ke = Cost of equity capital;

D = Dividend per equity share;

NP = Net proceeds of an equity share,

2

Ke = 10.45 = 0.19 or 19%

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price of the company's shares. In the present case, it can

be calculated according to the following formula:

D

Ke = MP

where

Ke = Cost of equity capital;

D = Dividend per equity share;

MP = Market price of an equity share.

2

Ke = 15 =0.133 or 13.3%.

determined on the basis on the expected dividend rate

plus the rate of growth in dividend. The rate of growth

in dividend is determined on the basis of the amount of

dividends paid by the company for the last few years.

The computation of cost of capital according to this

approach can be done by using the following formula:

D + g

Ke = NP

where

Ke = Cost of equity capital;

D = Expected dividend per share;

NP = Net proceeds of per share;

g = Growth in expected dividend.

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the cost of equity capital can also be determined by

using the above formula. However, the market price

(MP) should be used in place of net proceeds (NP) of

the shares as given above.

share of a company is Rs.90. The current dividend per

share is Rs.4.50. In case the dividends are expected to

grow at the rate of 7% , calculate the cost of equity

capital.

Solution

D + g

Ke = MP

4.50 + .07

= 90

= 0.5+ .07 = .12 or 12%.

calculate the cost of equity capital:

(i) Each share is of Rs. 150 each

(ii) The underwriting cost per share amounts to 2%.

(iii) The following are the dividends paid by the

company for the last five years:

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1987 10.50 1990 12.75

1988 11.00 1991 13.40

1989 12.50

(iv) The company has a fixed dividend pay out ratio,

(v) The expected dividend on the new shares

amounts to Rs. 14.10 per share.

through equity share capital, calculation of growth rate

will be necessary. During the last 4 years (and not 5

years, since dividends at the end of 1987 are being

compared with dividends at the end of 1991) the

dividends declared by the company have increased from

Rs.10.50 to Rs.13.40 giving a compound before of

1.276 (i.e., 13.40/10.50). By looking to the "compound

sum of one rupee tables" in the line of 4 years one can

find out that a sum of Re.l would accumulate to 1.276

in 4 years at 6% interest. This means that growth rate of

dividends is 6%. The cost of equity funds can now be

determined as follows:

D + g

Ke = MP

14.10 + 6%

= 147

= 9.6% + 6% = 15.6%.

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extent, helpful, in determining satisfactorily the

expectation of the investors. However, the

quantification of the expectations of growth of

dividends is a difficult matter. Usually, it is presumed

that the growth in dividends will be equal to the growth

rate in earnings per share.

According to this approach, it is the earning per share

which determines the market price of the shares. This is

based on the assumption that the shareholders capitalize

a stream of future earnings (as distinguished from

dividends) in order to evaluate their shareholdings.

Hence, the cost of capital should be related to that

earnings percentage which could keep the market price

of the equity shares constant. This approach, therefore,

takes into account both dividends as well as retained

earnings. However, the advocates of this approach

differ regarding the use of both earnings and the market

price figures. Some simply use of current earning rate

and the current market price of the share of the

company for determining the cost of capital. While

others recommend average rate of earnings (based on

the earnings of the past few years) and the average

market price (calculated on the basis of market price for

the last few years) of equity shares.

34

Ke = E

NP

where

Ke = Cost of equity capital;

D = Earning per share;

NP = Net proceeds of an equity share,

appropriate to use market price (MP) instead of net

proceeds (NP) for determining the cost of capital.

company consists of one lakh equity shares of Rs.100

each, its current earnings are Rs. 10 lakhs per annum.

The company wants to raise additional funds of Rs.25

lakhs by issuing new shares. The floatation costs are

expected to be 10% of the face value of the shares. You

are required to calculated the cost of equity capital

presuming that the earnings of the company are

expected to remain stable over the next few years.

Solution

E 10

Ke = NP = 90 = 0.11 or 11%.

35

should be determined on the basis of the returns

actually realized by the investors in a company on their

equity shares. Thus, according to this approach the past

records in a given period regarding dividends and the

actual capital appreciation in the value of the equity

shares held by the shareholders should be taken to

compute the cost of equity capital.

companies with stable dividends and growth records. In

case of such companies, it can be assumed with

reasonable degree of certainty that the past behaviour

will be repeated in the future also.

cost of Rs.240 on January 1, 1987. He held them for 5

years and finally sold them in January, 1992 for Rs.300.

The amount of dividend received by him in each of

these 5 years were as follows:

1987 Rs. 14 1990 Rs. 14.50

1988 Rs. 14 1991 Rs. 14.50

1989 Rs. 14.50

Solution

36

calculate the internal rate of return. This rate of return

can be calculated by "trial and error method" as

explained earlier. The rate comes to 10% as shown

below:

Rs. proceeds factor at Value

Rs. 10% Rs.

1987 14.00 .909 12.7

1988 14.00 .826 11.6

1989 14.50 .751 10.9

1990 14.50 .683 9.9

1991 14.50 .621 9.0

1992 300 .621 186.3

240.4

was Rs.240. The present value of cash inflows (as on

January 1,1987) amounts to Rs.240.40. Thus, at 10%,

the present value of the cash inflows over a period of 5

years is equal to the cash outflow in the year 1987. The

cost of equity capital can, therefore, be taken as 10%.

determining the rate of return required by the investors

provided the following three conditions are satisfied:

37

as regards risk,

(ii) The shareholders continue to expect the same rate

of return for bearing this risk,

(iii) The shareholders reinvested opportunity rate is

equal to the realized yield.

profits earned by them by way of dividend among their

shareholders. Some profits are retained by them for

future expansion of the business. Many people feel that

such retained earnings are absolutely cost free. This is

not the correct approach because the amount retained by

company, if it had been distributed among the

shareholders by way of dividend, would have given

them some earning. The company has deprived the

shareholders of this earnings by Retaining a part of

profit with it. Thus, the cost of retained earnings is the

earning forgone by the shareholders. In other words, the

opportunity cost of retained earnings may be taken as

the cost of the retained earnings. It is equal to the

income that the shareholders could have otherwise

earned by placing these funds in alternative

investments. For example, if the shareholders could

have invested the funds in alternative channels, they

could have got a return of 10%. This return of 10% has

been forgone by them because of the company is not

38

earnings may, therefore, be taken at 10%.

following manner. Suppose the earnings not retained

by the company is passed on to the shareholders, and

are invested by the shareholders in the new equity

shares of the same company, the expectation of the

shareholders from the new equity shares would be taken

as the opportunity cost of the retained earnings. In other

words, if earnings were paid as dividends and

simultaneously an offer for the right shares was made,

the shareholders would have subscribed to the right

shares on the expectation of certain return. This

expected return can be taken as the cost of retained

earnings of the company.

shareholders will have with them the amount of retained

earnings available when distributed by the company. In

actual practice, it does not happen. The shareholders

have to pay tax on the dividends received, incur

brokerage cost for making investments, etc. The funds

available with the shareholders are, therefore, less than

what they would have been with the company, had they

been retained by it. On account of this reason, the cost

of retained earnings to the company would be always

39

company (see illustration).

ascertaining the cost of retained earnings:

by the shareholders are subject to income tax.

Hence, the dividends actually received by them are

not the amount of gross dividends but the amount

of net dividend, i.e., gross dividends less income

tax.

(ii) Brokerage cost adjustment: Usually, the

shareholders have to incur some brokerage cost for

investing the dividends received. Thus, the funds

available with them for reinvesting will be reduced

by this amount.

shareholders is, therefore, the rate of return that

they can obtain by investing the net dividends (i.e.,

after tax and brokerage) in alternative opportunity

of equal quality.

Rs.50,000 per annum. The shareholders required rate of

return is 10%. It is expected that retained earnings, if

distributed among the shareholders, can be invested by

them in securities of similar type carrying return of 10%

40

will have to incur 2% of the net dividends received by

them as brokerage cost for making new investments.

The shareholders of the company are in 30% tax

bracket.

earnings to the company.

earnings to the company, it is necessary to calculate the

net amount available to the shareholders for investment

and the likely return earned by them. This has been

done as follows:

Rs.

Dividends payable to the shareholders 50,000

Less: Income tax @ 30% 15,000

After tax dividends 35,000

Less: Brokerage cost @ 2% 700

Net amount available for investment 34,300

of earning 10%, the amount of earning received by

them on their investment will amount to Rs.3,430 (i.e.

10% of Rs.34,300).

company among its shareholders, the company could

41

and brokerage cost, as above, would have been payable.

The company could have paid a sum of Rs.3,430 to the

shareholders if it could earn a return of 6.86%

calculated as follows:

3,430 X 100

Rs. 50,000 = 6.86%.

company on their retained earnings comes to 6.86%. It

may, therefore, be taken as the cost of the retained

earnings.

for income tax and brokerage cost payable by the

shareholders can be determined according to the

following formula:

kr = Ke(1-T) (1-B)

where

Kr = Required rate of return on retained earnings.

Ke = Shareholder's required rate of return.

T = Shareholders' marginal tax rate.

B = Brokerage cost.

above illustration can be calculated according to the

above formula, as follows:

kr = Ke(1-T)(1-B)

42

= 6.86%.

making adjustment for tax liabilities, is a difficult

process because personal income tax rates will differ

from shareholder to shareholder. Thus, it will be

necessary to find out the personal income-tax rates of

the different shareholders of the company in case cost

of retained earnings it to be calculated according to the

above approach. In case of a widely held public

company, there are a large number of shareholders of

varying means and incomes. It is, therefore, almost

impossible to determine a single tax rate that would

correctly reflect the opportunity cost of retained

earnings to every shareholder. Even computation of a

weighted average tax would also not give satisfactory

results. Some authorities have, therefore, recommended

the use of another approach termed by them as external

yield criterion. According to this approach the

opportunity cost of retained earnings is the rate of

return that can be earned by investing the funds in

another enterprise by the firm. Thus, according to this

approach, the cost of retained earnings is simply the

return on direct investment of funds by the firm and not

what the shareholders are able to obtain on their

investments. The approach represents an economically

justifiable opportunity cost that can be applied

consistently. Moreover, the need for determining the

43

the approach is follows.

not yet been universally accepted. In the absence of a

universally acceptable and practically feasible method

for determining separately the cost of retained earnings,

many accountants calculate the cost of retained earnings

on the same pattern as that of equity shares. Moreover,

when the cost of funds raised by equity shares, the need

for determining the separate cost for retained earnings

does not at all arise. Some calculate it on the Dividend

Payout Basis.

the average cost of capital is generally calculated on the

basis of weighted average method. This may also be

termed as overall cost of capital. The computation of

the weighted average cost of capital involves the

following steps:

funds: This involves the determination of the cost of

debt, equity capital, preference capital, etc., as

explained before. This can be done either on "before

tax" basis or "after tax" basis. However, it will be more

appropriate to measure the cost of capital on "after tax

44

an important figure in determining the cost of capital

and they can get dividends only after the taxes have

been paid.

determination of the proportion of each source of funds

in the total capital structure of the company. This may

be done according to any of the following method.

weights are assigned to each source of funds, in the

proportion of financial inputs the firm intends to

employ. The method is based on the logic that our

concern is with the new or incremental capital and not

with capital raised in the past. In case the weights are

applied in a ratio different than the ratio in which the

new capital is to be raised, the weighted average cost of

capital so calculated may be different from the actual

cost of capital. This may lead to wrong capital

investment decisions. However, the method of marginal

weighting suffers from one major limitation. It does not

consider the long-term implications of the firm's current

financing. A firm should give due attention to long-term

implications while designing the firm's financing

strategy. For example, a firm may accept a project

giving an aftertax return of 6% because it intends to

raise the funds required by issue of debentures having

an after-tax cost of 5%. In case next year the firm

45

cost of 9%, it will have to reject a project which gives a

return of only 8%. Thus, marginal weighting method

does not consider the fact that to-day's financing affects

tomorrow's cost.

(b) Historical weights method: According to this

method the relative proportions of various sources to

the existing capital structure are used to assign weights.

Thus, in case of this method the basis of weights is the

proportion of funds already employed by the firm. This

is based on the assumption that the firm's present capital

structure is optimum and it should be maintained in the

future also.

value or (ii) market value weights. The weighted

average cost of capital will be different, depending upon

whether book value weights are used or market value

weights are used.

of capital is theoretically more appealing on account of

the following reasons:

approximate to the actual amount to be received

from the sale of such securities.

(ii) The cost of each specific source of finance which

46

according to the prevailing market price.

to the following practical difficulties:

considerably.

(ii) Market values are not readily available as

compared to the book values. The book values can

be taken from the published records of the firm.

(iii) The analysis of the capital structure of the

company, in terms of debt-equity ratio, is based on

the book values and not on the market-values.

inconvenient as compared to book value weights.

However, market value weights are theoretically

consistent and sound, hence they are a better indicator

of the firm's cost of capital.

get on overall weighted average cost of capital.

a company, calculate the overall cost of capital, using

(a) book value weights and (b) market value weights.

47

Equity share capital Rs. 45,000 Rs. 90,000

(Rs. 10 shares)

Retained earnings 15,000

Preference share capital 10,000 10,000

Debentures 30,000 30,000

The after-tax cost of different sources of finance is as

follows:

Equity share capital: 14%; Retained earnings: 13%;

Preference share capital: 10%; Debenture: 5%.

Solution

(a) COMPUTATON OF WEIGHTED AVERAGE

COST OF CAPITAL

(BOOK VALUE WEIGHTS)

Source (i) Amount Proporti After Weighted

(Rs.) (2) on (3) tax Cost (Rs.)

(4) (5) = (3) x

(4)

Equity 45,000 .45 14% 6.30%

Share Capital

Retained Earnings 15,000 .15 13% 1.95%

Preference Share

Capital 10,000 .10 10% 1.00%

Debentures 30,000 .30 5% 1 .50%

Weighted average cost of capital (K0) 10.75%

48

capital can also be found as follows:

OF CAPITAE (BOOK VALUE WEIGHTS)

(Rs.) (2) tax cost after tax

(Rs.)(3) cost

(4)=(2)x

(3)

Equity Share Capital 45,000 14% 6,300

Retained Earnings 15,000 10% 1,950

Preference Share Capital 10,000 10% 1,000

Debentures 30,000 5% 1,500

Total 1,00,000 10,750

Weighted average cost of capital (K0)

10,750 X 1000

= Rs. 1,00,000 = 10.75%.

49

COST OF CAPITAL (MARKET VALUE WEIGHTS)

(Rs.) (2) on (3) tax Cost (Rs.)

(4) (5) = (3) x

(4)

Equity 90,000 0.692 14% 9.688

Share Capital

Retained Earnings - - - -

Preference Share

Capital 10,000 0.77 10% 0.770

Debentures 30,000 0.231 5% 1.155

Weighted average cost of capital (K0) 11.613%

Illustration 12: Excel Industrial Ltd., has assets of

1,60,000 which has been financed with Rs. 52,000 of

debt and Rs.90,000 of equity and a general reserve of

Rs.18,000. The firm's total profits after interest and

taxes for the year ended 31st March, 1998, were Rs.

13,500. It pays 8% interest on debentures at Rs. 100

share is selling at a market price of Rs.120 per share.

What is the weighted average cost of capital?

Solution

From the facts given in the question, the following

balance sheet may be drawn:

50

BALANCE SHEET

Liabilities Rs. Assets Rs.

900 Equity shares of 90,000 Total 1,60,000

Rs. 100 each Assets

Reserves 18,000

8% Borrowed funds 52,000 _______

1,60,000 1,60,000

Calculation of earnings per share:

1. Earnings after interest and tax

available for equity share holders Rs. 13,500

2. Number of equity shares outstanding

of Rs. 100 each Rs. 900

3. Earning per share (EPS) (1) / (2) Rs. 15

Kd = 8%(1-T)

= 8% (1-0.5) = 4%

basis of the earnings approach. It has been assumed that

the future earnings per share would be equal to the

present earning per share.

51

_____EPS__________ X 100

ke = Present market price of the share

Rs. 15 X 100

ke = Rs.120 = 12.5%.

using the market value weights as they are more

appealing than book value weights. Since the market

value of debt has not been given, it has been assumed

that its book value and market value are the same:

OF CAPITAL

Capital Value (MV) Costs (k) (MV)x (K)

Debt Rs. 52,000 4.0% Rs. 2,080

Equity 1,08,000 12.5% 13,000

1,60,000 Rs. 15,580

Rs. 15,580 X 100

Ke = Rs. 1,60,000 = 9.74% approx.

be ascertained on the basis of book value weights. In

52

retained earnings, it will be appropriate to take cost of

equity capital as also the cost of retained earnings. In

the present case, the book value of equity share capital

together with retained earnings amount to Rs. 1,08,000

(i.e., Rs.90,000 + 18,000). Hence, the weighted average

cost of capital, calculated on the basis of book value

weights will be same as calculated on the basis of

market value weights.

market at Rs.20 currently. The company pays a

dividend of Re. 1 per share and the investor expects a

growth rate of 5 per cent per year. Compute:

(a) the company's cost of equity capital.

(b) If the anticipated growth rate is 6% p.a., calculate

the indicated market price per share.

(c) If the company's cost of capital is 8% and the

anticipated growth rate is 5% p.a., calculate the

indicated market price if the dividend of Re.l per share

is to be maintained.

Solution

The relationship among cost of capital, dividend, price

and expected growth rate is given by the formula:

53

Dividend X 100 + Growth Rate %

Market Price

Re.l X 100 + 5%

Company's cost of equity capital = Rs. 20

= 10%

Dividend

(b) Market price = Cost of Equity -Growth Rate %

Re 1

Company's cost of equity capital = 10% - 6%

Re. 1

= 4% = Rs. 25

Re.l Re. 1

8%-5% = 3% = Rs. 33.33

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