COST OF CAPITAL

“Cost of Capital” is the minimum return expected by he contributors of capital. The
contributors may be equity share holders, debenture holders and preference share holders who
invest in equity shares, debentures and preference shares respectively of a company.
Simply the company has to earn a minimum amount (return) on the money contributed by
Re turn
x100
Investment
outsiders (Investment) i.e. return of Investment (ROI) =
The ROI is a charge on the company in real sense and so it is treated as “Cost”. It is usually
represented as % on the capital contributed.
The company usually uses cost of capital as a hurdle rate (or) interest rate (or) discount rate in
order to take a decision regarding investment in a project (or) Business.
There are various sources available for raising capital and these various sources have varied
levels of risk and return. If there is only one source of finance then the cost of that source of
finance will be the cost of capital. But the availability of finance from a single source is not
unlimited (i.e. limited) and not practical too.
So, the combined cost of all the sources of finance which the company uses is the cost of capital
of the company. (Don’t add up all the costs its is wrong).
The combined cost can be arrived by making weighted average of specific cost of capital.
Specific cost in the sense cost of each source.

(i) Cost of debentures: The cost of debentures is denoted by K d. Kd is usually the interest rate
that the company has to pay on the capital raised in the form of debentures.
i.e. Kd = Interest rate
But the advantage of raising debentures (or) debt capital is that interest is deductible
expenditure for tax purpose (Sec. 36 of Income tax Act).

What is the use of this advantage for the company while arriving at cost?

The answer to this question can be best explained with the help of an illustration.
Suppose that there are two companies ‘A’ and ‘B’. Company ‘A’ is an all equity company where
as company ‘B’ raises capital with a mix of debt and equity. The capital structure is as follows.

Company A Company B
Equity share capital 5,00,000 3,00,000
12% debentures --- 2,00,000
Total capital 5,00,000 5,00,000

The two companies are related to the same risk class and have the same Earnings (EBIT)

Company A Company B

1

000 Less: Interest N.46% 3. at premium. If there are floatation costs then cost of debt will be as follows: Intereste (1 .400 to its contributors.00.400 Both the companies are earning the same income. EBIT 1. The net cost of debentures to the company will be interest (-) interest x tax rate = interest (1 – tax rate)  Kd = Interest (1 .00. Thus the tax advantage is interest x tax rate = 24.tax rate) Usually expenses will be incurred by the company in raising capital and these expenses are termed as flotation (or) floating costs. If they are redeemed at premium then that premium should be apportioned over the maturity period of debenture.000 Less: Tax @ 35% 35.000 The difference in return is only due to interest and its tax advantage .000 49.000 + 49.600 EAT 65.000 1.00.company B is paying return (i. Company B pays (24. So.400) = 73.00. but the return to equity share holders vary.000 26. at discount.400 x 100 = 16.400.000 76.000 x 100 = 13% 5.00. Interest) to debenture holders as well as more return to equity holders as compared to company A.Tax rate) Kd  Net sale proceeds Net sale proceeds = capital raised (-) Flotation costs Debentures are redeemable at par. the cost of redeemable debentures is 2 .000 to it’s contributors of capital.000 EBT 1.400. Difference in return = 8. 65.000 x 35% = 8.e.000 Return on Equity (ROE) for company A is for company B 49.A 24. Company A pays 65.

dividend Kp  Net sale proceeds The cost of redeemable preference shares RV . but if the company fails to give them return. dividend + Kp  N RV + NSP 2 RV = Redeemable value of preference share NSP = Net sale proceeds (iii) Cost of loans: KL = Interest (1 – Tax rate) (iv) Cost of equity: In the case of preference shares and debt (debentures & loan). They are as follows: Computation of Cost of Equity (Ke) under various approaches: Price Approach 1.NSP Pr ef.Tax rate) + Kd  N RV  NSP 2 Rv = Redeemable value. There are various methods (or) approaches available in order to arrive at cost of equity. NSP = Net sale proceeds N = Maturity period (ii) Cost of Preference Shares: Dividend payable on preference shares is not a charge on profit and hence not deductible for tax purposes: Kp = preference dividend The preference dividend is inclusive of dividend distribution tax. But in the case of equity shares. RV-NSP Intereste (1 . it is not available. Dividend price Approach Dividend per share (DPS) Ke  x100 Market price per share (MPS) (or) Total dividend  x100 Market value of equity 3 . the rate of return payable by the company is available on the face of it. Though there is no compulsion on payment of dividend (or) return to equity share holders. they will shift their investment elsewhere. If there are flotation costs. The return may be in the form of dividends (or) capital appreciations. then Pr ef.

e. D0 (1+g) D0= Dividend paid by the company. Earnings Growth Approach EPS Ke  g P0 D1 = Expected dividend per share i. g = Retention ratio x Return on Investment (ROI) Dividend per share (DPS) Dividend Payout ratio = x100 Earnings per share (EPS) Dividend payout ratio means so much of the earnings paid as dividend and the balance of earnings is treated as retained earnings. P0 = Market price of share g = growth rate Computation of growth rate The earnings after paying dividends will be treated as Reserves and transferred to balance sheet which will be used as capital to generate earnings. Gordon’s Dividend Growth Approach D1 Ke  g P0 2. Retention Ratio = 1 – Dividend payout ratio DPS x100 EPS = 1– EPS  DPS Retained earnings x100  x100 EPS Total earnings = 4 . So. growth rate is the rate of return on retained earnings.2. Earnings Price Approach Earnings per share (EPS) Ke  x100 MPS (or) Total earnings  x100 MV of equity Growth Approach 1. So.

e. simply Equity Capital WE  Total Capital The proportions (or) weights may be Book value weights (or) market value weights. 5 . the return paid by a bank where he takes no risk i.e. the cost of reserves is nothing but cost of equity except that there are no flotation costs. So. Cost of Reserves Reserves are created out of profits and are shareholders funds. Capital assets Pricing model (CAPM) Ke = Rf +  (RM – RF) RF = Risk free rate  = Beta RM = Market return (RM – RF) = risk premium Beta Beta is the measure of risk. Kr = Ke (except flotation cost) Weighted average cost of capital (WACC) WACC (or) overall cost of capital Ko is the weighted average of each cost of specific source.e.. When an investor invests in a company he will expect a minimum return i.Realized yield approach D  PE  PB Ke  PB D = Dividend PE = Price at end PB = Price at beginning PE – PB = Capital appreciation. risk free rate (R f) plus premium for taking risk. But the latter are more appropriate then the former.. K o  WE x K E + WD x K D  WP x K P WE = weight of equity WD = weight of Debt weights are the proportions i. The premium is ‘’ times the market return more than Risk free rate of return = Rf + premium for taking risk = Rf +  (Rm – Rf) v.

000.100 Net earnings =Rs.000. (b) If the current market price of an equity share is Rs.00.000. 8% debentures at par. Problem 5 (a) A Ltd. The relevant information is as follows : Number of existing equity shares =10 lakhs Market value of existing share =Rs. is Rs. (c) A Ltd. 100 each. 100 each at a par.Problem 1 A company issues 10. 4. 9% debentures at a premium of 10%. 92 per share and the costs of new issue will be Rs. 12 per share initially and growth in dividends is expected to be 5%. You are required to calculate the cost of equity share capital.000. Compute the cost of debt capital. 100 each at a premium of 10%. The tax rate applicable to the company is 60%. we have computed the after-tax cost of debt as the firm saves on account of tax by using debt as a source of finance.00. Compute the cost of debt-capital. The floatation costs are expected to be 4% of the share price.000 equity shares of Rs. (d) B Ltd. issues Rs. 20. The company pays a dividend of Rs. (b) B Ltd. 175? Problem 2 (a) A company plans to issue 10000 new shares of Rs. Compute the cost of debt capital. 10% redeemable debentures at a discount of 5%. 1.50 and is expected to grow at a rate of 7%. The costs of floatation amount to Rs.000. Calculate cost of preference share capital if these shares are issued (a) at par. 10. 1. Problem 6 A company issues Rs. The costs of floatation are 2%. Will it make any difference if the market price of equity share is 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. 50. The tax rate applicable to the company is 50%. (b) at a premium of 10% and (c) of a debentures of 6%. Compute the cost of equity capital. 8% debentures at a premium of 10%. In all cases. Problem 7 XYZ Ltd. 2 per share. issues Rs.000. issues Rs.00. Problem 4 A firm is considering an expenditure of Rs. issues 20.00. 2 per share. The debentures are redeemable after 8 years. Cost of issue is Rs. 5 per share amounts to Rs.00. Calculate the cost of existing equity share capital Problem 3 The current market price of the shares of A Ltd. issues Rs.000. Calculate before tax and after tax. 75 lakhs for expanding its operations. The tax rate is 60%. Cost of debt assuring a tax rate of 55%. compute the cost of debt capital. 95. The company has been paying 25% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. 10. 8% preference shares of Rs. The tax rate applicable is 50%. 120. 8% debentures at a discount of 5%. Compute the cost of new issue of equity shares. 6 . The floatation costs are Rs.

100 share is Rs. 14% institutional term loan or 13% non-convertible debentures. 1.00. 100 each. Ltd. 160? c) Determine the effect of Income Tax on the cost of capital under both premises (Tax rate 40%).00. in Lacs Equity share capital 400 12% debentures 400 18% term loan 1. Find out the cost of preference share capital when it is issued at (i) 10% premium. The flotation cost is expected to be 10% of the face value. b) A company has 10% redeemable preference share which are redeemable at 6the end of 10 th year from the date of issue.a. The debentures would have to be issued at a discount of 2. as on 31-12- 1998: Rs.00.000. b) What difference will it make if the current price of the Rs.000.. 100 lakhs by one of two alternative method.5% and would involve cost of issue of Rs. 92 per share. 10 each. 2 per share. Find out the effective cost of preference share capital. Problem 11 A company is considering raising of funds of about Rs. 10. The cost of issue is Rs. The term loan option would attract no major incidental cost.00. 100 each. 100 each and realizes Rs. Find out the cost of equity capital given that the earnings are expected to remain same for coming years.000 by issuing new shares. Problem 12 The following information has been extracted from the balance sheet of Fashions Ltd. The shares are repayable after 12 years at par. The company wants to raise additional funds of Rs. 25. It had been paying dividends at a Consistent rate of 20% per annum. viz. Note: Both companies are paying income tax at 50%. Calculate the cost of preference share capital.000 by the issue of 10% preference share of Rs. 8% preference shares of Rs. Advise the company as to the better option based on the effective cost of capital in each case. c) The entire share capital of a company consist of 1. Redeemable after 8 years at a premium of 10%. ii) Y.000 p. 100 each Rs. Problem 10 a) A company raised preference share capital of Rs. and (ii) 10% discount. 95 per Debenture.000 equity share of Rs.Problem 8 ABC Ltd. issues 14% preference shares of face value Rs. issues 20. Its current earnings are Rs. 1. Problem 9 Calculate the cost of capital in the following cases: i) X Ltd. Assume a tax rate of 50%. The underwriting expenses are expected to 2%. issues 12% Debentures of face value Rs. Problem 13 7 .00.200 a) Determine the weighted average cost of capital of the company. The Debentures are redeemable after 10 years at a premium of 10%.

000 Reserves and Surplus Rs.Problem 14 ABC Ltd. 2 per share at the end of current year.00.30.5% 14% debentures 37. c) The cost of capital if in (b) above. 40. The would result in increasing the expected dividend to Rs. Problem 16 A Limited has the following capital structure: Equity share capital (2. 00. 10 each Rs. 20. Equity (expected dividend 12%) 10.00. has the following capital structure.000 The rate of tax for the company is 50%. 30. Calculate the weighted average cost of capital using the above figures. 1.00.00.00.5% 8 .0% 10% preference shares 12. growth rate increases to 10 per cent.000 8% Debentures Rs.00.000 6% preference shares Rs.000 consisting of: Ordinary shares (2. assuming 50% as the rate of income-tax.00. 10.000 8% Debentures Rs. Problem 17 The ABC Company has the total capital structure of Rs. Rs.000 shares of Rs. The tax rate may be presumed at 50 per cent. which will grow at 7 per cent for ever. 00. 3 and leave the growth rate unchanged but the price of share will fall to Rs.000 shares) Rs.000 debt by issuing 10 per cent debentures. 2. 15 per share.000 10% preference 5.000 You are required to calculate the weighted average cost of capital. It is expected that company will pay a dividend of Rs. 20.00.000 The market price of the company’s equity share is Rs. Current level of Equity Dividend is 12%. You are required to compute the following: a) A weighted average cost of capital based on existing capital structure. 1. b) The new weighted average cost of capital if the company raises an additional Rs.70.00. before and after tax Problem 15 The following information is available from the Balance Sheet of a company Equity share capital – 20. 80.000 shares) 50.000 8% loan 15.

11 per share. 00. 2% flotation costs iii) equity shares: Sale price Rs. 115 per share. has the following capital structure 4. Assume that the company is satisfied with its present capital structure and intends to maintain it. 100 each Rs. 00. b) Compute the new weighted average cost of capital if the company raises an additional Rs. The company is expected to declare a dividend of Rs. redeemable at 5% premium can be sold at par.000 debt by issuing 15% debenture. flotation costs. (b) Growth rate is reduced from 10 to 8% and (c) Market price is reduced to Rs. You have been supplied with the following information: BALANCE SHEET Additional Information: i) 20 years 14% debentures of Rs. 3. 20.The shares of the company sell for Rs. 15 per share. c) Compute the cost of capital if in (b) above. 4.000 11% Debentures Rs. Problem 19 An electric equipment manufacturing company wishes to determine the weighted average cost of capital for evaluating capital budgeting projects. but the price of share will fall to Rs. 00. find our the new WACC if (a) Dividend rate is increased from 10 to 12%. i) Find out the cost of equity capital and the WACC.500 face value. It is expected that company will pay next year a dividend of Rs. 20.000 12% Debentures.000 The current market price of the share is Rs. ii) 15% preference shares: Sale price Rs. This would result in increasing the expected dividend to Rs. 5 per share The corporate tax rate is 55% and the expected growth in equity dividend is 8% per year. 2 per share which will grow at 7% forever. Rs. with an expected growth rate of 10%. The expected dividend at the end of the current financial year is Rs. Assume a 50% tax rate. Problem 18 ABC Ltd. The applicable tax rate is 50%. You are required to: a) Computed a weighted average cost of capital structure. 00. 9 . 2% flotation costs.00. 3 and leave the growth rate unchanged. and ii) Assuming that the company can raise Rs. 1. 98.000 Equity shares of Rs. 5. 100 per share. 102.000 10% preference shares Rs. 10 at the end of the current year. 2. growth rate increases to 10%.