Cost of Capital

…..Prabhat 1
 Thought for the Day

It is not the load that breaks

you down, It’s the way you
choose to carry it.
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Introduction
➢The opportunity cost of capital is the minimum required rate
of return on funds committed to the project and it is used for
discounting it’s cash flow.
➢ The cost of Capital for project is defined by the risk, rather
than the characteristics of the firm undertaking the project.
➢The firm’s cost of capital is not the same thing as the
project’s cost of capital.

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Significance of cost of capital

➢Evaluating investment decision

➢Designing a firm’s debt policy

➢Appraising the financial performance of top management

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Concept of opportunity cost of capital

➢Shareholders opportunity & values

➢Creditors claim and opportunity

➢Risk difference in Shareholders and creditor claim

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Determining the components of cost of capital

➢Cost of Debts

➢Cost of Preference Capital

➢Cost of Equity Capital

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Cost of Debt

➢Debts issued at par

I. Debt issued at par : cost will be equal to coupon rate

II. Debt issued at premium or discount : cost will be equal

to IRR of cash flows

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Example 1
Que 1) What will be the cost of issue of Debenture, if issued
for 7 years with a coupon of 15% having face value of Rs
100/- and maturity amount is also Rs 100/- per
debenture.

Ans 15%

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Example 2
Que 2)What will be the approximate cost of issue of
Debenture, if issued for 4 years with a coupon of 15%
having face value of Rs 100/- and maturity amount is
Rs 110/- per debenture.

Ans 17.5%

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Cost of Preference capital

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Example 3
Que 3) A company issued 10% irredeemable preference shares . The
face value per share is Rs. 100/- but the share issue price is
95/- . What is the cost of preference shares?

Ans 10/95 X 100

= 10.52%
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Example 4
Que 4) A company issued 10% irredeemable preference shares .
The face value per share is Rs. 100/- but the share issue
price is 105/- . What is the cost of preference shares?

Ans 10 / 105 X 100

= 9.52%

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Cost of Equity capital

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Example 5
Que 5) Suppose the current market price of the share is Rs
90/- and the expected dividend per share next year is
Rs 4.50 , if the dividend is expected to grow at a
constant rate of 8%, the shareholder’s required rate of
return will be ?

Ans = (4.50 / 90) + 0.08 = 0.13 or 13%

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Example 6
Que 6) Suppose the current market price of the share is Rs
120/- and the current dividend is Rs 9.00 , if the
dividend is expected to grow at a constant rate of 8%,
the shareholder’s required rate of return will be ?

Ans = ((9 X 1.08) / 120) + 0.08 = 0.081 + 0.08 = 0.161 or 16.1%

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Example 7
A company's payout ratio is 0.45 and its expected return on
equity (ROE) is 23%. What is the company's implied growth
rate in dividends?
Growth Rate = (ROE)(1 - Payout Ratio)
= (0.23)(0.55)
= 12.65%

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Example 8
An investor is considering acquiring a common stock that he
would like to hold for one year. He expects to receive both $1.50
in dividends and $26 from the sale of the stock at the end of the
year. What is the maximum price he should pay for the stock
today to earn a 15 percent return?

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Answer
➢By discounting the cash flows for one period at the required
return of 15% we get:
➢x = (26 + 1.50) / (1+.15)
➢(x)(1.15) = 26 + 1.50
➢x = 27.50 / 1.15
➢x = 23.91

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Example 9
 If a preferred stock that pays a $11.50 dividend is trading at
$88.46, what is the market's required rate of return for this
security?

➢Value = D / k ,
➢= 11.50 / 88.46
➢= 0.1300, or 13.00%.

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Example 10
Calculate the value of a AAA preferred stock that pays an
annual dividend of $5.50 if the current market yield on AAA
rated preferred stock is 75 basis points above the current T-
Bond rate of 7%.
➢k = base yield + risk premium = 0.07 + 0.0075 = 0.0775
➢Value = Dividend / k
➢Value = 5.50 / 0.0775 = $70.97

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Example 11
Que 7) Suppose the current market price of the share is Rs
100/- and if the company sells new shares, the issue
price will be Rs 95/-. The expected dividend per share
next year is Rs 4.75 and it is expected to grow at a rate
of 6%. Calculate, (i) the cost of internal equity
(retained earning) and (ii) cost of external equity?
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Answer 11
Cost of Internal Equity
= (4.75 / 100) + 0.06
= 10.75%
Cost of External Equity
= (4.75 / 95) + 0.06
= 11%

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Cost of Equity capital

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Example 12

Que 12 ) Suppose in the year 2016, the risk free rate is 6% , the
market risk premium is 9% and β of company is 1.54.
The cost of equity?
Ans) Rf + (Rm – Rf) β
= 0.06 + (0.09) X 1.54
= 19.86%
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Example 13

Que 13 ) Suppose in the year 2017, the risk free rate is 5.852% ,
the market risk rate is 7.25% and β of company is 1.62.
The cost of equity?
Ans) Rf + (Rm – Rf) β
= 0.05852 + (0.0725 – 0.05852) X 1.62
= 8.11%
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Weighted Average Cost of Capital (WACC)

➢Once the component cost have been calculated, they are

multiplied by the proportions of the respective sources of
capital to obtain (WACC).
➢The proportion of capital must be based on target capital
structure.
➢WACC is the composite, or overall cost of capital.

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Steps for calculating WACC

 Calculate the cost of specific source of funds.

 Multiply the cost of each source by it’s proportion in the

capital structure.

 Add the weighted component costs to get the WACC.

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Example 10
Que 14) Calculate the weighted Average Cost of Capital?
.
Source of finance Amount Cost
Share Capital 4,50,000 18%
Reserve & Surplus 1,50,000 18%
Preference Share Capital 1,00,000 11%
Debt 3,00,000 8%

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Example 11
Que 15) The tax rate applicable is 30%. Calculate the weighted
Average Cost of Capital?
. Source of finance Amount Cost
Share Capital 2,55,000 18%
Reserve & Surplus 4,36,000 18%
Preference Share Capital 1,25,000 11%
Debt 5,50,000 8%

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Thanks

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