Cost of Capital: Concept,

Components, Importance,
Example, Formula and
Significance
Cost of capital is a composite cost of the individual sources of
funds including equity shares, preference shares, debt and
retained earnings.

The overall cost of capital depends on the cost of each source and
the proportion of each source used by the firm. It is also referred to
as weighted average cost of capital. It can be examined from the
viewpoint of an enterprise as well as that of an investor.

Some of the components of cost of capital are:-

1. Cost of Debt Capital 2. Cost of Preference Capital 3. Cost of

Equity Capital 4. Cost of Retained Earnings 5. Weighted
Average Cost of Capital 6. Marginal Cost of Capital 7. The Cost
of Preferred Stock 8. Return on Capital.

Cost of Capital: Components, Concept,

Importance, Example, Formula and Significance
Cost of Capital – With Formula for Calculation
1. Cost of Debt Capital:

Generally, cost of debt capital refers to the total cost or the rate of
interest paid by an organization in raising debt capital. However, in
a real situation, total interest paid for raising debt capital is not
considered as cost of debt because the total interest is treated as an
expense and deducted from tax. This reduces the tax liability of an
organization.

Therefore, to calculate the cost of debt, the organization needs to

make some adjustments. Let us understand the calculation of cost
of debt with the help of an example.
Suppose an organization raised debt capital of Rs.10000 and paid
10% interest on it. The organization is paying corporation tax at the
rate of 50%. In this case, the total 10% of interest rate would not be
deducted from tax and the deduction would be 50% of 10%.

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Therefore, the cost of debt would be only 5%. While calculating cost
of debt capital, discount allowed, underwriting commission, and
cost of advertisement are also considered.

These expenses are added to the amount of interest paid, which is

considered as total cost of debt capital. For example- when an
organization increases its proportion of debt capital more than the
optimum level, then it increases its risk factor. Therefore, the
investors feel insecure and their expectations of EPS start
increasing, which is the hidden cost related to debt capital.

Formulae to calculate cost of debt are as follows:

1. When the debt is issued at par –

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KD= [(1 – T) x R] x 100

Where,

KD = Cost of debt

T = Tax rate

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R = Rate of interest on debt capital

KD = Cost of debt capital

2. Debt issued at premium or discount when debt is irredeemable –

KD = [1 / NP x (1 -T) x 100]

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Where,

NP = Net proceeds of debt

3. Cost of redeemable debt –

KD= [{I (1-T) + (P – NP / N) x (1- T)} / (P + NP / 2)] x 100

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where,

N = Numbers of years of maturity

P = Redeemable value of debt

2. Cost of Preference Capital:

Cost of preference capital is the sum of amount of dividend paid and

expenses incurred for raising preference shares. The dividend paid
on preference shares is not deducted from tax, as dividend is an
appropriation of profit and not considered as an expense.

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Cost of preference share can be calculated by using the

following formulae:

1. Cost of redeemable preference shares –

Kp = [{D + F / N (1 – T) + RP / N} / {P + NP / 2}] x 100

Where,

KP = Cost of preference share

D = Annual preference dividend

F = Expenses including underwriting commission, brokerage, and

discount
N = Number of years to maturity

RP = Redemption premium

P = Redeemable value of preference share

NP = Net proceeds of preference shares

2. Cost of irredeemable preference shares –

KP = (D / NP) x 100

3. Cost of Equity Capital:

It is very difficult to calculate the cost of equity capital as compared

to debt capital and preference capital. The main reason is that the
equity shareholders do not receive fixed interest or dividend. The
dividend on equity shares varies depending upon the profit earned
by an organization. Risk factor also plays an important role in
deciding rate of dividend to be paid on equity capital. Therefore,
there are various approaches to calculate cost of equity capital.

The explanation of these approaches are as follows:

i. Dividend Price Approach:

The dividend price approach describes the investors’ view before

investing in equity shares. According to this approach, investors
have certain minimum expectations of receiving dividend even
before purchasing equity shares. An investor calculates present
market price of the equity shares and their rate of dividend.

The dividend price approach can be mathematically

calculated by using the following formula:

KE = (Dividend per share / Market price per share) x 100

KE = Cost of equity capital

However, the dividend price approach his criticized on

certain grounds, which are as follows:
a. Does not take into consideration the appreciation in the value of
capital. The dividend price approach is based on the assumption
that investors expect some dividend on their shares. It completely
ignores the fact that some investors also consider the chances of
capital appreciation, which increases the value of their shares.

b. Ignores the impact of retained earnings, which affect both the

market price of shares and the amount of dividend paid. For
example- suppose if an organization keeps major portion of its
profit as retained earnings then it would pay low dividend, which
may decrease the market price of its shares.

ii. Earnings Price Ratio Approach:

The earnings price ratio approach suggests that cost of equity

capital depends upon amount of fixed earnings of an organization.
According to the earnings price ratio approach, an investor expects
that a certain amount of profit must be generated by an
organization. Investors do not always expect that the organization
distribute dividend on a regular basis.

Sometimes, they prefer that the organization invests the amount of

dividend in further projects to earn profit. In this way, the
organization’s profit would increase, which in turn increases the
value of its shares in the market.

The formula to calculate cost of capital through the

earnings price ratio approach is as follows:

KE = E / MP

where,

E = Earnings per share

MP = Market price

However, this approach is criticized on the following

grounds:

a. Assumes that EPS would remain constant

b. Assumes that market price per share would remain constant

c. Ignores the fact that all the earnings of an organization are not
distributed in the form of dividend. However, some part of earnings
may be kept in form of retained earnings.

iii. Dividend Price Plus Growth Approach:

The dividend price plus growth approach refers to an approach in

which the rate of dividend grows with the passage of time. In the
dividend price plus growth approach, investors not only expect
dividend but regular growth in the rate of dividend. The growth rate
of dividend is assumed to be equal to the growth rate in EPS and
market price per share.

In the dividend price plus growth approach, cost of capital

can be calculated mathematically by using the following
formula:

KE = [(D / MP) + G] x 100

Where,

D = Expected dividend per share, at the end of period

G = Growth rate in expected dividends

This approach is considered as the best approach to evaluate the

expectations of investors and calculate the cost of equity capital.

iv. Realized Yield Approach:

In the realized yield approach, an investor expects to earn the same

amount of dividend, which the organization has paid in past few
years. In this approach, the growth in dividend is not considered as
major factors for deciding the cost of capital.

This approach is based on the following assumptions:

a. Risk factor remains constant in an organization. Returns in the

given risk remain the same as per the expectations of shareholders.
b. Realized yield is equivalent to the reinvestment opportunity rate
for shareholders.

According to the realized yield approach, cost of capital

can be calculated mathematically by using the following
formula:

KE = [{(D – P) / p} – 1] x 100

Where,

P = Price at the end of the period,

p = Price per share to day

v. Capital Asset Price Model (CAPM):

CAPM helps in calculating the expected rate of return from a share

of equivalent risk in the capital market. The cost of shares that carry
risk would be equal to cost of lost opportunity. For example- an
investor has two investment options- to buy the shares of either X
Ltd. or Y Ltd. If the investor decides to buy the shares of X Ltd. then
the cost of shares of Y Ltd. would be the cost of lost opportunity.

CAPM is based on the following assumptions:

a. A rationale investor would always avoid risk

b. A rationale investor would always wish to maximize the expected

yield

c. All investors would have similar expectations

d. All investors can lend freely on the riskless rates of return

e. Capital market is in good condition and there is no existence of

tax

f. Capital market is competitive in nature

g. Securities are completely divisible and there is no transaction cost

The computation of cost of capital using CAPM is based on the
condition that the required rate of return on any share should be
equal to the sum of risk less rate of interest and premium for the
risk.

According to CAPM, cost of capital can be calculated

mathematically by using the following formulae:

E = R1 + β {E (R2) – R1}

Where,

E = Expected rate of return on asset

β = Beta coefficient of assets

R1 = Risk free rate of return

E (R2) = Expected return from market portfolio

This value can be calculated by analyzing data of usually five years.

Formula used to calculate beta value is as follow:

β = PIM (SD1) (SDM) / SD2M

Where,

β = Beta of stock

PIM = Correlation coefficient between the returns on stock, I and the

returns on market portfolio, M.

SD1 = Standard deviation of returns on assets

SDM = Standard deviation of returns on the market portfolio

SD2M = Variance of market returns

vi. Bond Yield Plus Risk Premium Approach:

The bond yield plus risk premium approach states that the cost on
equity capital should be equal to the sum of returns on long-term
bonds of an organization and risk premium given one equity shares.
The risk premium is paid on equity shares because they carry high
risk.

Mathematically, the cost of capital is calculated as:

Cost of equity capital = Returns on long-term bonds + Risk

premium

The bond yield plus risk premium approach is based on the fact that
a risky organization would have high financial leverage. As a result
of this, it would be earning higher profit. Therefore, the equity
shareholders due to higher risks on their investments expect higher
returns in the form of risk premium.

vi. Gordon Model:

The Gordon model was proposed by Myron Gordon to calculate cost

of equity capital. As per this model, an investor always prefers less
risky investment as compared to more risky investment. Therefore,
an organization should pay risk premium only on risky investment.
The Gordon model also suggests that an investor would always
prefer more of those investments, which would provide them
current income.

The Gordon model is based on the following assumptions:

a. The rate of return on the investments of an organization is

constant

b. The cost of equity capital is more than the growth rate

c. The corporation tax does not exist in the economy

d. The organization has perpetual existence

e. The growth rate of the organization is a part of retention ratio and

its rate of return
According to the Gordon model, cost of capital can be
calculated mathematically by using the following formula:

P = E (1 – b) / K- br

Where,

P = Price per share at the beginning of the year

E = Earnings per share at the end of the year

b = Fraction of retained earnings

K = Rate of return required by shareholders

r = Rate of return earned on investments made by the organization

4. Cost of Retained Earnings:

Retained earnings are organizations’ own profit reserves, which are

not distributed as dividend. These are kept to finance long-term as
well as short-term projects of the organization. It is argued that the
retained earnings do not cost anything to the organization. It is
debated that there is no obligation either formal or implied, to earn
any profit by investing retained earnings.

However, it is not correct because the investors expect that if the

organization is not distributing dividend and keeping a part of profit
as reserves then it should invest the retained earnings in profitable
projects. Further, the investors expect that the organization should
distribute the profit earned by investing retained earnings in the
form of dividend.

Cost of retained earnings can be calculated with the help

of various approaches, which are as follows:

i. KE = KR Approach:

Assumes that if the profit earned by an organization is not retained

but is distributed as dividend, then the shareholders would invest
this dividend in other projects to earn further profit. If an
organization retains the dividend then it prohibits the shareholders
from earning more profit.

Therefore, for retaining the dividend, the organization should earn

the profit, which the shareholders would have earned by investing
the dividend in other projects. Therefore, the amount of profit
expected from the organization on retained earnings is the cost of
retained earnings.

ii. Soloman Erza Approach:

Includes the two options that an organization has that is either to

retain the earnings to meet future uncertainties or invest in its or
other organization’s projects.

5. Weighted Average Cost of Capital:

Weighted average cost of capital is determined by multiplying the

cost of each source of capital with its respective proportion in the
total capital. Let us understand the concept of weighted average cost
of capital with the help of an example. Suppose, an organization
raises capital by issuing debentures and equity shares. It pays
interest on debt capital and dividend on equity capital.

When the organization adds the total interest paid on debt capital to
the total dividend paid on equity capital, it obtains weighted average
cost of capital. An organization requires to generate the profit on its
various investments equal to the weighted average cost of capital.

Weighted average cost of capital can be calculated

mathematically by using the following formula:

Weighted Average Cost of Capital = (KE x E) + (KP x P) + (KD x D) +

(Kr x R)

Where,

E = Proportion of equity capital in capital structure

P = Proportion of preference capital in capital structure

D = Proportion of debt capital in capital structure

KR = Cost of proportion of retained earnings in capital structure

R = Proportion of retained earnings in capital structure

6. Marginal Cost of Capital:

Marginal cost of capital can be defined as the cost of additional

capital required by an organization to finance the investment
proposals. It is calculated by first estimating the cost of each source
of capital, which is based on the market value of the capital. After
that, it is identified that which source of capital would be more
appropriate for financing a project. The marginal cost of capital is
ascertained by taking into consideration the effect of additional cost
of capital on the overall profit.

In simpler terms, the marginal cost of capital is calculated in the

same manner as the weighted average cost of capital is calculated by
just adding additional capital to the total cost of capital.

Marginal cost of capital can be calculated mathematically

by using the following formula:

Marginal Cost of Capital = KE {E / (E + D + P + R)} + KD {D / (E + D

+ P + R)} + KP {P / (E + D + P + R)} + KR {R / (E + D + P + R)}

Cost of Capital – Cost of Debt, Preferred Stock, Retained

Earnings, Equity Stock, Weighted Average Cost of Capital and
Return on Capital
The following are the components of cost of capital:

1. The Cost of Debt:

Debt financing is one of the more frequently sought forms because

it is one of the least costly. In terms of the cost of capital definition,
the firm must make sure that when it borrows funds, the rate
earned through use of the debt-invested funds is equal to or greater
than the cost of this debt.

Thus, the cost of debt must be equal to the rate of return earned on
debt-invested funds, so that the earnings available to the common
shareholder remain unchanged. This means that the explicit
component cost of debt is equal to the rate of return earned by
investors, or the interest rate on debt.

Thus the cost of capital is really a minimization concept in the sense

that a minimum rate of return that must be earned on invested
rupees is specified. Of course, a higher rate of return, above the cost
factor to the firm, is much more desirable. Initially we may define
the cost of debt as the interest rate the firm has to pay to the lending
source, whether it be to a bank or for a new debt issue the firm has
placed with the public market.

This will be referred to as the cost of debt because this is what the
firm has to pay annually to its debt investors for borrowing the sum.
The firm must earn such a rate of return on its debt-financed
investments that the earnings available to the common sharehold-
ers remain unchanged.

If less than an estimated per cent return were received on the

investment, the earnings available to the shareholders (earnings per
share) would decline, and this could have an adverse effect on the
price of the stock.

2. The Cost of Preferred Stock:

Preferred stock (or preference shares) is frequently referred to as a

hybrid security which is somewhere between debt and common
equity. It is similar to debt in that it pays a fixed commitment or
annual dividend, and, in case of liquidation, the claim to the assets
of the corporation by preferred holders has priority over the claims
of the common shareholders.

It is similar to equity, or common stock, in that if the dividends are

not paid, the result is not corporate bankruptcy. To the investor, an
investment in preferred stock is less risky than one in the common
stock of the corporation, but more risky than an investment in its
debt securities.

3. The Cost of Using Retained Earnings:

Equity capital usually consists of two components. The first is the

amount of funds available in the form of net income that may be
used to pay dividends or may be retained in the business for asset
purchases. The second source of equity capital is the amount of
funds raised by a new common stock issue. 

The definition of the cost of retained earnings is the rate of return

that must be earned on equity-invested capital so that the total yield
available to the common shareholders remains unchanged. The cost
of retained earnings simplifies to the rate of return that
stockholders expect to earn on the common stock of the firm. This
expected or required rate of return can be determined from the
valuation formula for common stock.

It was stated that the value or price of a share of common

stock is equal to:

Thus the required rate of return is equal to the dividends yield plus
the growth rate of dividends, which will reflect itself in future prices.
If, for example, a firm plans to pay Rs. 2.40 dividend, its
current price is Rs40, and it has an expected growth rate
of 6 per cent, we could calculate the rate of return earned
on this stock as:

With a dividend yield of 6 per cent and a growth rate of 6 per cent,
the rate return earned by investors on this stock is 12 per cent.

This rate of return paid by the corporation becomes a required rate

of return to the investor who applies the opportunity cost doctrine.
If 12 per cent has been the historical rate of return on the stock, the
investor will expect this to continue. If it decreases, he or she will
re-evaluate the position in the stock and possibly sell.

Investors classify firms by risk classes and then seek the firm that
pays the highest return in the given risk class. If the firm continues
to make investments that yield 12 per cent, the rate of return to the
common shareholder will remain unchanged, and the investor will
yield 12 per cent. If, however, the firm yields less than 12 per cent,
this will lead to a revaluation of the required rate of return and
possibly a decrease in the price of the stock.

The growth rate of earnings, dividends, and stock price was

expected to be 6 per cent. The stock price at the beginning of Year 1
was Rs.40. At the end of Year 1, the earnings were Rs.4.80 per
share, and since the firm pays 50 per cent in dividends, the
dividends were Rs.2.40. The remaining Rs.2.40 was retained to be
invested in Year 2.

From Equation (20), the rate of return for Year 1 was calculated to
be 12 per cent (k = (Rs.2.40/40) + 0.06 = 0.12). The stock price,
growing at the 6 per cent growth rate, would be Rs.42.40 (1.06 x 40)
at the end of Year 1. This price increase results from the fact that the
firm is expected to earn a 12 per cent return on Rs.2.40 per share
reinvested capital.
To explain more fully, assume the firm will have net income of
Rs.4.80 again at the end of Year 2 (unless investment is made). The
firm retains from Year 1 Rs.2.40 per share for this investment. It
will need to earn a 12 per cent return on this reinvested capital
during Year 2 in order to justify the price at the beginning of Year 2
of Rs.42.40.

The earnings, therefore, at the end of Year 2 would be Rs.5.088 per

share- Rs.4.80 + (0.12 x Rs.2.40). A 50 per cent dividend would be
Rs.2.544. Earnings and dividends have grown by 6 per cent, which
was the expected rate at the beginning of Year 1. The stock price at
the end of Year 1 was Rs.42.40.

This can be verified:

Therefore, for the price to be Rs.42.40 at the end of Year 1, the firm
must be able to invest the retained funds at 12 per cent.

Consider the result if the company expects it can only reinvest this
Rs.2.40 per share retained earnings at 6 per cent. The earnings at
the end of Year 2 would be Rs 4.944: Rs.4.80 + (.06 x Rs.2.40). A
50 per cent dividend would be Rs.2.472. Earnings and dividends
have only grown at a 3 per cent rate.

The stock price at the end of Year 1 was supposed to be

Rs.42.40, but this cannot be verified:

Since the retained funds are not expected to be invested at 12 per

cent, the value of stock will decrease as long as investors fed that the
firm will not earn that 12 per cent in the future.

4. The Cost of Issuing New Equity Stock:

It will be found that the cost of issuing new common stock or

external equity is slightly higher than the cost of internal equity or
retained earnings. This is because the price that the stock is sold for
in the market is not the price the firm receives.

As with preferred stock, when new common stock is issued, firms

utilize the services of investment bankers to help place it; for their
services, the bankers are paid a commission, which is referred to as
the flotation costs of underwriting a new equity issue.

The price the firm is interested in to determine its cost of equity for
a new issue is the net price, which is the market price of the stock
less the’ flotation costs.

The cost of external equity is found with Equation (21):

The formalization for the cost of external equity is basically the

same as the one for the cost of retained earnings or internal equity.
It states that the cost of equity is equal to the expected dividend
yield plus the expected growth of earnings, dividends, and price.
Only in the case of a new issue or external equity will the denom-
ination, P, become the net price per share the corporation will
receive in cash when the new issue is sold.

5. Weighted Average Cost of Capital:

When examining the cost of capital for a firm, we are not always
interested in examining the cost of a single component such as debt
or preferred stock or equity but may want to know the total cost of
capital to the firm, considering all forms of financing.
The cost of long-term debt, preferred stock, and equity, considered
together, is referred to as the average cost of capital. But is it appro-
priate to simply add the three costs together and then divide by 3 to
arrive at an average? The answer is no.

Very seldom do the three forms of financing contribute equally to

the capital structure of a firm. If they do not, it is unfair to state, for
example, that the cost of preferred stock contributes equally to the
overall average cost of capital for the firm, when in fact there is
hardly any preferred stock in the capital structure.

A good way to measure the average cost of capital for the firm
accurately is to derive what is termed a weighted average cost of
capital. This technique applies weights to each source of financing
in terms of its contribution to the capital structure of the firm; the
average thus is a simple weighted average.

Calculation of the Weighted Average Cost of Capital:

The calculation process to derive the weighted average cost of

capital is quite simple. Assume that a firm had in its balance sheet
Rs.35 million of debt, Rs.15 million of preferred stock, and Rs.50
million of common equity.

Further assume that the average before-tax rate for all debt is 6 per
cent; that the preferred stock has a dividend yield of 8 per cent, and
that the component cost of equity is equal to 12 per cent Table 5
shows how the weighted average cost of capital for this firm is
calculated.
We first list all the rupee amounts of debt, preferred stock, and
common equity. Next, these dollar amounts are converted into per
cent form by expressing each as a percentage of the total financing
for the firm. These percentage components become the weights for
the weighted average.

Next, we list the component costs for each source of financing. To

arrive at the weighted average cost of capital, we multiply the
percentage weights by the component costs and then sum the
answers. For this illustration, the weighted average cost of capital is
equal to 8.28 per cent

The Cost of New and Historical Capital:

The historical data on which the illustrations of the calculation of

the cost of capital have been based are derived by looking at the past
balance sheets of a corporation and pulling out information on
capital structure and associated costs. This is fine for certain
situations, but there are times when historical data are not ade-
quate.
 We divide the
product of per cent of total with component cost by 100 to obtain a
percentage; figures rounded to nearest hundredth.

One of the primary applications of the results of a cost of capital

analysis is in the capital budgeting process of selecting among
alternative investments. In utilizing cost of capital information in
capital budgeting, the concern is with the cost of obtaining new
funds, whether they be debt, preferred stock, or common equity.

In periods of rising interest rates, the cost of new capital or the

incremental cost of capital will be higher than the historical
weighted average cost of capital.

In using incremental costs, the same logic applies as in using the

weighted average cost of capital. If a firm uses debt it is using up
this source of cheap funds, since as the new level of debt increases,
the firm’s leverage position moves toward or beyond the industry
norm. This will jeopardize the firm’s access to future debt capital
markets. A good example of this is the firm that uses too much debt.

At some future time it may need more capital, but the only market
open to it will be equity, because the market will not absorb another
debt issue from it. If the equity market is not available, due to a
decline in the price of the company’s stock or a general decline in
the stock market, the firm could be in considerable trouble in terms
of its ability to raise the needed capital.

This is a perfect illustration of why it is important for a company to

maintain a proper balance between debt and equity. If this is done
(as in the example with the firm with a 45 per cent optimal leverage
ratio), the firm will have access to both markets. If one market is in
a period of decline, it can turn to the other as a source of funds.

If the firm is interested in utilizing cost of capital information for

capital budgeting decisions, which involve new projects or
investment alternatives, the analysis should also include new cost
data. Then it is possible to compare rates of return on these projects
with the cost of capital for raising new capital to undertake
investment alternatives.

6. Return on Capital:

Rate of Return on Capital is widely used to appraise the effective-

ness of management performance, to select the contents of an
investment portfolio, and to make decisions regarding new product
development and acquisition of plant and equipment.
Unfortunately, the term means different things to different people.
Some refer to it as ‘rate of return on investment’.

Definition:

Return on capital is the relationship, usually expressed as a ratio or

percentage, between the income (or “profit” or “interest”) from an
enterprise or undertaking and the related investment or capital
commitment.

The Mercantile Rate of Return:

The mercantile rate of return is the ratio (expressed in percentage
form) between some figure appearing on the contemporary income
statement and some figure appearing on the contemporary balance
sheet.

For illustrative purposes, a simplified income statement for a hypo-

thetical company for the year ending December 31, 1990 and the
related balance sheets at the beginning and end of the year are
presented in Tables 7 and 8 respectively.

Referring to the figures given there, the mercantile rate

might be computed as follows:

This mercantile method of computing rate of return on capital has

also been referred to as the “accountant’s method” (a lamentable
libel on a proud profession!) and the “financial- statement method.”
Assets are chosen as the base when it is desired to measure the
performance of management in using the total amount of property
entrusted to its control. Thus, for internal management purposes
and from the point of view of the entity as a whole, the important
thing may be the effectiveness with which management makes use
of the total assets of the company.

In contrast, stockholders’ equity may be the base of the

computation when appraising not only the overall use of the assets,
but also the extent to which financing methods were advantageous
from the point of view of the stockholders.

The two approaches may be distinguished by the terms “return on

assets” and “return,” or “yield,” on “equity.”

To illustrate the distinction, suppose the corporation had

been partly financed by the issue of 10% bonds and that
the liabilities and equity section of the balance sheet was
as follows:
The computation of return on assets would be identical to the
previous computation. It would be the ratio of total income
(Rs.1,330) earned from the use of all assets (averaging Rs.5,647)
without considering the amounts of that income available for the
different types of investors and without considering the extent to
which those assets had been financed by particular classes of
investors.

In contrast, emphasizing the interests of stockholders, it

would be necessary to relate the net income available to
stockholders with the stockholders’ equity, specifically:

Trading on the Equity:

Return on assets and return on equity may be used to understand

the effect of “trading on the equity.” Where bondholders are paid a
lower rate of return on their investment than the rate of return
earned on total assets, stockholders will benefit. Stockholders, in
effect, will receive the benefit on the extra return earned on the
assets financed by bondholders.

The following leverage factor may be computed to assess

the extent to which return on equity is improved over
return on assets a$ a result of trading on the equity:
Where this leverage factor is greater than 1 (as in the example), the
stockholders may have benefited through use of the funds supplied
by bondholders at a lower rate of return than that earned on the
assets.

To determine whether stockholders have really benefited, however,

it is further necessary to assess or attempt to weigh the greater risk
that may be incurred by title company as a result of the greater fixed
obligation imposed by the interest and principal on the bonds.

Some companies use gross assets (that is, assets before deducting
the depreciation taken on these assets in prior years) instead of net
assets in computing return on assets.

Such companies justify their use of gross assets by their desire to

prevent the rate of return from rising as the net book value of
depreciable assets is reduced by depreciation. Undepreciated cost
provides an unchanging base and, so long as annual income is
constant, the rate return is stable.

This viewpoint involves certain preconceptions not only about the

stability of future earnings but also about what rate of return ought
to be: Should the figure for rate of return be stable from year to year
because it is stable or because the accountant expects it to be stable
and therefore adopts conventions that make it stable?

Some accountants have argued that the relevant investment base

should instead be assets net of accumulated depreciation allow-
ances, since it seems inconsistent to compare a profit figure from
which depreciation has been deducted with an investment figure
from which the accumulated depreciation has not been deducted.

There are also many other variations regarding the rate base and
dealing with matters such as whether the assets should include
excess or idle assets, assets still in construction, assets financed by
short-term sources of credit, etc.

There are also many variations in the income figure employed for
the mercantile rate of return. Thus some companies do not deduct
taxes because they are anxious to measure those things under the
control of management, and they feel that taxes, while somewhat
subject to managerial control (tax planning), are more under the
control of Congress than of management.

There are also variations in practice regarding the inclusion of

dividend income, interest income, and “other income” and “other
expenses” in computing net income for the rate of return
calculation.

Whatever variations exist with regard to the capital base and the
return on that capital, certain common features seem to be evident
in the mechanics of computation. Thus, most companies attempt to
get a “representative” figure for the capital base in the sense that it
is the average of the relevant balance sheet magnitude at the
beginning and end of the year, or it is a thirteen-point average of the
balance sheet magnitude at the beginning of the year and at the end
of the following twelve months.

Furthermore, most companies “annualize” their income statement

figure; thus, net income for two months would be multiplied by
12/2 to get its annual equivalent.

Cost of Capital – Cost of Debt, Preference Share Capital,

Equity Share Capital and Retained Earnings
These sources of finance are called components of cost of capital.

Specific Sources of Finance:

It includes:

1. Cost of Debt
2. Cost of Preference Share Capital

3. Cost of Equity Share Capital

4. Cost of Retained Earnings.

1. Cost of Debt:

A company may raise the debt in a number of ways. It may borrow

funds from the financial institutions or public either in the form of
public deposits or debentures (bonds) for a specified period of time
at a specified rate of interest. A debenture or bond may be issued at
par, at a discount or at a premium. The contractual rate of interest
forms the basis for calculating the cost of any form of debt.

Debt may either be irredeemable or redeemable after a certain

period.

Cost of both these types may be calculated as follows:

(A) Cost of Irredeemable Debt:

(i) Cost of Irredeemable (Perpetual) Debt, before Tax:

(ii) Cost of Irredeemable (Perpetual) Debt, after Tax:

When a company uses debt as a source of finance then it saves a

considerable amount in payment of tax because the amount of
interest paid on the debts is a deductible expense in computation of
tax.

Thus, the effective cost of debt is reduced because of saving in

taxation.

Cost of debt after tax is:

(B) Cost of Redeemable Debt:

Normally a company issues a debt which is redeemable after a

certain period during its life-time. Such a debt is termed as
Redeemable Debt. Cost of redeemable debt may also be calculated
before tax and after tax.

Before tax cost of redeemable debt is calculated as

follows:

Debt Redeemable at Premium:

If the debt or debentures are redeemable at premium after a certain

period, premium payable on redemption will also be taken into
consideration.

2. Cost of Preference Share Capital:

A fixed rate of dividend is payable on preference shares. But, unlike

debt, the dividend is payable at the discretion of the Board of
Directors and there is no legal binding to pay the dividend.

Nevertheless, companies usually pay the stipulated

dividend, if there are sufficient profits, for a number of
reasons:

(i) The preference shareholders carry a prior right to receive

dividends over the equity shareholders. Unless, therefore, the firm
pays out the dividend to its preference shareholders, it will not be
able to pay anything to equity shareholders.
(ii) Preference shares are usually cumulative which means that
preference dividend will get accumulated till it is paid. As long as it
remains in arrears, no dividend can be paid to equity shareholders.

(iii) Non-payment of preference dividend may entitle their holders

to participate in the management of the company as voting rights
are conferred on them in such cases.

(iv) Non-payment of preference dividend adversely affects the fund

raising capacity of the firm.

(v) Market value of the equity shares can be adversely affected

because of non-payment of preference dividend.

For these reasons, dividends are usually paid regularly on

preference shares except when there are insufficient profits.
Therefore, the stipulated dividend on preference shares, like the
interest on debt, constitutes the basis for the calculation of the cost
of preference shares.

However, unlike interest payments on debts, dividend payable on

preference shares is not tax-deductible. Preference dividend is paid
out of after tax earnings of the company. Hence, no adjustment is
required for taxes while computing the cost of preference capital.
Since interest on debts is tax deductible and preference dividend is
not, the after-tax cost of preference capital is substantially higher
than the after-tax cost of debt.

There are two types of preference shares:

(i) Irredeemable, and (ii) Redeemable.

(i) Computation of Cost of Irredeemable (or Perpetual)

Preference Capital:

The cost of preference shares which has no specific

maturity date is calculated as follows:
The cost of preference shares is not adjusted for taxes because
preference dividend is paid after the Corporate Taxes have been
paid.

(ii) Computation of Cost of Redeemable

Preference Capital:

Redeemable preference capital has to be returned to the preference

shareholders after a stipulated period.

The cost of preference capital which has a specific

maturity date is calculated as follows:

3. Cost of Equity Share Capital:

The cost of equity share capital is most difficult and controversial

cost to measure. This is so because unlike cost of debt and cost of
preference capital, there is not any stipulated rate of return which
has to be paid on equity capital. The rate of equity dividend varies
from year to year depending upon the profits earned by the
company and the discretion of the directors.

It is not legally binding for companies to pay dividends to equity

shareholders. It may, therefore, prima facie, appear that equity
capital is free of cost. But this is not true. Equity capital like other
sources of funds, does certainly involve an opportunity cost to the
firm. When equity shareholders invest their funds in the firm’s
equity shares they also expect returns in the form of dividends and
capital gains commensurate with their risk of investment.

Hence, the market value of equity shares is determined by the

return that the shareholders expect and get. If the company does
not meet the expectation of its shareholders regarding payment of
dividends, it will have an adverse effect on the market price of its
shares. The equity shares thus implicitly involve a return in terms of
dividend expected by the shareholders and, therefore, carry a cost.

In fact, the cost of equity capital is relatively the highest among all
the sources of funds. This is so because the equity shares involve the
highest degree of financial risk since they are entitled to receive
dividend and return of principal after all other obligations of the
firm are met. As compensation to the higher risk, they expect a
higher return and, therefore, higher cost is associated with them.

According to J. C. Van Horne- “Cost of Capital is the minimum rate

of return that a firm must earn on the equity-financed portion of an
investment project in order to leave unchanged the market price of
the shares.”

In practice, it is a formidable task to measure the cost of

equity because of two reasons:

(i) It is very difficult to estimate the expected dividends, and

(ii) The future earnings and dividends are expected to grow over
time.

Growth in dividends should be estimated and incorporated in the

computation of the cost of equity which is not an easy task.

The cost of equity capital can be computed by the

following methods:

(i) Dividend Yield Method

(ii) Dividend Yield plus Growth in Dividend Method

(iii) Earning Yield Method

(iv) Earning Yield plus Growth in Earning Method

(v) Realised Yield Method

(i) Dividend Yield Method:

It is also known as Dividend/Price method. This method is based on

the assumption that when an investor invests in the equity shares of
a company he expects to get a payment at least equal to the rate of
return prevailing in the market. Hence, in order to ascertain cost of
equity capital according to this method dividend received is divided
by the market value of the share.

The equation is:

Dividend yield method of Computation of cost of equity capital

assumes that- (i) shareholders give prime importance to dividends,
and (ii) risk in the firm remains unchanged.

This method suffers from the following limitations:

a. It ignores the growth in the rate of dividend

b. It ignores retained earnings, and

c. It ignores the expectations of shareholders about increase in

share prices.

As such, this method is suitable only when the company has stable
earnings and stable dividend policy.

(ii) Dividend Yield plus Growth in Dividend Method:

Dividend yield method discussed above does not take care of future
growth in the rate of dividend whereas in actual practice
shareholders expect growing rate of dividend. Hence, when the
dividends of a firm are expected to grow at a constant rate this
method is used to compute the cost of equity capital-

Dividend yield plus growth in dividend method is based

upon the following assumptions:

a. Price earnings ratio does not change

b. The payout ratio (the percentage of earnings distributed as

dividend) does not change, and

c. The market price of the company’s share increase in proportion to

the increase in the rate of dividend.

The limitation of this method is that it ignores retained earnings.

However, the method is quite suitable when there is a constant
growth in dividends.

(iv) Earning Yield plus Growth in Earning Method:

Earning yield method does not take care of future growth in the rate
of earnings of the company whereas the earnings of a company are
usually expected to grow in future.

If the EPS of a company is expected to grow at a constant

rate of growth, the cost of equity capital can be computed
as follows:

(v) Realised Yield Method:

One of the major problems in the measurement of cost of equity
capital is that the expectations of the shareholders regarding the
rate of return on their investment in the company’s shares cannot
be estimated accurately. It is not possible to estimate future
dividends and earnings correctly because both of these depend
upon so many uncertain factors.

The realised yield method overcomes this problem by assuming that

the shareholders would expect the same rate of return in the future
as they have realised in the past. Hence, as per this method actual
average rate of return realised by the shareholders in the past is
applied to compute the cost of equity capital. To compute the
realised yield in the past both dividends received by the
shareholders in the past as well as appreciation in the value of
equity shares are considered.

This method of computing cost of equity capital is based

upon the following assumptions:

(i) No significant changes are expected in the risk complexion of the

firm.

(ii) Shareholders would feel satisfied if they earn same rate of return
in future, which they have earned in the past.

(iii) Shareholders expect to earn the same rate of return as the

realised yield even if they invest elsewhere

(iv) No significant changes are expected in the market price of

company’s share.

Computation of Cost of Newly Issued Equity Shares:

When a company issues new equity shares, it is not possible to

realise the full market value on the newly issued shares. This is
because on new issues the company has to incur flotation costs such
as underwriting commission, brokerage, printing etc. As such, in
order to ascertain the cost of capital of new issues flotation costs are
deducted from the expected market price.
In such a case P0 (Market Price) will be changed with NP (Net
Proceeds).

4. Cost of Retained Earnings:

It is sometimes argued that retained earnings carry no cost since a

firm is not required to pay dividend on retained earnings. However,
this is not true. Though retained earnings do not have any explicit
cost to the firm but they involve an opportunity cost. Retained
earnings accrue to a firm only because a part of the earnings has not
been paid out to the equity shareholders as dividends.

If the earnings were not retained and were distributed to them as

dividends, they could have invested such dividend in other firms
and could have earned a return thereon. Because of withholding of
dividends, shareholders lose the opportunity to invest such
dividends elsewhere and forgo the return on the investment of such
dividends.

Thus retained earnings involve opportunity cost. A firm is required

to earn on the retained earnings at least equal to the rate that would
have been earned by the shareholders if they were distributed to
them. This is the cost of retained earnings.

An alternative way to compute the cost of earning is to use

‘external-yield criterion’. This criterion is based on assumption of
external investment of funds by the firm itself. In other words, the
opportunity cost of retention of earnings is the rate of return that
could be earned by investing the funds in another enterprise by the
firm instead of what would be obtained by the shareholders on their
investments.

Hence, the firm should estimate the yield it can earn from external
investment opportunities by investing the retained earnings
elsewhere. The rate of return that could be thus earned constitutes
the cost of retained earnings. The cost of retained earnings (K r)
under the assumption of external-yield criterion would be
approximately equal to the cost of equity capital (K e). However,
Kr would be slightly lower than the Ke due to differences in flotation
cost. Thus –

Kr = Ke (1 – Percentage Brokerage or Flotation Cost)

Where,

Kr = Cost of Retained Earnings

Ke = Cost of Equity Capital

Weighted Average Cost of Capital:

Capital structure of a company consists of different sources of

capital. Cost of these different sources of capital is also calculated by
different methods. Hence, after the calculation of cost of capital of
these different sources of capital a practical difficulty arises as to
what is the cost of overall capital structure of the firm.

In order to solve this problem finance managers developed the

concept of Weighted Average Cost of Capital. It is also known as
composite cost or overall cost. The use of weighted average and not
the simple average is warranted by the fact that the proportions of
various sources of funds in the capital structure of a firm are
different.

The computation of weighted cost of capital involves the

following steps:

(i) Compute the cost of each source of funds (i.e. cost of debt, cost of
preference capital, cost of equity capital and cost of retained
earnings).

(ii) Assign weights to specific costs

(iii) Multiply the cost of each of the sources by the assigned weights

(iv) Divide the total weighted cost by the total weights.

Weighted average cost of capital can be computed as
follows:

Assignment of Weights:

For Computing Weighted average cost of capital, it is necessary to

determine the proportion of each source of finance in the total
capitalisation. For this purpose weights will have to be assigned to
various sources of finance.

Weights may be assigned by any of the following methods:

(a) Book Value Weights

(b) Market Value Weights

(a) Book Value Weights:

Book value weights (or proportions) are computed from the values
taken from the balance sheet. The weight to be assigned to each
source of finance is the book value of that source of finance divided
by the book value of total sources of finance.

Advantages of Book Value Weights:

(i) Book values are readily available from the published records of
the firm.

(ii) Book value weights are more realistic because the firms set their
capital structure targets in terms of book values rather than market
values.

(iii) The analysis of capital structure in terms of debt-equity ratio is

based on book values.
(iv) Book value weights are not affected by the fluctuations in the
capital market.

(v) In the case of those companies whose securities are not listed,
only book value weights can be used.

Limitations of Book Value Weights:

(i) The costs of various sources of finance are calculated using

prevailing market prices. Hence weights should also be assigned
according to market values.

(ii) The present economic values of various sources of capital may

be totally different from their book values.

(b) Market Value Weights:

As per market value scheme of weighting, the weights to different

sources of finance are assigned on the basis of their market values.
The weight assigned to a source of finance is equal to the market
value of that source of finance divided by the market value of all
sources of finance.

Advantages of Market Value Weights:

(i) The costs of various sources of finance are calculated using

prevailing market prices. Hence, it is proper to use market value
weights.

(ii) Weights assigned according to market values of the sources of

finance represent the true economic values of various sources of
finance.

Limitations of Market Value Weights:

(i) Market value weights may not be available as securities of all the
companies are not actively traded.

(ii) It is very difficult to use market value weights because the

market prices of securities fluctuate widely and frequently.
(iii) Equity capital gets greater importance while using market value
weights. In brief, while the book value is operationally convenient,
the market value basis is theoretically consistent and logical, and
therefore a better indicator of a firm’s true capital structure.

Cost of Capital – Cost of Equity Share, Preference Share and

Debt
The total cost of capital of a firm consists of the cost of
various segments of total funds, which may be classified
as follows:

1. Cost of Equity Share

2. Cost of Preference Share

3. Cost of Debt (Debentures & Bonds)

Component # 1. Cost of Equity Shares:

The cost of equity share may be defined as minimum rate of return

that the company must earn on that portion of the total capital
employed which is financed by equity capital, so that the market
price of the share of the company remains unchanged.

Factors affecting the cost of equity share:

The considerable factors while calculating the cost of

equity include:

(a) Price of an equity share in the beginning of the year.

(b) Expected equity dividend at the end of a year.

(c) Growth factor

Different Models as to the calculation of cost of equity

share:

(a) Dividend Yield Method

(b) Dividend Growth Method

(a) Dividend Yield Method:

Under this method the cost of equity share capital is calculated on

the basis of the present value of the expected future streams of
dividends. Here, the cost of equity capital will be the rate of
expected dividend which will maintain the market price of equity
shares.

Note:

P indicates market price per share which is quoted in the stock

exchange. But for new companies which go for IPO (Initial Public
Offers) the net proceeds is considered as market price per share.

The Flotation expenses (issue expenses) include underwriting

commission, Brokerage, bank commission, printing expenses etc.

(b) Dividend Growth Method:

This method is based Gordon’s Dividend growth model. Under this

method, the cost of equity share capital is calculated on the basis of
the present value of the expected future streams of dividends and
the rate of growth in dividend. This growth rate of dividend (G) is
equal to the compound growth rate in earnings per share.

The formula under this model-

Component # 2. Cost of Preference Shares:

The cost of preference share capital is the dividend expected by its

holders. The payment of preference dividend is not adjusted for
taxes as they are paid after taxes and is not deductible.

The cost of preference share capital is calculated by dividing the

fixed dividend per share by the price per preference share.

Factors affecting the cost of preference shares are:

The considerable factors while calculating the cost of pref.

shares are:

(a) Fixed dividend rate

(b) Issue expenses like underwriting commission, brokerage etc.

(c) Discount/Premium on issue/Redemption.

Preference shares may be redeemable or irredeemable. In India,

irredeemable preference shares are not allowed. Redeemable pref.
shares are redeemable after the expiry of certain number of years,
but the redemption date of which is not announced at the time of
issue of shares. They are compulsorily repayable within a maximum
period of 10 years.

a. Computation of the Cost of Irredeemable Preference

Shares:

b. Calculation of Cost of Redeemable Preference Shares:

If the preference shares are redeemable after the expiry of a fixed

period, then the cost of preference shares would be-
Note:

If in any problem mentions the date of redemption, they are

assumed as redeemable pref. shares. If not they are assumed as
irredeemable pref. shares.

Component # 3. Cost of Debt:

A debt may be in the form of Bond or Debenture.

A bond is a long term debt instrument or security. Bonds are issued

by the Government and the public sector companies. Bonds issued
by the government do not have any risk of default, because it
honours obligation of its bonds. Bonds of the public sector
companies in India are generally secured, but they are not free from
the risk of default.

The private sector companies also issue bonds, which are called
debentures in India. A Company in India can issue secured and
unsecured debentures.

Factors Affecting the Cost of Debt:

The considerable factors while calculating Cost of Debt

are:

(a) Fixed Rate of Interest – Interest rate is fixed and known to

debenture or bond holders. Interest paid on a debenture or bond is
tax deductible. The interest rate is also called coupon rate. Coupons
are detachable certificates of interest.
(b) Face value – Face value is called par value and interest is paid
on face value.

(c) Issue expenses are like underwriting commission and brokerage.

(d) Income tax rate – interest paid tax deductible.

(e) Maturity – A bond or debenture is generally issued for a

specified period of time. It is repaid on maturity.

(f) Redemption value – A bond or debenture may be redeemed at

par or at premium or at discount.

(g) Market value – The price at which a bond or debenture currently

sold or bought is called the market value. Market value may be
different from par value or redemption value.

Cost of Irredeemable Debentures:

The Companies are not allowed to issue irredeemable debentures.

All the debentures are redeemable within a maximum period of 5
years. But some companies especially, banking companies can raise
funds through hybrid securities in the form of perpetual bonds and
debentures. They continue forever in the balance sheet of Banking
Companies. They are redeemable at the option of the bank. Hence,
such debentures are called irredeemable debentures.

Computation of the Cost of Irredeemable Debentures:

Where,

Kd = Cost of debentures

I = Interest payable on debenture

T = Marginal Tax rate (decimal point)

P = Net Proceeds, received on issue of debenture

Meaning of Cost of Capital:
An investor provides long-term funds (i.e., Equity shares,
Preference Shares, Retained earnings, Debentures etc.) to a
company and quite naturally he expects a good return on his
investment.
In order to satisfy the investor’s expectations the company should
be able to earn enough revenue.

ADVERTISEMENTS:

Thus, to the company, the cost of capital is the minimum rate of

return that the company must earn on its investments to fulfill the
expectations of the investors.

If a company can raise long-term funds from the market at 10%,

then 10% can be used as cut-off rate as the management gains only
when the project gives return higher than 10%. Hence 10% is the
discount rate or cut-off rate. In other words, it is the minimum rate
of return required on the investment project to keep the market
value per share unchanged.

In order to maximise the shareholders’ wealth through increased

price of shares, a company has to earn more than the cost of capital.
The firm’s cost of capital can be determined by working out
weighted average of the different costs of raising different sources of
capital.

Some definitions of financial experts are given below for

the clear conception of cost of capital:
ADVERTISEMENTS:

Ezra Solomon defines “Cost of capital is the minimum

required rate of earnings or cutoff rate of capital
expenditure”.
According to Mittal and Agarwal “the cost of capital is the
minimum rate of return which a company is expected to
earn from a proposed project so as to make no reduction
in the earning per share to equity shareholders and its
market price”.
According to Khan and Jain, cost of capital means “the minimum
rate of return that a firm must earn on its investment for
the market value of the firm to remain unchanged”.
Cost of capital depends upon:
ADVERTISEMENTS:

(a) Demand and supply of capital,

(b) Expected rate of inflation,

(c) Various risk involved, and

(d) Debt-equity ratio of the firm etc.

Significance of Cost of Capital:

ADVERTISEMENTS:

The concept of cost of capital plays a vital role in decision-making

process of financial management. The financial leverage, capital
structure, dividend policy, working capital management, financial
decision, appraisal of financial performance of top management etc.
are greatly influenced by the cost of capital.

The significance or importance of cost of capital may be

stated in the following ways:
1. Maximisation of the Value of the Firm:
For the purpose of maximisation of value of the firm, a firm tries to
minimise the average cost of capital. There should be judicious mix
of debt and equity in the capital structure of a firm so that the
business does not to bear undue financial risk.

2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking
capital budgeting decisions. Generally cost of capital is the discount
rate used in evaluating the desirability of the investment project. In
the internal rate of return method, the project will be accepted if it
has a rate of return greater than the cost of capital.

ADVERTISEMENTS:

In calculating the net present value of the expected future cash

flows from the project, the cost of capital is used as the rate of
discounting. Therefore, cost of capital acts as a standard for
allocating the firm’s investible funds in the most optimum manner.
For this reason, cost of capital is also referred to as cut-off rate,
target rate, hurdle rate, minimum required rate of return etc.

3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions
of business concern.

4. Management of Working Capital:

In management of working capital the cost of capital may be used to
calculate the cost of carrying investment in receivables and to
evaluate alternative policies regarding receivables. It is also used in
inventory management also.

5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The
dividend policy of a firm should be formulated according to the
nature of the firm— whether it is a growth firm, normal firm or
declining firm. However, the nature of the firm is determined by
comparing the internal rate of return (r) and the cost of capital (k)
i.e., r > k, r = k, or r < k which indicate growth firm, normal firm
and decline firm, respectively.

6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In
designing optimum capital structure that is the proportion of debt
and equity, due importance is given to the overall or weighted
average cost of capital of the firm. The objective of the firm should
be to choose such a mix of debt and equity so that the overall cost of
capital is minimised.

7. Evaluation of Financial Performance:

The concept of cost of capital can be used to evaluate the financial
performance of top management. This can be done by comparing
the actual profitability of the investment project undertaken by the
firm with the overall cost of capital.

Measurement of Cost of Capital:

Cost of capital is measured for different sources of capital structure
of a firm. It includes cost of debenture, cost of loan capital, cost of
equity share capital, cost of preference share capital, cost of retained
earnings etc.

The measurement of cost of capital of different sources of

capital structure is discussed:
A. Cost of Debentures:
The capital structure of a firm normally includes the debt capital.
Debt may be in the form of debentures bonds, term loans from
financial institutions and banks etc. The amount of interest payable
for issuing debenture is considered to be the cost of debenture or
debt capital (Kd). Cost of debt capital is much cheaper than the cost
of capital raised from other sources, because interest paid on debt
capital is tax deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1
– t)
where Kd = Cost of debenture
r = Fixed interest rate

t = Tax rate

ADVERTISEMENTS:

(ii) When the debentures are issued at a premium or discount but

redeemable at par

Kd = I/NP (1 – t)
where, Kd = Cost of debenture
I = Annual interest payment

ADVERTISEMENTS:

t = Tax rate

Np = Net proceeds from the issue of debenture.

(iii) When the debentures are redeemable at a premium or discount

and are redeemable after ‘n’ period:
Kdb = I+1/n (R V– NP)
½ (R V– NP)
where Kd = Cost of debenture .
I = Annual interest payment

t = Tax rate

NP = Net proceeds from the issue of debentures

RV = Redeemable value of debenture at the time of maturity

Example 1:
(a) A company issues Rs. 1,00,000, 15% Debentures of Rs. 100 each.
The company is in 40% tax bracket. You are required to compute
the cost of debt after tax, if debentures are issued at (i) Par, (ii) 10%
discount, and (iii) 10% premium.

(b) If brokerage is paid at 5%, what will be the cost of debentures if

issue is at par?
Example 2:
ZED Ltd. has issued 12% Debentures of face value of Rs. 100 for Rs.
60 lakh. The floating charge of the issue is 5% on face value. The
interest is payable annually and the debentures are redeemable at a
premium of 10% after 10 years.

What will be the cost of debentures if the tax is 50%?

B. Cost of Preference Share Capital:

For preference shares, the dividend rate can be considered as its
cost, since it is this amount which the company wants to pay against
the preference shares. Like debentures, the issue expenses or the
discount/premium on issue/redemption are also to be taken into
account.

(i) The cost of preference shares (KP) = DP / NP

Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.

(ii) If the preference shares are redeemable after a period of ‘n’, the
cost of preference shares (KP) will be:

where NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares

DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its
dividend is not allowed deduction from income for income tax
purposes. The students should note that both in the case of debt and
preference shares, the cost of capital is computed with reference to
the obligations incurred and proceeds received. The net proceeds
received must be taken into account while computing cost of capital.

Example 3:
A company issues 10% Preference shares of the face value of Rs. 100
each. Floatation costs are estimated at 5% of the expected sale price.

What will be the cost of preference share capital (K P), if preference

shares are issued (i) at par, (ii) at 10% premium and (iii) at 5%
discount? Ignore dividend tax.
Solution:
We know, cost of preference share capital (KP) = DP/P
Example 4:
Ruby Ltd. issues 12%. Preference Shares of Rs. 100 each at par
redeemable after 10 years at 10% premium.

What will be the cost of preference share capital?

Example 5:
A company issues 12% redeemable preference shares of Rs. 100
each at 5% premium redeemable after 15 years at 10% premium. If
the floatation cost of each share is Rs. 2, what is the value of
KP (Cost of preference share) to the company?
C. Cost of Equity or Ordinary Shares:
The funds required for a project may be raised by the issue of equity
shares which are of permanent nature. These funds need not be
repayable during the lifetime of the organisation. Calculation of the
cost of equity shares is complicated because, unlike debt and
preference shares, there is no fixed rate of interest or dividend
payment.

Cost of equity share is calculated by considering the earnings of the

company, market value of the shares, dividend per share and the
growth rate of dividend or earnings.

(i) Dividend/Price Ratio Method:

An investors buys equity shares of a particular company as he
expects a certain return (i.e. dividend). The expected rate of
dividend per share on the current market price per share is the cost
of equity share capital. Thus the cost of equity share capital is
computed on the basis of the present value of the expected future
stream of dividends.

Thus, the cost of equity share capital (Ke) is measured by:

Ke = where D = Dividend per share
P = Current market price per share.

If dividends are expected to grow at a constant rate of ‘g’ then cost

of equity share capital

(Ke) will be Ke = D/P + g.

This method is suitable for those entities where growth rate in
dividend is relatively stable. But this method ignores the capital
appreciation in the value of shares. A company which declares a
higher amount of dividend out of given quantum of earnings will be
placed at a premium as compared to a company which earns the
same amount of profits but utilizes a major part of it in financing its
expansion programme.

Example 6:
XY Company’s share is currently quoted in market at Rs. 60. It pays
a dividend of Rs. 3 per share and investors expect a growth rate of
10% per year.

You are required to calculate:

(i) The company’s cost of equity capital.

(ii) The indicated market price per share, if anticipated growth rate
is 12%.

(iii) The market price, if the company’s cost of equity capital is 12%,
anticipated growth rate is 10% p.a., and dividend of Rs. 3 per share
is to be maintained.

Example 7:
The current market price of a share is Rs. 100. The firm needs Rs.
1,00,000 for expansion and the new shares can be sold at only Rs.
95. The expected dividend at the end of the current year is Rs. 4.75
per share with a growth rate of 6%.
Calculate the cost of capital of new equity.

Solution:
We know, cost of Equity Capital (Ke) = D/P + g
(i) When current market price of share (P) = Rs. 100

K = Rs 4.75 / Rs. 100 + 6% = 0.0475 + 0.06 = 0.1075 or 10.75%.

(ii) Cost of new Equity Capital = Rs. 4.75 / Rs. 95 + 6% = 0.11 or,
11%.

Example 8:
A company’s share is currently quoted in the market at Rs. 20. The
company pays a dividend of Rs. 2 per share and the investors expect
a growth rate of 5% per year.

You are required to calculate (a) Cost of equity capital of the

company, and (b) the market price per share, if the anticipated
growth rate of dividend is 7%.

Solution:
(a) Cost of equity share capital (Ke) = D/P +g = Rs. 2/Rs. 20 + 5% =
15%
(b) Ke = D/P + g
or, 0.15 = Rs. 2 / P + 0.07 or, P = 2/0.08 = Rs. 25.

Example 9:
Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a
stock exchange at a market price of Rs. 28. A constant expected
annual growth rate of 6% and a dividend of Rs. 1.80 per share has
been paid for the current year.
Calculate the cost of equity share capital.

Solution:
D0 (1 + g)/ P0 + g = 1.80 (1 + .06)/ 28 + 0.06
= 0.0681 + 0.06 = 12.81%

(ii) Earnings/Price Ratio Method:

This method takes into consideration the earnings per share (EPS)
and the market price of share. Thus, the cost of equity share capital
will be based upon the expected rate of earnings of a company. The
argument is that each investor expects a certain amount of earnings
whether distributed or not, from the company in whose shares he
invests.

If the earnings are not distributed as dividends, it is kept in the

retained earnings and it causes future growth in the earnings of the
company as well as the increase in market price of the share.

Thus, the cost of equity capital (Ke) is measured by:

Ke = E/P where E = Current earnings per share
P = Market price per share.

If the future earnings per share will grow at a constant rate ‘g’ then
cost of equity share capital (Ke) will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the
factor of capital appreciation or depreciation in the market value of
shares. Adjustment of Floatation Cost There are costs of floating
shares in market and include brokerage, underwriting commission
etc. paid to brokers, underwriters etc.
These costs are to be adjusted with the current market price of the
share at the time of computing cost of equity share capital since the
full market value per share cannot be realised. So the market price
per share will be adjusted by (1 – f) where ‘f’ stands for the rate of
floatation cost.

Thus, using the Earnings growth model the cost of equity

share capital will be:
Ke = E / P (1 – f) + g
Example 10:
The share capital of a company is represented by 10,000 Equity
Shares of Rs. 10 each, fully paid. The current market price of the
share is Rs. 40. Earnings available to the equity shareholders
amount to Rs. 60,000 at the end of a period.

Calculate the cost of equity share capital using Earning/Price ratio.

Example 11:
A company plans to issue 10,000 new Equity Shares of Rs. 10 each
to raise additional capital. The cost of floatation is expected to be
5%. Its current market price per share is Rs. 40.

If the earnings per share is Rs. 7.25, find out the cost of new equity.
D. Cost of Retained Earnings:
The profits retained by a company for using in the expansion of the
business also entail cost. When earnings are retained in the
business, shareholders are forced to forego dividends. The
dividends forgone by the equity shareholders are, in fact, an
opportunity cost. Thus retained earnings involve opportunity cost.

If earnings are not retained they are passed on to the equity

shareholders who, in turn, invest the same in new equity shares and
earn a return on it. In such a case, the cost of retained earnings (K r)
would be adjusted by the personal tax rate and applicable
brokerage, commission etc. if any.

Many accountants consider the cost of retained earnings as the

same as that of the cost of equity share capital. However, if the cost
of equity share capital i9 computed on the basis of dividend growth
model (i.e., D/P + g), a separate cost of retained earnings need not
be computed since the cost of retained earnings is automatically
included in the cost of equity share capital.

Therefore, Kr = Ke = D/P + g.

Example 12:
It is given that the cost of equity of a company is 20%, marginal tax
rate of the shareholders is 30% and the Broker’s Commission is 2%
of the investment in share. The company proposes to utilise its
retained earnings to the extent of Rs. 6,00,000.

Find out the cost of retained earnings.

E. Overall or Weighted Average Cost of Capital:

A firm may procure long-term funds from various sources like
equity share capital, preference share capital, debentures, term
loans, retained earnings etc. at different costs depending on the risk
perceived by the investors.

When all these costs of different forms of long-term funds are

weighted by their relative proportions to get overall cost of capital it
is termed as weighted average cost of capital. It is also known as
composite cost of capital. While taking financial decisions, the
weighted or composite cost of capital is considered.

The weighted average cost of capital is used by an

enterprise because of the following reasons:
(i) It is useful in taking capital budgeting/investment decisions.

(ii) It recognises the various sources of finance from which the

investment proposal derives its life-blood (i.e., finance).

(iii) It indicates an optimum combination of various sources of

finance for the enhancement of the market value of the firm.

(iv) It provides a basis for comparison among projects as a standard

or cut-off rate.
I. Computation of Weighted Average Cost of Capital:
Computation of Weighted Average cost of capital is made
in the following ways:
(i) The specific cost of each source of funds (i.e., cost of equity,
preference shares, debts, retained earnings etc.) is to be calculated.

(ii) Weights (i.e., proportion of each, source of fund in the capital

structure) are to be computed and assigned to each type of funds.
This implies multiplication of each source of capital by appropriate
weights.

Generally, the-following weights are assigned:

(a) Book values of various sources of funds

(b) Market values of various sources of capital

(c) Marginal book values of various sources of capital.

Book values of weights are based on the values reflected by the

balance sheet of a concern, prepared under historical basis and
ignoring price level changes. Most of the financial analysts prefer to
use market value as the weights to calculate the weighted average
cost of capital as it reflects the current cost of capital.

But the determination of market value involves some difficulties for

which the measurement of cost of capital becomes very difficult.

(iii) Add all the weighted component costs to obtain the firm’s
weighted average cost of capital.

Therefore, weighted average cost of capital (Ko) is to be calculated

by using the following formula:
Ko = K1w1 + K2w2 + …………
where K1, K2 ……….. are component costs and W1, W2 ………….. are
weights.
Example 13:
Jamuna Ltd has the following capital structure and, after
tax, costs for the different sources of fund used:

Example 14:
Excel Ltd. has assets of Rs. 1,60,000 which have 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 2006 were Rs. 13,500. It pays 8% interest on
borrowed funds and is in the 50% tax bracket. It has 900 equity
shares of Rs. 100 each selling at a market price of Rs. 120 per share.

What is the Weighted Average Cost of Capital?

Example 15:
RIL Ltd. opts for the following capital structure:

Example 16:
In considering the most desirable capital structure for a
company, the following estimates of the cost Debt and
Equity Capital (after tax) have been made at various levels
of debt-equity mix:

You are required to determine the optimum debt-equity mix for the
company by calculating composite cost of capital. 

Optimal debt-equity mix for the company is at the point where the
composite cost of capital is minimum. Hence, the composite cost of
capital is minimum (10.75%) at the debt-equity mix of 3: 7 (i.e., 30%
debt and 70% equity). Therefore, 30% of debt and 70% equity mix
would be an optimal debt-equity mix for the company.

The meanings of beta coefficient –

 If the coefficient is 1 it indicates the price of the stock /security is

moving in line with the market

 If coefficient <1; the return of the security is less likely to respond to

the market movements

 If the coefficient > 1; the returns from the security are more likely to

respond to market movements thereby also making it volatile.

What is the Marginal Cost of Capital?
Marginal Cost of Capital is the total combined cost of debt, equity, and
preference taking into account their respective weights in the total
capital of the company where such cost shall denote the cost of raising
any additional capital for the organization which aides in analyzing
various alternatives of financing as well as decision making.

Marginal Cost of Capital = Cost of Capital of Source of New Capital

Raised
The weighted marginal cost of capital Formula = It is calculated in case the
new funds are raised from more than one source and it is calculated as
below:

Weighted Marginal Cost of Capital = (Proportion of Source 1 * After-

Tax Cost of Source1) + (Proportion of Source2 * After-Tax Cost of
Source2) +….+ (Proportion of Source * After-Tax Cost of Source)

Example #1
Company present capital structure has funds from three different sources
i.e., equity capital, preference share capital and the debt. Now the company
wants to expand its current business and for that purpose, it wants to raise
the funds of $ 100,000. The company decided to raise capital by issuing
equity in the market as according to the present situation of a company it is
more feasible for the company to raise capital through the issue of equity
capital rather than the debt or preference share capital. The cost of issuing
equity is 10 %. What is the marginal cost of capital?

Solution:

It is the cost of raising an additional dollar of a fund by the way of equity,

debt, etc. In the present case, the company raised the funds by issuing the
additional equity shares in the market for $ 100,000 cost of which is 10 %
so the marginal cost of capital of the raising of new funds for the company
will be 10 %.

Example #2
The company has a capital structure and the after-tax cost as given below
from different sources of funds.
The firm wants to further raise the capital of $ 800,000 as it is planning to
expand its project. Below are the details of the sources from which the
capital is raised. The after-tax cost of debt will remain the same as present
in the existing structure. Calculate the marginal cost of capital of the
company.

WMCC = (50 % * 13 %) + (25 % * 10 %) + (25 % * 8 %)

WMCC = 6.50 % + 2.50 % + 2.00 %

WMCC = 11 %

Thus the weighted marginal cost of the capital of raising new capital is 11
%.

Advantages
Some of the advantages are as follows:
  It aims in the change of overall cost of capital because of the raising

of one more dollar of the fund.

 It helps in decision making whether or not to raise further funds for

business expansion or new projects by discounting the future cash

flows with a new cost of capital.

 It helps in deciding by what means the new funds to be raised and in

which proportion.

Disadvantages
Some of the disadvantages are as follows:

 It ignores the long term implications of raising a new fund.

 It doesn’t aim at maximization of shareholder’s wealth unlike the

weighted average cost of capital.

 This concept can’t be applied to a new company.

Important Points
The marginal cost of capital is the cost of raising an additional dollar of a
fund by the way of equity, debt, etc. It is the combined rate of
return required by the debt holders and shareholders for the financing of
additional funds of the company.
C
Conclusion
It is the weighted average cost of the new proposed capital funding
calculated by using their corresponding weights. The marginal weight
implies the weight of that additional source of funds among the entire
proposed funding. In case if any company decides to raise additional fund
through various sources through which already funding have been done
earlier and the additional raising of the fund will be in the same ratio as
they were earlier existing then the marginal cost of capital will be same as
that of the weighted average cost of capital.

But in the real scenario, it might happen that additional funds will be raised
with some different components and/or in some different weights. In this,
the marginal cost of capital will not be equal to the weighted average cost
of capital.

THE KEY COMPONENTS OF THE COST OF CAPITAL

There are four critical components that must be estimated in order to

estimate the cost of capital.
 Key Take

Key Takeaways

Firms raise capital from investors in the form of debt and equity with the intention of investing
that capital into developing products and services for customers. Back in Chapter One, we
introduced the goal of maximizing shareholder wealth and, in order to accomplish this goal, the
firm needs to invest this capital in such a manner as to ensure that the return generated exceeds
the cost of acquiring the capital. To evaluate this, the firm needs to be able to estimate their
marginal cost of capital. This is done by determining the market value weights of the appropriate
financing sources and the costs of the individual financing sources. These values are then used to
create a weighted average to estimate the firms cost of capital. It is important to remember that
the appropriate cost of each financing source is effectively the required return demanded by
investors. However, there are some challenges that occur in that we need to acknowledge that
interest expense is a pre-tax expense, so the cost of debt needs to reflect the interest tax shield. In
addition, the cost of common is difficult to model precisely, so we often use an average of multiple
methods in order to try to get a more reliable estimate. Finally, it is important to recognize that
the cost of capital will vary depending on the mix of debt vs. equity financing (capital structure)
that the firm chooses. Therefore, firms need to reflect on how their decision related to capital
structure can be optimized to keep the cost of capital low and the value of the firm high.
QUESTION 1
Why do we need to convert debt to an after-tax cost when preferred stock and
common stock do not take this same conversion?

QUESTION 2
Why is the cost of common stock the highest of the three types of financing and the
cost of debt the lowest?

QUESTION 3
What advantage do we get from using three different methods to calculate the cost
of common stock financing?

QUESTION 4
Why is the YTM used as the before tax cost of financing rather than the coupon
rate?

QUESTION 5
Should we use market values to estimate our financing proportions or book values?
Why?

QUESTION 6
Why is the MCC important? What is it used for?

QUESTION 7
To use the MCC as the required return in our capital budgeting analysis, what two
conditions must be met?

QUESTION 8
If a firm can lower their cost of capital, all else equal, this should result in an increase
in the value of the firm. True or False? Explain.

QUESTION 9
If debt is the cheapest form of financing, then issuing more debt should automatically
lower our cost of capital. True or False? Explain.