COST OF CAPITAL

The Cost of Capital is an important financial

concept. It links the company’s long-term financial
decisions with the shareholders’ value as
determined in the market place. Two basic
conditions must be fulfilled so that the company’s
cost of capital can be used to evaluate new
investment:
1) The new investments being considered have the
same risks as the typical or average investment
undertaken by the firm.
2) The financing policy of the firm remains
unaffected by the investments that are being made.

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The term cost of capital refers to the minimum
rate of return that a firm must earn on its
investments so as to keep the value of the
enterprise intact. It represents the rate of
return which the firm must pay to the
suppliers of capital for use of their funds.
Cost of Capital is really a rate of return, it is not a
cost as such.
A firm’s cost of capital represents minimum rate
of return that will result in at least maintaining
(If not increasing) the value of its equity
shares.
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Cost of Capital as a rate of return is calculated on
the basis of actual cost of different components
of capital.
It is usually related to long-term capital funds.
Cost of Capital has three components:
a) Return at Zero Risk Level.
b) Premium for Business Risk.
c) Premium for Financial Risk.
Cost of Capital with financial risk > Cost of Capital
with Business Risk > Cost of Capital with no risk.
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Explicit Cost and Implicit Cost : Explicit cost is
the discount rate that equate the present
value of the expected incremental cash
inflows with the present value of its
incremental cash out flows. Implicit cost is the
rate of return associated with the best
investment opportunity for the firm and its
shareholders that will be foregone if the
project presently under consideration by the
firm were accepted.
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Average Cost and Marginal Cost
Future Cost of Capital
Specific Cost and Combined Cost
Computation of cost of capital from individual
sources of funds helps in determining the
overall cost of capital for the firm. There are
four basic sources of long-term funds for a
business firm: (i) Long-term Debt and
Debentures, (ii) Preference Share Capital,
(iii) Equity Share Capital, (iv) Retained Earnings
 Cost of Long-Term Debts

Cost of long-term debt represents the minimum

rate of return that must be earned on debt
financed investments if the firm’s value is to
remain intact. Long-term debt may be issued
at par, at premium or discount. It may be
Perpetual (irredeemable) or redeemable.
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The formula for perpetual will be as follows:

Kd = ( I (1- T)) / Np
Where
Kd = Cost of debt after tax
I = Annual Interest Payment
Np = Net Proceeds of Loans
T = Tax Rate
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Example, a company issues 10% irredeemable

debentures of Rs. 1,00,000. The company is in
60% tax bracket.
Answer:
Cost of debt at par = 4%
Cost of debt issued at 10% discount = 4.44%
Cost of debt issued at 10% premium = 3.63%
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For computing cost of redeemable debt, the
period of redemption is considered. The cost
of long-term debt is the investor’s yield to
maturity adjusted by the firm’s tax rate plus
distribution cost. The question of yield to
maturity arises only when the loan is taken
either at discount or at premium. The formula
for cost of debt will be:
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Kd = I (1 – T) + ( RV – NP ) / n / ( RV + NP ) / 2

Where : NP = net amount realized on debt issue

I = Annual interest payment
T = Tax rate applicable
RV = Redemption Value
n = Maturity period of debt.
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Example, A company raised loan by selling 2,500
debentures with 10% rate of interest at a
discount of Rs. 2 per debenture (Par value =
Rs. 100), redeemable at 8% premium in the
10th year-end. Underwriting and other
issuance costs amounted to 3% of the
proceeds. The tax rate is 40%.

Answer: 7.18%
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Cost of Term Loans: Term loans are loans taken

from banks or financial institutions for a
specified number of years at a pre-determined
interest rate. The cost of term loans is equal to
the interest rate multiplied by ( 1 – tax rate ).
Kt = I ( 1 – T ) , where I is interest and T is tax
rate.
 Cost of Preference Capital:
Cost of preference share capital represents the rate
of return that must be earned on preferred stocks
financed investments to keep the earnings
available to residual stockholders unchanged. The
companies can issue only redeemable preference
shares. Cost of capital for such shares is that
discount rate which equates the funds available
from the issue of preference shares with the
present values of all dividends and repayment of
preference share capital. This present value
method for cost of preference share capital is
similar to that used for cost of debt capital; the
only difference is that in place of ‘interest’, stated
dividend on preference share is used.
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Kp = D + ( RV – NP ) / n / ( RV + NP ) / 2

Where : NP = net amount realized on issue

D= Annual preference dividend
RV = Redemption Value
n = Maturity period of debt.
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Example: KKR Ltd. has recently come out with a

preference share issue to the tune of Rs.100
lakhs. Each preference share has a face value
of Rs.100 and a dividend of 12% payable. The
shares are redeemable after 15 years at a
premium of Rs.15 per share. The company
hopes to realize Rs.98 per share now.
Calculate the cost of preference capital.
Answer: 12.33%
 Cost of Equity Capital
Equity shareholders do not have a fixed rate of
return on their investment. There is no legal
requirement to pay regular dividends to them.
Measuring the rate of return to equity holders
is a difficult and complex exercise. There are
many approaches for estimating return:
Earnings price method; Earnings price plus
growth rate method; Dividend price method;
Dividend price plus growth rate method;
Realized Yield method and Capital asset
pricing method.
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Some people are of the opinion that equity
capital is free of cost for the reason that a
company is not legally bound to pay dividends
and also the rate of equity dividend is not
fixed like preference dividends. This is not a
correct view as equity shareholders buy
shares with the expectation of dividends and
capital appreciation. Dividends enhance the
market value of shares and therefore equity
capital is not free of cost.
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Example 1: A firm has Rs. 5 EPS with 10% growth
rate of earnings over a period of 3 years. The
current market price of equity share is Rs. 50.

Ke = (EPS ( 1 + Growth rate )3) x 100 / MP

Answer: 13.31%
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Example 2: Suraj Metals are expected to declare
a dividend of Rs.5 per share and the growth
rate in dividends is expected to grow @ 10%
p.a. The price of one share is currently at Rs.
110 in the market. What is the cost of equity
capital to the company?
Ke = (Expected dividend / MP) x 100 + Growth
Answer: 14.54%
 Capital Asset Pricing Model(CAPM)

This model establishes a relationship between

the required rate of return of a security its
systematic risks expressed as BETA. According
to this model, Ke = Rf + BETA ( Rm – Rf )
Where, Rf is the risk free rate of return and Rm
is return on market.
The CAPM is based on some assumptions, some
of which are:
1. Investors are risk-averse.
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2. Investors make their investment decisions on
a single-period horizon.
3. Transaction costs are low and therefore can
be ignored. This translates to assets being
bought and sold in any quantity desired. The
only considerations mattering are the price
and amount of money at the investor’s
disposal.
4. All investors agree on the nature of return and
risk associated with each investment.
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Example3: What is the rate of return ( equity
capital ) for a company if its BETA is 1.5, risk
free rate of return is 8% and the market rate
of return is 20%?
Answer: 26%
 Cost of Retained Earnings

A company’s earnings can be reinvested in full to

fuel the ever-increasing demand of company’s
fund requirements or they may be paid off to
equity holders in full or they may be partly
held back and invested and partly paid off.
These decisions are taken keeping in mind the
company’s growth stages.
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High growth companies may reinvest the entire
earnings to grow more. Shareholders of
companies with high growth prospects
utilizing funds for reinvestment activities have
to be compensated for parting with their
earnings. Therefore the cost of retained
earnings is the same as the cost of
shareholder’s expected return from the firm’s
ordinary shares.
 Weighted Average cost of Capital

Weighted average cost of capital, also known as

composite cost of capital, overall cost of
capital or weighted marginal cost of capital, is
the average of the costs of each sources of
funds employed by the firm, properly
weighted by the proportion they hold in the
capital structure of the firm.
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Example1:
A firm has the following capital structure:
12% Debt Rs.20,00,000; 10% Preference shares
Rs.10,00,000; Equity shares Rs. 30,00,000 and
Retained Earnings Rs.40,00,000. Tax rate 40%.
Cost of Equity Capital is 18%.
Calculate WACC.
Answer: ( 15.04% = 1.44+1+5.4+7.2 )
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Example2:
From the following information , compute WACC
of SGL(Assume Tax rate = 35%):
Debt to Total Funds: 2:5
Preference Capital to Equity Capital : 1:1
Preference Dividend Rate: 15%
Interest on Debentures: Rs.20K for half-year
EBIT at 30% of Capital Employed: Rs.300K
Cost of Equity Capital is 24%
Answer: ( 2.6 + 4.5 + 7.2 = 14.30% )
 SIGNIFICANCE OF COST OF CAPITAL

The determination of the firm’s cost of capital is

important because
i) Cost of capital provides the very basis for
financial appraisal of new capital expenditure
proposals and thus serves as acceptance
criterion for capital expenditure projects.
ii) Cost of capital helps the managers in
determining the optimal capital structure of
the firm.
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iii) Cost of capital serves as the basis for
evaluating the financial performance of top
management.
iv) Cost of capital also helps in formulating
dividend policy and working capital policy
v) Cost of capital can serve as capitalization rate
which can be used to determine capitalization
of a new firm.

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