COST OF CAPTIAL

Cost of capital is the minimum rate of return a firm

must earn on its investment in order to satisfy the
expectation of investor who provide long-term funds
for investment.

 In other words it may be defined as “the

minimum rate of return that a firm must earn on its
investment for the market value of the firm to remain
unchanged”.
 Importance of cost of
capital
1.In Capital Budgeting decision the future benefits are
discounted at the cost of capital to ascertain its present
values.

2.Cost of capital is related to the firm’s objective of

wealth maximization. Wealth is maximized when an
investment gives return higher than the cost of capital.

3.Several other decisions like leasing; working capital

management etc. requires estimating the cost of
capital.
 Factors affecting the cost of
capital
1. Risk free interest rate:-
It is the interest expected from a risk free default free-
investment (example, Government Securities). This
consists of two components:
 
(a)Real interest Rate:-
Payable to the lender for supplying the funds.
 
(b)Purchasing power risk premium:-
It is the extra interest paid to maintain the purchasing
power of the money lend during the period of inflation.
 Factors affecting the cost of
capital ( cont.)
2. Business Risk:-
It is the risk associated with the firms promise to
pay interest to investors. Business risk is related to
the response of firms EBIT to changes in sales
revenue. If a firm accepts a proposal which is more
risky than the average present risk the investor will
probable raise the cost of capital to include a
business risk [That is operating leverage].
 Factors affecting the cost of
capital ( cont.)
3. Financial Risk:-
It is related to the response of EPS to change in
EBT [financial leverage]. The greater the amount of
borrowed funds in the capital structure the greater
the financial risk and the higher the financial risk
premium expected by share holders.
 Factors affecting the cost of
capital ( cont.)
3. Liquidity or marketability of the investment

The higher the liquidity relating to investment. The

lower would be the premium demanded by any
investor.

Cost of capital = Risk free interest + Business risk and

premium + Financial risk premium
Cost of different sources of Funds:
1. Cost of bonds and debts:
(a)Cost of irredeemable debt:
 
I(1-Tax)
Kd =
S.V.
 
 
Where, I = Interest rate; t= tax; S.V. = Net sale value.
1. A Company has 15% perpetual debt of Rs. 1,00,000. The tax rate is 35%
determine
the cost of debt (Kd) assuming a) debt is issued at par, b) issued at 10%
discount,
c) issued at 10% premium. Face value is Rs.100 each.
Solution:-
(a)Issued at par:
15(1-0.35)
Kd =
100
 

15x0.65

= =0.975 (or) 9.75%

100
 (b) Issued at 10% discount

15(1-0.35)
Kd =
90
 
15 x 0.65
= = .108 (or) 10.83%
90
  
(c) Issued at 10% premium
15 (1– .35)
Kd =
110
 
15 x 0.65
Kd = = .0886 (or) 8.86 %
110
2.Cost of redeemable debts & debentures:

I(1-t)+R.P.-S.P / Life in yrs.

Kd =
R.P. + S.P. / 2

R.P. = Redemption price

S.P. = Sale price or present price
 2. A Ltd. Issued 15% debentures of Rs.100 each at a discount of 2%,
issue expenses; were Rs.1 per debenture. The debentures are
redeemable at pat at the end of 10 years. Tax rate being 50% calculate
Kd.
 
Solution:
 
1 5(1-0.5)+100-97 / 10
Kd =
100+ 97 / 2
 
7.5+0.3
Kd = = 0.0792%
98.5
 
If the debts are redeemed in installments over a period then the cost
of debt is measured as the rate of discount which equates the P.V. of
the post tax interest + the principle amount repayment with the net
proceeds of the debt issued.
 3. A Ltd. Issued Rs.100, 15% debt at par repayable in 3
annual installments of Rs.30, Rs.30 and Rs.40 at the
end of the 7th, 8th, 9th years respectively. The issued cost
is 3% and the tax rate 60%
Calculate Kd.
Solution:-
Inflow = 100-3=Rs.97
Outflow :-
Interest 1-7 years = 100x15% = 15(1-0.6) = Rs.6 p.a
Repayment 7th year end =Rs.30
Interest 8th year = (70x15%) (1-0.6) =Rs. 4.2
8th year repayment =Rs. 30
Interest 9th year = (40x15%) (1-0.6) =Rs. 2.4
Repayment 9th year =Rs. 40
The cost of debt will be that discount rate which is used discount cash
inflows so that the P.V. of all the cash outflows is equal to P.V. of the
inflows (Rs. 97). Since the cost of debt is 15% and after considering the
cost benefit it is only 6% [i.e., 15(1-0.6)]. The interest rate will be
somewhere in the region of 6%. Therefore let us take 6% discount the cash
outflows.

(6xPVIFA 6%, 7 years)+(30xPVIF 6%, 7 years)+(34.2xPVIF 6%,8 years)+

(42.4xPVIF 6%, 9 years) =
(6x5.582)+(30x0.665)+(34.2x0.627(42.4x0.590)

= 33.49+19.95+21.44+25.10 = 99.98

NPV = (6%) = 99.98 – 97 = 2.8

 
Since the NPV is more, the interest rate is something more than 6%. Let
us
assume it is 7%
(6xPVIFA 7%, 7 years)+(30xPVIF 7%, 7 years)+(34.2xPVIF7%, 8 years)+ (42.4xPVIF
7%, 9 years) =
(6x5.389)+(30x0.623)+(34.2x0.582)+ (42.4x0.544) = 32.334+18.96+19.90+23.06
= 94.26 = 94.00
NPV (7%) = 94-97= -3 It is negative therefore interest rate is below 7%
6% = +2.98
7% = -3.00
1% = 5.98
? = 3
3x1
5.98 =0.50
 
Cost of debt = 7-0.50 = 6.5%
 
Cost of preference shares:
Cost of redeemable preference shares:-
D(1+t)+R.P.-S.P. / Life in years : note Dividend tax at the rate of 10%
(R.P. + S.P) / 2
 
4. A Ltd. Issues 12% preference shares of Rs.100 each
redeemable after 12years at par. The amount realized on
issue is Rs.95. Calculate cost of preference shares.
Solution:
= 12(1+.1)+100-95 / 12
(100+95)/2
 
= 13.20+0.4167
97.5
= 0.1396
= 13.96%
5. X Ltd issued 12% preference shares of Rs.100 each
at Rs.95, repayable in two equal installments at the end
of the 10th and 11th year respectively. Calculate the cost
of preference shares.
Solution:
Cash inflow = Rs.95
Cash outflow
From 1-10 years = Rs.12 = (10% Rs. 12) = Rs.12 +1.2 =
Rs. 13.20
End of 10th year = Rs. 50
End Installments
11th year interest = Rs. 50x12% = 6+(10% of Rs.6)
Interest = 6+0.6 = 6.60
End of 11th year = Rs. 50.00 =56.60
The cost of the preference shares will be that discount
rate which the present value of the various cash
outflows will be equal to the value of the inflow i.e.,
Rs.95.
Assume the cost of capital will be 12% so P.V. of cash
outflows will be
= (13.20xPVIFA 10 years, 12%) + (50xPVIF 10 years, 12%)
+ (56.60xPVIF 11 years, 12%)
= (13.20x5.650)+(50x0.322)+(56.60x0.287) =
74.58+16.10+16.24 =Rs. 106.92
NPV = 106.92-95 = 11.92
NPV = 106.92-95 =  
11.92
Since the P.V. at 12% is more than Rs.95. we take a
higher rate of 15%
= (13.20xPVIFA 10 years, 15%) + (50xPVIF 10 years,
15%) + (56.60xPVIF 11 years, 15%)
= (13.20x5.019)+(50x0.247)+(56.60x0.215) =
66.25+12.35+12.169 =Rs. 90.77
NPV = 90.77-95 = -4.23
Rate NPV
12% 11.92
15% -4.23
3% 16.15 4.23 x 3
=0.79
? 4.23 16.15
Cost of preference capital will be 15-0.79 =14.21%
Cost of equity capital
Since there is no definite commitment to pay
dividend it may appear that equity capital has no cost.
This is not true. The goal of wealth maximization is
achieved only if dividends are paid. Since Share prices
depend on the dividends expected and received by
share holders. The equity shares thus carry a cost an
implicit cost which is basically dividend expectation of
the share holders. In fact, equity cost is the highest
since they are exposed to the highest degree of
financial risk as they received dividends only after all
other financial commitments are met. The cost of
equity capital is defined as “the minimum rate of return
that a firm must earn on its equity financial portion of
an investment project in order to leave the market price
of the shares unchanged.
(i) How to calculate the dividend price approach
D(1+DT)
Ke=
P
This method is used when dividend is constant per
annum.
Where, D= Dividend
DT= Dividend Tax @10%
P= Current market price
(ii) Where constant dividend growth is expected
(when dividend is not constant)
That is D/P+G approach
D(1+DT)
Ke= +G
P
 
Where, D= Dividend which we will get for next year i.e.,
current dividend +increase due to growth.
D= Dividend
P= Current market price
G=Growth % in dividend
6. The market price of a company share is Rs.17. The
dividend expected a year hence is Rs.2. The growth
Ke
rate of dividend is 8% calculate the
Solution:-
D(1+DT)
Ke= +G
P
2(1+0.1)
Ke= + 0.08 =0.1294+0.08=0.2094
17

Cost of equity= 0.2094x100=20.94%

 7. The current market price of a share is Rs.150. The
current dividend is Rs.3 which is expected to grow at
the rate of p.a. CalculateKe.
Solution:-
D is current year so next year dividend
3+(8% of Rs.3) = 3+0.24=Rs.3.24
D(1+DT)
Ke= +G
P
3.24(1+0.1)
Ke= + 0.08 =0.02376+0.08=0.10376
150

Cost of equity= 10.38%

(iii)Earning price approach
EPS
Ke= x 100 where P= market price
P
 
(iv)Realized yield approach
Here the cost of equity capital is taken as the
actual rate of return realized by investor as a result of
holding shares over a period it is that rate which
equates the dividend received over the period of
holding the shares plus the sale value of the shares
with the actual price paid for the shares.
8. A purchased a share on 1st January 1996 for Rs.200.
During 1996,1997 and 1998s he received Rs.14, Rs.18
and Rs.25 as dividend and sold the shares on 31st
December 98 for Rs.290. Calculate the cost of equity.
Solution:-
The outflow is Rs.200
Calculation of cash inflow
At the end of 1996 = Rs.14
At the end of 1997 = Rs.18
At the end of 1998 = Rs.25+290 = Rs.315
Total cash inflow Rs. 347
Assume the rate of return is 20%
 = (14xPVIF 1 year, 20%) + (18xPVIF 2 years, 20%) +
(315xPVIF 3 years, 20%)
= (14x0.833)+(18x0.694)+(315x0.579)
= 11.662+12.492+182.385 =Rs. 206.539
NPV = 206.539-200 = 6.54
That is positive NPV
The rate shall be more than 20% so let as assume 21%
rate.
= (14xPVIF 1 year, 21%) + (18xPVIF 2 years, 21%) +
(315xPVIF 3 years, 21%)
=(14x0.826)+(18x0.683)+(315x0.564) =
11.564+12.294+177.66 =Rs. 201.518
NPV = 201.518-200 = 1.518
That is positive NPV
 Rate NPV
20% +6.54
21% +6.54 1% 5.02
? = 1.52
1.52x1
5.2 =0.303
Ke = 21+0.303 = 21.303%
The cost of equity = 21.3%
  
(v) Cost of equity based on bond yields
Bonds refer to securities issued by Govt.
Ke = By + Rp
Where, By = yield on a risk free long term bond
Rp = Risk premium for investment in equity.
 
 
(vi) Capital asset pricing model (CAPM)
It explains the behavior of security prices and provides a
mechanism whereby investors could assess the impact of
proposed security investment on their overall port folio risk
and return.
(Port folio diversifying the investment)
Assumptions:-
1.All investors have homogeneous expectations
regarding expected returns and are well informed
about securities.
2. There are no transaction costs by buying or selling
investments.
3. No Single investor can affect market prices
significantly.
4. All investor prefer that investment which provides
the highest return for a given level of risk or the lowest
risk for a given level of return.
The risk to which an investment is exposed falls into two categories:-
1. Systematic or no diversifiable risk
2. Unsystematic or diversifiable risk
 
Systematic risk is attributable to factors that affect all firms.
Example, Interest rate changes, inflation, political changes etc. This
risk cannot be eliminated.

Unsystematic risks are risks which affect different firms in different

ways examples management capabilities, strikes, competition,
availability of raw material, Government policies affecting individual
firms etc. These risks can be eliminated through diversification.

It is the non-diversifiable risk that the investor should consult with

according to CAPM.

In non-diversifiable risk of a security is expressed in terms of Beta

co-efficient. Beta is a measure of degree of responsiveness of the
securities return with the market return.
The CAPM divides the cost of equity into two parts .
1.The risk free rate of return available from investments in Govt. securities
2. And additional risk premium for investing in a particular share such risk
premium is equal to the different between the expected market return and
the risk free rate of return multiplied by the beta factor.
1. Risk free Rate = Rf
+
2. Risk premium Rate (Rm
-
R
)
fB
That is
Ke = Rf
+
B(
R-
R
)
m
f

Where Rf
=Th
e
r
e
t
ur
n
ex
p
e
ct
f
o
rr
i
s
kf
r
ee
s
e
cu
r
i
t
y
.
Rm
=
A
ve
r
a
g
er
a
te
o
f
re
t
u
r
ne
x
pe
c
t
e
da
n
al
l
i
nv
es
t
m
en
t
s
.
B = Beta co-efficient
10. The risk free rate of return is 8% the return on market
port folio is 12% calculate the cost of 3 equity stocks
whose beta values save (a) 0.8, (b) 1.2, and (c) 1.7
Solution:-
Value of (a) = Rf+B (Rm-Rf)
= 8+0.8(12-8)
= 8+3.2
= 11.2%
(b) = 8+1.2(12-8)
= 8+4.8
= 12.8%
(c) = 8+1.7(12-8)
= 8+6.8
= 14.8%
10. The beta value of X Ltd. Share Rs. 1.4. The Company has been
maintaining an 8% growth rate in dividend. The last dividend paid
was Rs. 4 per share. The rate on Govt. securities is 10% white the
return on market port folio is 15%. The current market price of the
share is Rs.36 calculate the Ke. Would you recommend purchasing
the share of X Ltd.
Solution:-
Ke = Rf+B (
R m-Rf)
= 10+1.4(15-10) =10+7=17%
Ke =17%

D(1.1)
Ke= +G
MP
 D(1.1)
Ke-G=
MP
 
D(1.1)
MP=
Ke-G
 
 
4 (1.0.8) (1.1) 4.752
MP= =
0.17 - 0.08 0.09

= 52.89
 
 
Market price = Rs.52.89 .The market price of the share shall be Rs.
52.80 since it is available for Rs.36. The share should be purchased .
CPAM (Cont.)
Cost of term loans from financial institutions will be Ke= I(1-t)
Cost of retained earnings:
Retained earnings are undistributed profits belonging to share holders.
By not distributing such profits as dividends the company is depriving the
share holders of a return which they would have got at the invested profits
they would have got at the invested profits that were distributed. For the
company which retains profits these finds must be utilized and retained
earned on such funds that the share holders would have earned if such
profits were distributed. Therefore, cost of retained earnings (Kr) may be
defined as,
“the opportunity cost of dividend withheld from shareholders. However
in practice cost of retained earnings is assumed to be the same as cost of
equity.”
 
Weighted average cost of capital
Firms used different sources of funds. Hence the overall cost of capital
is an importance by taking decisions regarding investment proposals. In
calculating such costs it is the weighted average COC that is used as the
proportion of various sources of funds in the capital structure are different
weightage can be given bases on book value of these funds or market
value. Whit the both values are obtain convenient it is the market value that
is theoretically sound and therefore better indicator of the overall cost of
capital.
11. The company’s capital structure consists of the following:-

Source After tax cost B value Rs. Market value

Debt 8% 3,00,000 3,00,000
Prof.capital 14% 1,00,000 1,90,000
Retained earnings 17% 2,00,000 -
Equity capital 17% 3,00,000 6,40,000

Calculate weighted average COC using:-

(a)Book value as weights
(b)Market value as weights.
Solution:-
(a) Book value as weights
Source B value After tax cost Cost
Debt 3,00,000 8% 24,000 Pref.
capital 1,00,000 14% 14,000
Retained earnings 2,00,000 17% 34,000
Equity capital 3,00,000 17% 51,000
  9,00,000 1,23,
000
Weighted average cost of capital (WAC) =
Cost 1,23,000
x100 = x100 = 13.67%
Funds 9,00,000
Solution:-
(b) Market value as weights

Source Market value After tax cost

Cost
Debt 3,00,000 8% 24,000 Pref.
capital 1,90,000 14% 26,600
Retained earnings - - -
Equity capital 6,40,000 17% 1,08,800
  11,30,000 1,59,400
Weighted average cost of capital (WAC) =
Cost 1,59,400
x100 = x100 = 14.11%
Funds 11,30,000
12. S Ltd. Has the following book value of capital structure.
Rs.
Equity capital (Rs.10 each) 100 lakhs
11% pref. share capital (Rs.100 each) 10 ”
Retained earnings 120 ”
13.5% Debentures (Rs.100 each) 50 ”
12% Term loans 80 ”
360 ”
 

1.The next expected dividend per share is 1.5%.The dividend per share is
expected to grow @ 7%.The market price per share is Rs.20 .
2.Preference shares are redeemed at par after 10 years currently selling at Rs.75
3.Debentures are redeemable at par after 6 years is currently selling at Rs.80.
4.The tax rate is 50%

Calculate weighted average COC using book value and market value as weights.
Solution:
Cost of equity
D(1+t) 1.5(1.1)
Ke= +G= +0.07
MP 20
 
1.65
= + 0.07 = 0.0825+0.07 = 0.1525 = 15.25%
20
 
This 15.25% includes cost of retained earnings.
 
(b) Cost of retained earnings = Kr=15.25%. It is same as Ke.
 
(c) Cost of pref. capital Kp.
= D(1+t)+R.P.-S.P. / Life in years
R.P. + S.P. / 2
= 11(1.1)+100-75 / 10
100+75 / 2
=12.1 + 2.5/87.5 = 14.6/87.5 = 0.1669x100 = 16.69%
Kp = 16.69%

(d)Cost of . DEBENTURE Kd. =

= I (1-t)+R.P.-S.P. / Life in years
R.P. + S.P. / 2
= 13.5(1-0.5)+100-80 / 6
100+80/ 2
= 6.75 + 3.33/90 = 10.08/90 = 11.20
Kd = 11.20x100 = 11.2%..
(e) Cost of term loan Kt =
I(1-t) = 12(1-0.5)= 6%
 Calculation of weighted average COC
(a)Using Book value as weights.
Source After tax cost B value Rs. Cost
Euquity capital 15.25% 100 15.25
Pref.capital 16.69% 10 1.67
Retained earnings 15.25% 120 18.30
Debentures 11.20% 50 5.60
Term loan 6% 80 4.80
360 45.62
Cost 45.62
WA.COC= x100 = x100 =
12.67%
Fund 360
(b)Using Market value as weights
Source After tax cost Market value Rs. Cost
Equity 15.25% 200 30.50
Pref.capital 16.69% 7.5 1.25
Debentures 11.20% 40 4.48
Term loan 6% 80 4.80
327.50 41.03
41.03
WA.COC= x100 = 12.53%
327.50
 

13. R Ltd. Has the following capital structure.

Rs.
Equity capital (Rs.20 each) 40 lakhs
6% pref. share capital (Rs.100 each) 10 ”
8% Debentures 30 ”
Market price of equity is Rs. 20
The current dividend is Rs.2 per share which is expected to grow at 7% per
annum. The tax rate is 50%
Calculate:-
(i) Weighted average COC based on book value
(ii)The new weighted average COC if the company an additional
Rs.20 lakhs, as 10% Debentures to finance for expansion. This
would resulted in increasing expected dividend per share to Rs.3
and increase growth rate of dividend to 10%. But the market
price
of equity share will fall to Rs.15.
Solution:-
(a) Cost of equity capital
 
D (1+DT) 2.14(1+0.1) 2.354
Ke= +G= +0.07 =
MP 20 20
= 0.1877 = 18.77%
 
(b) Cost of pref. shares Kp
 
D (1+DT) 6(1.1)
Kp= = x100 = 6.6%
MP 100

(c) Cost of Debentures Kd =I(1-t)

=8(1-0.5) = 8x0.5 = 4%
 
Calculation of weighted average COC
(1) Using book value as weights
Source After tax cost B value Rs Cost
Enquiry capital 18.77% 40 7.51
Pref.capital 6.6% 10 0.66
Debentures 4% 30 1.20
80 9.37
9.37
WA.COC = x100 = 11.71%
80
2.(a) Cost of equity capital
D (1+DT) 3(1.1)
Ke= +G= +0.1 = 0.22+0.1=0.32x100=32%
MP 15
 
(b) Cost of Debentures Kd =I(1-t)
=10(1-0.5) = 10x0.5 =5%
 
 
Calculation of new W.A.COC
Source After tax costB value Rs. Cost Enquiry capital
32% 40 12.80
Preference capital 6.6% 10 0.60
Debentures 4% 30 1.20
Debentures 5% 20 1.00
100 15.66

15.66
WA.COC = x100 = 15.66%
100
 
14. A Ltd. Wishes raise an additional finance of Rs.10
lakhs to meeting its investment plans. It has Rs.2,10,
000 in the form of retained earnings available for
investment.
The following are the further details:-
(a)Debt Equity Ratio = 3:7
(b)Cost of debt (Kd)
(i) Upto Rs.1,80,000 = 10%
(ii) Over Rs.1,80,000 = 16%
(c)EPs =Rs.4
(d) Dividend payout Ratio = 50%
(e)Expected growth rate of dividend = 10%
(f)Current market price per share= Rs.44
(g)Tax rate = 35%
 (1)You are required to determine the pattern for
raising
additional finance assuming the company intends
to
maintain its existing debt equity ratio.
(2) Determine the cost of additional debt.
(3) Determine the cost of equity capital and retained
earnings.
(4) Compute the W.A Cost for additional finance
using
book value as weights.
Solution:-
Debt 3
Debt – Equity Ratio = = =
Equity 7
 
10 x3/10 = Rs.3 lacs debt + 7 lacs as equity
Debt = Rs.3,00,000
Equity (Rs.7,00,000) 10,00,000

Retained Earnings Equity shares

2,10,000 4,90,000
 
Total requirement = Rs.10,00,000
Debt = Rs. 3,00,000
Retained earnings =Rs. 2,10,000
Equity capital
(7,00,000-2,10,000) Rs. 4,90,000
10,00,000
(1)Pattern of finance
10% debt = Rs.1,80,000
16% debt = Rs.1,20,000 3,00,000
Retained earnings Rs.2,10,000
Equity capital Rs.4,90,000 7,00,000
10,00,000
2. Cost of additional debet
I (1-t)
Kd=
Issued price (S.V.)
 
= (18,000 + 19,200) (1-35)
3,00,000
 
= 37,200x0.65
3,00,000

= 0.0806x100 =8.06%
(or)

1,80,000 1,20,000
10 (1-t) x + 16 (1-t) x
3,00,000 3,00,000
 

3.9+4.16 = 8.06%
(3) Cost of equity & Retained earnings.

DPS
Dividend payout Ratio = 50% =
EPS

x
EPS = Rs.4 = 50% =
4
x = 4 x 50% = Rs.2 (Dividend)
D (1+DT)
Ke = +G
MP
2.2 (1.1)
Ke = +0.1 = 0.055 + 0.1 = 0.155
44
Ke = 0.155 x 100 = 15.5%
Calculation of Weighted
Average Cost of Capital

 Source After tax cost Book value Cost
 Equity 15,5% 4,90,000 75,950
 Retained
 Earnings 15.5% 2,10,000 32,550
 Debt 8,06% 3,00,000 24,180
 Total 10,00,000 1,32,680

 WACOC =1.32,680 / 10,00,000 =13.27%