CostofCapit

al
SEM VI
(Teacher:
-S.Bhatt
achar
yya)
A.CostofDebent
ures:
Thecapit
alst
ructureofaf ir
m nor mallyi
ncludest hedebtcapit
al.Debtmaybei nthe
for
m ofdebenturesbonds,t ermloansf r
om f i
nanciali
nsti
tuti
onsandbankset c.The
amountofinterestpay abl
ef orissuingdebent ureisconsideredto bethecostof
debent
ureordebtcapi t
al(Kd).Costofdebtcapi talismuchcheapert hanthecostof
capi
tal
rai
sedfrom othersources,becauseinter
estpaidondebtcapitali
staxdeduct
ibl
e.

ThecostofI
rr
edeemabl
edebent
ure:

Irr
edeemabl edebti sthatdebtwhichisnotrequir
edtober epai
dduringthelif
etimeof
thecompany .Suchdebtcar ri
esacouponr at
eofi nt
erest
.Thiscouponrateofi nt
erest
representsthe bef oretaxcostofdebt .Af tertaxcostofper petualdebtcan be
calculat
edbyadj ust
ingthecorporat
etaxwi t
ht hebefor
etaxcostofcapital.Thedebt
maybei ssuedatpar ,atdiscountoratpr
emi um.Thecostofdebti stheyiel
dondebt
adjustedbytaxr ate.

Costofi
rr
edeemabl
edebt(
Kd)=I
/NP(
1–t
)

Where,
I=Annuali
nter
estpay
ment
NP=Netproceedsf
rom i
ssueofdebent
ureorbond
t=Taxrat
e

Exampl
e:
Acompanyi ssued12%debentur
esatparforRs2,
00,
000.Comput
etheaf
ter
-t
axcost
ofdebent
uresassumingthetaxrat
eat30%.
Exampl
e:
(a)AcompanyissuesRs.1,00,000,15%DebenturesofRs.100each.Thecompanyisin
40%taxbracket
.Youar erequiredtocomput ethecostofdebtaft
ertax,i
fdebent
ures
arei
ssuedat(i
)Par,(
ii
)10%di scount,and(
ii
i)10%premium.
(
b)I
fbr
oker
agei
spai
dat5%,
whatwi
l
lbet
hecostofdebent
uresi
fissuei
satpar
?

Ans:

Calcul
ati
onofNetIssuePrice:
NP=Costoft heDebentur
e–[ (Di
scountonI
ssue,
IfAny
)or(+Pr
emi
um ofI
ssue)
]–
(Fl
otat
ionCost)

ThecostofRedeemabl edebenture:
Redeemabl edebti sthatdebtwhi chRequiredt ober epai
dduringthel if
eti
meoft he
company .Suchdebtcar ri
esacouponr ateofi nt
erest.Thiscouponr ateofi nt
erest
representsthe beforet axcostofdebt .Af tertaxcostofper petualdebtcan be
calculat
edbyadj usti
ngt hecorporatetaxwit hthebeforetaxcostofcapi tal
.Thedebt
maybei ssuedatpar ,atdiscountoratpr emium.ThedebtmayAl sobeRedeemedat
par,atdiscountoratpremium.Thecostofdebti stheyieldondebtadjustedbytaxrate.

Exampl e:
ZED Ltd.hasi ssued12% Debenturesoff acev al
ueofRs.100f orRs.60lakh.The
fl
oati
ngchar geoftheissueis5%onf acevalue.Theinter
esti
spay
abl
eannual
l
yandt he
debenturesareredeemableatapremium of10%af ter10year
s.
Whatwi llbethecostofdebent
uresi
ft het
axi s50%?
Kd=CostofDebenture(
Aft
ert
ax)
I=Int
erestpnDebentur
e
R=Redembl ePri
ce
P=NetI ssuePr
ice
N=NumberofYear s
Ans:
.

B.CostofPr
efer
enceShar
eCapi
tal
:
Forpreferenceshar es,t
hedivi
dendrat
ecanbeconsi der
edasi t
scost,si
ncei ti
sthi
s
amountwhi ch t he company want
st o pay againstthe pr
efer
ence shares.Li
ke
debentures,theissueexpensesort
hediscount
/premium oni
ssue/r
edemptionareal
so
tobetakeni ntoaccount.

CostofIrr
edeemablepr
eferenceshares(KP)=DP /NP
Where,DP 
=Prefer
encedi
videndpershare
NP=Netpr oceedsfr
om t
hei ssueofpref
erenceshar
es.

Exampl
e:
Acompanyissues10%Preferencesharesofthef aceval
ueofRs.100each.Fl
oatat
ion
cost
sareest
imatedat5%oftheexpectedsalepr i
ce.
Whatwil
lbethecostofpr
eferencesharecapital(
KP),i
fpref
erenceshar
esar
eissued(i
)
atpar
,(i
i
)at10%premium and(ii
i)at5%discount?Ignor
edivi
dendtax.

Ans:
CostofRedeemabl
epr
efer
enceshar
es(
KP)

Exampl
e:
Acompanyissues12%r edeemabl
eprefer
encesharesofRs.100eachat5%pr emium
r
edeemableaft
er15yearsat10%premium.Ift
hefloatat
ioncostofeachshar
eisRs.2,
whati
stheval
ueofKP (
Costofpref
erenceshar
e)tothecompany ?

Ans:

C.CostofEqui
tyShar
eCapi
tal
:
Thef undsrequir
edf oraproj
ectmayber ai
sedbyt hei ssueofequityshar
eswhi chare
ofper manentnat ur
e.Thesef undsneednotber epay abl
eduringt hel
if
eti
meoft he
organisat
ion.Calcul
ati
onoft hecostofequitysharesi scomplicatedbecause,unl
ike
debtandpr efer
enceshares,t
hereisnofi
xedrateofinterestordi
videndpayment.

Costofequi
tyshar
eiscalcul
atedbyconsi
der
ingtheear
ningsofthecompany,market
val
ueoftheshar
es,di
vi
dendpershareandt
hegrowthrat
eofdivi
dendorear
nings.

(
i)Di
vi
dend/
Pri
ceRat
ioMet
hod:

Wher
e,
D=Divi
dendpershar e
P=Currentmarketpri
cepershar
e.
g=ExpectedConstantGr
owthrate
Eaxmpl
e:
XYCompany ’
sshareiscurrent
lyquotedi nmarketatRs.60.I tpaysadivi
dendofRs.3
pershareandinvest
orsexpectagrowt hrateof10%pery ear.
Calculat
e:
(i
)Thecompany ’scostofequit
ycapit
al .
(i
i)Theindi
catedmarketpri
cepershar e,i
fanti
cipat
edgrowt hrateis12%.
(i
ii
)Themar ketpri
ce,i
fthecompany ’
scostofequi t
ycapit
ali s12%,anti
cipat
edgr
owth
rateis10%p.a.,
anddivi
dendofRs.3pershar ei
st obemai ntained.

Ans:

Exampl
e:
Acompany’
sshareiscurrent
lyquotedint hemarketatRs.20.Thecompanypay
sa
di
vi
dendofRs.2pershar
eandt hei
nv est
orsexpectagr
owthrat
eof5%peryear
.

Calcul
ate
(a)Costofequi
tycapi
tal
ofthecompany,
(b)Themarketpri
cepershar
e,i
ftheant
ici
pat
edgr
owt
hrat
eofdi
vi
dendi
s7%.

Ans:

(
a)Costofequi
tyshar
ecapit
al(
Ke)=D/
P+g
=Rs.2/Rs.20+5%
=15%

(
b)Costofequit
yshar
ecapi
tal
(Ke)
 =D/
P+g
0.15=Rs.2/P+0.07
P=2/0.
08
P=Rs.25.
(
ii
)Ear
nings/
Pri
ceRat
ioMet
hod:

Exampl
e:
Thesharecapi
talofacompanyisrepresent
edby10,000Equit
ySharesofRs.10each,
ful
lypai
d.Thecur r
entmar
ketpriceoft heshareisRs.40.Earni
ngsavai
labl
etothe
equit
yshar
ehol
dersamounttoRs.60,000attheendofaperi
od.

Ans:

Exampl
e:
AcompanyI ssued10,
000Equi
tySharesofRs.10each.
Thecostoffloat
ati
oni
sexpect
edt obe5%.It
scurrentmar
ketpr
icepershar
eisRs.40.
I
ftheearni
ngspersharei
sRs.7.25.

Ans:

Wher
ef=Fl
otat
ioncost
Capi
  talAssetPr
ici
ngModel(
CAPM)
:

Ke 
= Rf + 
β × 
(Rm –Rf)

Where:
Rf=Risk-
f r
eeRateofRet
urn
β=equitybeta(l
ever
ed)
Rm =Mar ketRet
urn

D.CostofRet
ainedEar
nings:
Thepr of
it
sretai
nedbyacompanyf orusi
ngint heexpansionofthebusi
nessal
soentail
cost.WhenEar ni
ngsAreRet ai
nedInTheBusi ness,Sharehol
dersareforcedt
oforego
di
vidends.Thedivi
dendsforgonebyt heequit
yshareholdersar
e,infact
,anoppor
tunit
y
cost.Thusret
ainedear
ningsinvol
veopportuni
tycost.

Retai
nedear ningsareoneoft heimpor t
anti
nternalsourcesoff i
nance.Pr ofi
tav ai
labl
e
toequitycanbedi str
ibutedasdi vidend.Butapr oporti
onoft hatisdi stri
butedand
Remaining i
s keptf orRei nv
estment.Therefore Ret ai
ned earnings i
st he divi
dend
for
egonebyt heequi
tyshar eholder
s.Sinceequit
yshar eholder
sar etheactualclaimants
oftheretai
nedear ni
ngs,thecostofr etai
nedearnings,i
sequi v
alenttocostofequi ty.

Costofr
etai
nedear
nings(
Kr)wi
l
lbecal
cul
ated Kr=Ke  

E.Ov
eral
lorWei
ght
edAv
erageCostofCapi
tal
:

Af i
r m maypr ocur
el ong-ter
mf undsf r
om v arioussour cesl i
keequi tysharecapital,
preferenceshar ecapi tal
,debentures,terml oans,retainedear ningset c.atdiffer
ent
costsdependi ngont her i
skperceivedbyt heinv estor
s.
Whenal lthesecost
sofdi f
fer
entf ormsofl ong- t
ermf undsar ewei ght
edbyt hei
rrelati
ve
propor ti
onstogetover all
costofcapi t
alitistermedaswei ghtedav er
agecostofcapi t
al.
Itisal soknownascomposi tecostofcapi tal.Whilet aki
ngf inancialdeci
sions,the
weight edorcomposi tecostofcapi tal
isconsi dered.
Cal
cul
ati
onofWei
ght
edAv
erageCostofCapi
tal
:
 Thespeci
fi
ccostofeachsour
ceoffunds(i.
e.,costofequi
ty,
pref
erenceshar
es,
debt
s,r
etai
nedear
ningset
c.)i
stobecalcul
ated.

 Weight
s(i.
e.,
propor
ti
onofeach,
sour ceoff
undinthecapi
talst
ruct
ure)aretobe
computedandassignedtoeacht ypeoffunds.Thisimpli
esmul t
ipl
icat
ionof
eachsour
ceofcapit
albyappr
opri
ateweight
s.

 (i
ii
)Addallt
hewei
ght
edcomponentcost
stoobt
aint
hef
ir
m’swei
ght
edav
erage
costofcapi
t .
al

Thewei
ght
sar
eassi
gned:
 Bookv al
uesofvarioussourcesoffunds
 Marketvaluesofvarioussourcesofcapi
tal
 Marginalbookval
uesofv ari
oussourcesofcapi
tal
.

Wei
ght
edav
eragecostofcapi
tal
(Ko)=K1W1 
+K2W2 
+…………KnWn

Wher
eK1,
K2=Componentcost
s
W2 
W1, =Wei
ght
s.

Exampl
e:
ALtdhasthefol
lowi
ngcapi
tal
str
uct
ureand,
aft
ert
axcost
sofCapi
talf
ort
hedi
ff
erent
sour
cesoffund.
Ans:

Exampl
e:

Theopt
imum debt
-equi
tymi
xfort
hecompanybycal
cul
ati
ngcomposi
tecostofcapi
tal
. 
Ans:

 Opti
maldebt -
equi
tymixf
ort
hecompanyi
satt
hepoi
ntwher
ethecomposi
te
costofcapi
tali
sMini
mum.

 Ther
efor
e,Thecompositecostofcapi
tal
isminimum (10.
75%)att
hedebt
-equi
ty
mixof3:7(i
.e.
,30%debtand70%equity)
.Theref
ore,
30%ofdebtand70%equity
mixwouldbeanopti
maldebt-equi
tymi
xforthecompany .