Top 4 Sources of Finance (With Formula and Calculations)

7/16/2021 Top 4 Sources of Finance (With Formula and Calculations)
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Top 4 Sources of
Finance (With
Formula and
Calculations)
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This article throws light upon the

top four sources of finance. The
sources are: 1. Cost of Debt 2.
Cost of Preference Capital 3. Cost
of Equity Share Capital 4. Cost of
Retained Earnings.
Finance: Source # 1. Cost of Debt:

i. Cost Perpetual/Irredeemable
Debt:
The cost of debt is the rate of interest

‘Women’s oppression is integrally linked to
capitalism’: Mythily Sivaraman
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For example, a company issues

Rs. 1,00,000 10% debentures at
par; the before-tax cost of this
debt issue will also be 10% By way
of a formula, before-tax cost of
debt may be calculated as:
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(i) Kdb = I/P
where, K db = Before tax cost of debt
I = Interest
and P = Principal
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In case the debt is raised at premium

or discount, we should consider P as
the amount of net proceeds received
from the issue and not the face value of
securities.
The formula may be changed to:
(ii) Kdb = I/NP (where, NP= Net

Proceeds)
Further, when debt is used as a source

of finance, the firm saves a
considerable amount in payment of tax
as interest is allowed as a deductible
expense in computation of tax. Hence,
the effective cost of debt is reduced.
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The After-tax cost of debt may be

calculated with the help of
following formula:
(iii) Kda = Kdb (1-t) = I/NP (1-t)
where, K da = After-tax cost of debt
t = Rate of tax.
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Illustration 1:
(a) X Ltd. issues Rs. 50,000 8%
debentures at par. The tax rate
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applicable to the company is 50%.

Compute the cost of debt capital.
(b) Y Ltd. issues Rs. 50,000 8%

debentures at a premium of 10%. The
tax rate applicable to the company is
60%. Compute cost of debt capital.
(c) A Ltd. issues Rs. 50,000 8%

debentures at a discount of 5%. The tax
rate is 50%, Compute the cost of debt
capital.
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(d) B Ltd. issues Rs. 1,00,000 9%

debentures at a premium of 10%. The
costs of floatation are 2%. The tax rate
applicable is 60%. Compute cost of
debt-capital.
Solution:

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ii. Cost of Redeemable Debt:
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Usually, the debt is issued to be

redeemed after a certain period during
the life time of a firm. Such a debt is
known as redeemable debt. The cost of
redeemable debt capital may be
computed by using yield to maturity,
also called internal rate of return or
trial and error method. The
approximate cost of redeemable debt
can also be computed by using the
simple shortcut method.
(a) Yield to Maturity or Trial and

Error Method: ‘Women’s oppression is integrally linked to
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(i) Before tax cost of redeemable

debt:
where, V0 = Current value or the issue

price of debt/debenture
Vn = Redeemable value of debt
I, I2 …In = Amount of annual interest

in period 1, 2 ………………… , and so on
n = Number of years to redemption
kd = Yield to maturity or internal rate

of return or cost of debt/debenture
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The value of kd (yield to maturity) can

be found by trial and error method
using present value tables.
(ii) After tax cost of redeemable

debt:
kda = kdb (1-t)
Where, kdb = After tax cost of debt
kdb = Before tax cost of debt
t = Tax Rate
Illustration 2:
A five year Rs. 100 debenture of a firm

can be sold for a net price of Rs. 95.90.
The coupon rate of interest is 14 per
cent per annum, and the debenture
will be redeemed at 5 per cent
premium on maturity. The firm’s tax
rate is 35 per cent. Compute the yield Mythily Sivaraman
capitalism’:
to maturity and the after tax cost of
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debenture. Privacy - Terms
The present value factors at 15%

and 17% per p.a. are as given
below:
Solution:
(b) Shortcut Method to Compute

Cost of Redeemable Debt:
In order to avoid the complex

calculations of hit and trial
method, we can compute the
approximate cost of redeemable
debt by using the following
simple formula:
(i) Before-tax cost of redeemable debt,
where, I = Annual Interest

n = Number of years in which Frontline
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to be redeemed Read Next Story
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RV = Redeemable value of debt
NP = Net proceeds of debentures
(ii) After-tax cost of redeemable debt
Where, I = Annual interest
t = Tax rate
n = Number of years in which debt is

to be redeemed
RV = Redeemable value of debt
NP = Net proceeds of debentures
Illustration 3:
A company issues Rs. 10,00,000 10%

redeemable debentures at a discount of
5%. The costs of floatation amount to
Rs. 30,000. The debentures are
redeemable after 5 years. Calculate
before-tax and after-tax cost of debt
assuming a tax rate of 50%.
Solution:

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Illustration 4:
A 5-year Rs. 100 debenture of a firm

can be sold for a net price of Rs. 96.50.
The coupon rate of interest is 14 per
cent per annum, and the debenture
will be redeemed at 5 per cent
premium on maturity. The firm’s tax
rate is 40 per cent. Compute the after-
tax cost of debenture.
Solution:
Illustration 5:
Assuming that a firm pays tax at

50% rate, compute the after tax
cost of debt capital in the ‘Women’s oppression is integrally linked to
following cases: Frontline | Sponsored
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(i) A perpetual bond sold at par,

coupon rate of interest being 7%;
(ii) A 10 year, 8% Rs. 1.000 per bond

sold at Rs. 950 less 4% underwriting
commission.
Solution:
iii. Cost of Debt Redeemable in

Installments:
Financial institutions generally require

principal to be amortised in
installments. A company may also
issue a bond or debenture to be
redeemed periodically. In such a case,
principal amount is repaid each period
instead of a lump sum at maturity and
hence cash outflows each period
include interest and principal. The
amount of interest goes on decreasing
each period as it is calculated on the
outstanding amount of debt.
The before-tax cost of such a debt

can be calculated as below:
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Illustration 6:
A company is proposing to issue a 5-

year debenture of Rs. 1000 at 14 per
cent rate of interest per annum. The
debenture amount will be amortised
equally over its life. If the present value
of the debenture for an investor is Rs.
1046.59, calculate the minimum
required rate of return or the cost of
debt.
Solution:
iv. Cost of Existing Debt:
If a firm wants to compute the current

cost of its existing debt, the current
market yield of the debt should be
taken into consideration.
Suppose a firm has 10% capitalism’: Mythily Sivaraman
debentures of Rs. 100 each
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outstanding on January 1, 2006
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to be redeemed on December 31,

2012 and the new debentures
could be issued at a net realisable
price of Rs. 90 in the beginning of
2008, the current cost of existing
debt may be computed as:
v. Cost of Zero Coupon Bonds:
Sometimes companies issue bonds or

debentures at a discount from their
eventual maturity value and having
zero interest rate. No interest is
payable on such debentures before
their redemption and at the time of
redemption the maturity value of the
bond is to be paid to the investors.
The cost of such debt can be

calculated by finding the present
values of cash flows as below:
(i) Prepare the cash flow table using an

arbitrary assumed discount rate to
discount the cash flows to the present
value.
(ii) Find out the net present value by oppression is integrally linked to
‘Women’s
deducting the present value ofcapitalism’:
the Mythily Sivaraman
outflows from the present value of the Read Next Story
inflows. Privacy - Terms
(iii) If the net present value is positive,

apply higher rate of discount.
(iv) If the higher discount rate still

gives a positive net present value,
increase the discount rate further until
the NPV becomes negative.
(v) If the NPV is negative at this higher

rate, the cost of debt must be between
these two rates.
The following illustration explains the

procedure of determining the cost of
zero coupon bonds.
Illustration 7:
X Ltd. has issued redeemable zero

coupon bonds of Rs. 100 each at a
discount rate of Rs. 60 repayable at the
end of fourth year. Calculate the cost of
debt.
Solution:

vi. Floating or Variable Rate
Debt: Frontline | Sponsored
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The interest on floating rate debt

changes depending upon the market
rate of interest payable on gilt edged
securities or the prime lending rate of
the bank. For example, suppose a
company raises debt from external
sources on the terms of prime lending
rate of the bank plus four per cent.
If the prime lending rate of the bank is

8% p.a., the company will have to pay
interest at the rate of 12% p.a. Further,
if the prime lending rate falls to 6%
p.a., the company shall pay interest at
only 10% p.a.
Illustration 8:
ABC Ltd. raised a debt of? 50 lakhs on

the terms that interest shall be payable
at prime lending rate of bank plus
three percent. The prime lending rate
of the bank is 7 per cent. Calculate the
cost of debt assuming that the
corporate rate of tax is 35%.
Solution:
vii. Real or Inflation Adjusted

Cost of Debt: ‘Women’s oppression is integrally linked to
In the days of inflation, the real cost of Read Next Story
debt is much less than the nominal Privacy - Terms
cost as the fixed amount is payable

irrespective of the fall in the value of
money because of price level changes.
The real cost of debt can be calculated
as below:
Real Cost of Debt = 1 + Nominal Cost

of Debt/1 + Inflation Rate
Illustration 9:
Excel Ltd. has issued 5000 10%

Debentures of Rs. 100 each. The rate of
inflation is 6%. Calculate the real cost
of debt.
Solution:
Finance: Source # 2. Cost of

Preference Capital:
A fixed rate of divided is payable on
preference shares. Though dividend is
payable at the discretion of the Board
of directors and there is no legal
binding to pay dividend, yet it does not
mean that preference capital is cost
free. The cost of preference capital is a
function of dividend expected by its
investors, i.e., its stated dividend.
In case dividends are not paidFrontline
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preference shareholders, it will affect
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the fund raising capacity of the firm.

Hence, dividends are usually paid
regularly on preference shares except
when there are no profits to pay
dividends.
The cost of preference capital

which is perpetual can be
calculated as:
KP = D/P
where KP = Cost of Preference Capital
D = Annual Preference Dividend
P = Preference Share Capital

(Proceeds.)
Further, if preference shares are issued

at Premium or Discount or when costs
of floatation are incurred to issue
preference shares, the nominal or par
value of preference share capital has to
be adjusted to find out the net
proceeds from the issue of preference
shares.
In such a case, the cost of

preference capital can be
computed with the following
formula:
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It may be noted that as dividends are

not allowed to be deducted in
computation of tax, no adjustment is
required for taxes.
Sometimes Redeemable Preference

Shares are issued which can be
redeemed or cancelled on maturity
date.
The cost of redeemable

preference share capital can be
calculated as:
where, Kpr = Cost of Redeemable

Preference Shares
D = Annual Preference Dividend
MV = Maturity Value of Preference

Shares
NP = Net Proceeds of Preference

Shares.
Illustration 10:
A company issues 10,000 10%

Preference Shares of Rs. 100 each. Cost
of issue is Rs. 2 per share. Calculate
cost of preference capital if these
shares are issued (a) at par, (b) at a Read Next Story
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premium of 10%, and (c) at a discount

of 5%.
Solution:
Illustration 11:
A company issues 10,000 10%

Preference Shares of Rs. 100 each
redeemable after 10 years at a
premium of 5%. The cost of issue is Rs.
2 per share. Calculate the cost of
preference capital.
Solution:
Illustration 12:
A company issues 1,000 7% Preference

Shares of Rs. 100 each at a premium of
10% redeemable after 5 years at par.
Compute the cost of preference capital. Mythily Sivaraman
capitalism’:
Solution: Read Next Story
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Equity Share Capital:
The cost of equity is the ‘maximum

rate of return that the company must
earn on equity financed portion of its
investments in order to leave
unchanged the market price of its
stock.’ The cost of equity capital is a
function of the expected return by its
investors.
The cost of equity is not the out-of-

pocket cost of using equity capital as
the equity shareholders are not paid
dividend at a fixed rate every year.
Moreover, payment of dividend is not a
legal binding. It may or may not be
paid.
But it does not mean that equity share

capital is a cost free capital.
Shareholders invest money in equity
shares on the expectation of getting
dividend and the company must earn
this minimum rate so that the market
price of the shares remains unchanged.
Whenever a company wants to‘Women’s
raise oppression is integrally linked to
additional funds by the issue of new| Sponsored
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equity shares, the expectations of the Read Next Story
shareholders have to evaluate. Privacy - Terms
The cost of equity share capital

can be computed in the following
ways:
(a) Dividend Yield Method or

Dividend/Price Ratio Method:
According to this method, the cost of

equity capital is the ‘discount rate that
equates the present value of expected
future dividends per share with the net
proceeds (or current market price) of a
share’.
Symbolically:
Ke = D/NP or D/MP
where, Ke = Cost of Equity Capital
D = Expected dividend per share
NP = Net proceeds per share and
MP = Market Price per share.
The basic assumptions underlying this

method are that the investors give
prime importance to dividends and
risk in the firm remains unchanged.
The dividend price ratio method

does not seem to consider the
growth in dividend: capitalism’: Mythily Sivaraman
(i) It does not consider future earnings Read Next Story
or retained earnings, and Privacy - Terms
(ii) It does not take into account the

capital gains.
This method of computing cost of

equity capital is suitable only when the
company has stable earnings and
stable dividend policy over a period of
time.
Illustration 13:
A company issues 1000 equity shares

of Rs. 100 each at a premium of 10%.
The company has been paying 20%
dividend to equity shareholders for the
past five years and expects to maintain
the same in the future also. Compute
the cost of equity capital. Will it make
any difference if the market price of
equity share is Rs. 160?
Solution:
(b) Dividend Yield Plus Growth in

Dividend Method:
When the dividends of the firm are

expected to grow at a constant rate and
the dividend-pay-out ratio is constant
this method may be used to compute
the cost of equity capital. According to Read Next Story
this method the cost of equity capital is Privacy - Terms
based on the dividends and the growth

rate.
Further, in case cost of existing equity

share capital is to be calculated, the NP
should be changed with MP (market
price per share) in the above equation.
Ke = D1/MP + G
Illustration 14:
(a) A company plans to issue 1000 new

shares of Rs. 100 each at par. The
floatation costs are expected to be 5%
of the share price. The company pays a
dividend of Rs. 10 per share initially
and the growth in dividends is
expected to be 5%. Compute the cost of
new issue of equity shares.
(b) If the current market price of an

equity share is Rs. 150, calculate the
cost of existing equity share capital.
Solution:

Read Next Story
Illustration 15: Privacy - Terms
The shares of a company are selling at

Rs. 40 per share and it had paid a
dividend of Rs. 4 per share last year.
The investor’s market expects a growth
rate of 5 per cent per year.
(a) Compute the company’s equity cost

of capital;
(b) If the anticipated growth rate is 7

per cent per annum, calculate the
indicated market price per share.
Solution:
Alternatively:
Ke = D1/MP + g
Or, MP = D1/Ke – g
= 4.28/0.155 – 0.07 = Rs. 50.35
(c) Earning Yield

Method/Earning Price Ratio:
According to this method, the capitalism’:
cost of Mythily Sivaraman
equity capital is the discount rate that
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equates the present values of expected
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future earnings per share with the net

proceeds (or, current market price) of
a share.
Symbolically:
Ke = Earnings per share/Net Proceeds
= EPS/NP
where, the cost of existing capital is to

be calculated:
Ke = Earnings per share/Market Price

per share
= EPS/MP

equity capital may be employed
in the following cases:
(i) When the earnings per share are

expected to remain constant.
(ii) When the dividend pay-out- ratio is

100 per cent or when the retention
ratio is zero, i.e., all the available
profits are distributed as dividends.
(iii) When a firm is expected to earn an

amount on new equity shares capital,
which is equal to the current rate of
earnings. capitalism’: Mythily Sivaraman
(iv) The market price of the share is Read Next Story
influenced only by earnings per share. Privacy - Terms
Illustration 16:
A firm is considering an expenditure of

Rs. 60 lakhs for expanding its
operations. The relevant information is
as follows:
Compute the cost of existing equity

share capital and of new equity capital
assuming that new shares will be
issued at a price of Rs. 52 per share
and the costs of new issue will be Rs. 2
per share.
Solution:
(d) Realised Yield Method:
One of the serious limitations of using

dividend yield method or earnings
yield method is the problem of
estimating the expectations of the
investors regarding future dividends
and earnings. It is not possible to
estimate future dividends and earnings
correctly; both of these dependcapitalism’:
upon Mythily Sivaraman
so many uncertain factors.
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To remove this drawback, realised

yield method, which takes into account
the actual average rate of return
realised in the past, may be applied to
compute the cost of equity share
capital. To calculate the average rate of
return realised, dividend received in
the past along with the gain realised at
the time of sale of shares should be
considered. The cost of equity capital is
said to be the realised rate of return by
the shareholders.

equity share capital is based upon
the following assumptions:
(a) The firm will remain in the same

risk class over the period;
(b) The shareholders’ expectations are

based upon the past realised yield;
(c) The investors get the same rate of

return as the realised yield even if they
invest elsewhere;
(d) The market price of shares does not

change significantly.

Retained Earnings:
It is sometimes argued that retained
earnings do not involve any cost
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because a firm is not required to pay
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dividends on retained earnings.

However, the shareholders expect a
return on retained profits. Retained
earnings accrue to a firm only because
of some sacrifice made by the
shareholders in not receiving the
dividends out of the available profits.
The cost of retained earnings may be

considered as the rate of return which
the existing shareholders can obtain by
investing the after-tax dividends in
alternative opportunity of equal
qualities. It is, thus, the opportunity
cost of dividends foregone by the
shareholders.
Cost of retained earnings can be

computed with the help of
following formula:
Kr = D1/NP + G or D1/MP + G
where, Kr = Cost of retained earnings
D = Expected dividend at the end of

the year
NP = Net proceeds of share issue
G = Rate of growth.
MP = Market price per share ‘Women’s oppression is integrally linked to

Further, it is important to note that
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shareholders, usually, cannot obtain Privacy - Terms
the entire amount of retained profits

by way of dividends even if there is 100
per cent payout ratio. It is so because
the shareholders are required to pay
tax on their dividend income. So, some
adjustment has to be made for tax.
However, tax adjustment in

determining the cost of retained
earnings is a difficult problem because
all shareholders do not fall under the
same tax bracket. Moreover, if the
shareholders wish to invest their after-
tax dividend income in alternative
securities, they may have to incur some
costs of purchasing the securities, such
as brokerage.
Hence, the effective rate of return

realised by the shareholders from the
new investment will be somewhat
lesser than their present return from
the firm.
To make adjustment in the cost of

retained earnings for tax and
costs of purchasing new
securities, the following formula
may be adopted:

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Illustration 17:
A firm’s Ke (return available to

shareholders) is 15%, the average tax
rate of shareholders is 40% and it is
expected that 2% is brokerage cost that
shareholders will have to pay while
investing their dividends in alternative
securities. What is the cost of retained
earnings?
Solution:
Supernormal Growth:
It dividends of a firm are expected to

grow at a supernormal growth rate
during the periods when it is
experiencing very high demand for its
products and then, the dividends grow
at a normal rate when the demand
reaches the normal level, the constant
growth equation [P0 (or MP) = D0
(1+g)/Ke – g] can be suitably modified
to calculate the cost of equity.
In case, the dividends of a firm

are expected to grow at a
supernormal growth rate, gs, for
n years and then grow at acapitalism’: Mythily Sivaraman
normal growth rate, gn, till
Read Next Story
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infinity; the cost of equity share

can be calculated as:
Illustration 18:
The equity share of a company is

currently selling at Rs. 305.08 and it is
currently paying a dividend of Rs. 4.24
per share. The dividend is expected to
grow at a 18 per cent annual rate for
five years and then at 12 per cent
forever. Calculate the cost of equity
capital.
Solution:
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Top 4 Sources of Finance (With Formula and Calculations)

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7/16/2021 Top 4 Sources of Finance (With Formula and Calculations)

This article throws light upon the

Finance: Source # 1. Cost of Debt:

The cost of debt is the rate of interest

Read Next Story

For example, a company issues

(i) Kdb = I/P

where, K db = Before tax cost of debt

‘Women’s oppression is integrally linked to

Read Next Story

In case the debt is raised at premium

The formula may be changed to:

(ii) Kdb = I/NP (where, NP= Net

Further, when debt is used as a source

‘Women’s oppression is integrally linked to

Read Next Story

The After-tax cost of debt may be

(iii) Kda = Kdb (1-t) = I/NP (1-t)

where, K da = After-tax cost of debt

applicable to the company is 50%.

(b) Y Ltd. issues Rs. 50,000 8%

(c) A Ltd. issues Rs. 50,000 8%

(d) B Ltd. issues Rs. 1,00,000 9%

‘Women’s oppression is integrally linked to

Read Next Story

ii. Cost of Redeemable Debt:

Usually, the debt is issued to be

(a) Yield to Maturity or Trial and

(i) Before tax cost of redeemable

where, V0 = Current value or the issue

Vn = Redeemable value of debt

I, I2 …In = Amount of annual interest

n = Number of years to redemption

kd = Yield to maturity or internal rate

‘Women’s oppression is integrally linked to

Read Next Story

The value of kd (yield to maturity) can

(ii) After tax cost of redeemable

kda = kdb (1-t)

Where, kdb = After tax cost of debt

kdb = Before tax cost of debt

A five year Rs. 100 debenture of a firm

The present value factors at 15%

(b) Shortcut Method to Compute

In order to avoid the complex

(i) Before-tax cost of redeemable debt,

where, I = Annual Interest

RV = Redeemable value of debt

NP = Net proceeds of debentures

(ii) After-tax cost of redeemable debt

Where, I = Annual interest

n = Number of years in which debt is

RV = Redeemable value of debt

NP = Net proceeds of debentures

A company issues Rs. 10,00,000 10%

‘Women’s oppression is integrally linked to

Read Next Story

A 5-year Rs. 100 debenture of a firm

Assuming that a firm pays tax at

Read Next Story

(i) A perpetual bond sold at par,

(ii) A 10 year, 8% Rs. 1.000 per bond

iii. Cost of Debt Redeemable in

Financial institutions generally require