Cost of capital is the rate of return that a firm must earn on its project/investment to maintain its mar

component of capital. By component, we mean the different sources from which a capital of a compa
Cost of Capital capital, preference share capital and debt capital i.e. debentures and bonds. The cost of each compon
combined to arrive at overall cost, it is referred to as the Weighted Cost of Capital. WACC is also ca

(a)X Ltd issues Rs 50,000 8% debentrues at par. The tax rate applicable to the company is 50%. Com
(b) Y Ltd issues Rs 50,000 8% debenture at a premium of 10%. The tax rate applicable to the compa
debt capital.
Q.1
(c) A Ltd issues Rs 50,000 8% debentures at a discount of 5%. The tax rate is 50%, compute the cos
(d) B Ltd issues Rs 100,000 9% debentures at a premium of 10%. The cost of floatation are 2%. The

(a) Kda = Interest (1-t)/Net Proceed (b) Kda = Interest (1-t)/Net Proceed
= 4000 (1-0.5)/50000 = 4000 (1-0.6)/55000
Solution
= 4000(0.5)/50000 = 4000(0.4)/55000
= 4% = 2.91%
vestment to maintain its market value and attract funds. Cost of capital includes cost of each
m which a capital of a company is formed or funds are raised by a company. It includes equity share
ds. The cost of each component is called specific cost of capital and when these specific cost are
of Capital. WACC is also called composite or combined cost of capital.

to the company is 50%. Compute the cost of debt capital.

rate applicable to the company is 60%. Compute cost of

ate is 50%, compute the cost of debt capital.

ost of floatation are 2%. The rax rate applicable is 60%. compute cost of debt capital.

(c) Kda = Interest (1-t)/Net Proceed (d) Kda = Interest (1-t)/Net Proceed
= 4000 (1-0.5)/47500 = 9000 (1-0.6)/1,07,800
= 4000(0.5)/47500 = 9000(0.4)/1,07,800
= 4.21% = 3.34%
Usually, the debt is issued to be redeemed after a certain period during the life time of a
firm. Such a debt issue is known as redeemable debt.

(i) Before tax cost of debt,

Kdb = I + ⅟n (P-NP)

1/2 (P+NP)
Where, I = Interest
n = no of years in which debt is to be redeemed
P = Proceed at par
NP = Net Proceed

(ii) after tax cost of debt,

Kda = Kdb (1-t)
Q. 2 A company issue Rs 10,00,000 10% redeemable debentures at a discount of 5%. The cost
of flotation amount is Rs 30,000. The debentures are redeemable after 5 years. Compute before
tax and after tax cost of debt assuming a tax rate of 50%.
Solution:
Kdb = I + ⅟n (P-NP) = 100,000 + 1/5 (10,00,000 - 9,20,000) = 12.08%

1/2 (P+NP) 1/2 (10,00,000 + 9,20,000)

Kda = Kdb (1-t) = 12.08 (1-0.5) = 12.08 (0.5) = 6.045 %

Sometimes debentures are to be redeemed at premium, i.e. more than the face value
after expiry of a certain period. The cost of such debt redeemable at premium may be
computed as below.

(i) Before tax cost of debt,

Kdb = I + ⅟n (RV-NP)

1/2 (RV+NP)
Where, I = Interest
n = no of years in which debt is to be redeemed
RV = Redeemable Value of debt
NP = Net Proceed

(ii) after tax cost of debt,

Kda = Kdb (1-t)

Q. 3 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 percent.
Compute after tax cost of debenture.

Solution (i) Before tax cost of debt,

Kdb = I + ⅟n (RV-NP)

1/2 (RV+NP)

14 + 1/5 (105-96.5)

1/2 (105+96.5)
= 15.58%

(ii) after tax cost of debt,

Kda = Kdb (1-t)

Kda = 15.08 (1-0.4) = 15.08 (0.6) = 9.35 %
 X Ltd has issued redeemable zero coupon bond of Rs 100 each at a discount
Q.4 rate of Rs 60 repayble at the end of fourth year. Compute the cost of debt.

Hit and trial method

Year Cash flow Discout factor at 12 % P.V. at 12 % Discount factor at 14%
Solution 0 60 1 60 1
4 100 0.636 63.6 0.592
NPV 3.6 NPV
Cost of debt = Lower rate + NPV at lower rate * (High Rate-Low rate)
(NPV at low - NPV at high)
= 12 + 3.60/(3.60+0.80) *(2)
= 13.64 %
ach at a discount
he cost of debt.

P.V. at 14 %
60
59.2
-0.8
* (High Rate-Low rate)
)
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.
ABC Ltd raised a debt of Rs 50 lakhs on the terms that interest shall be
payable at prime lending rate of bank plus three percent. The prime
Q. 5 lending rate of the bank is 7 per cent. Compute the cost of debt
assuming that corporate rate of tax is 35 %.

Before tax cost of debt = Kdb = 7% + 3% = 10%

Solution After tax cost of debt = Kda = Kdb (1-t) = 10% (1-0.35) = 10% (0.65) = 6.5%
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect
the real cost of funds to the borrower and the real yield to the lender or to an investor. A nominal
interest rate refers to the interest rate before taking inflation into account.
Excel Ltd has issued 5000 10 % debentures of Rs 100 each. The rate of inflation
Q. 6 is 6% calculate the real cost of debt.
Real cost of debt = 1 + Nominal Cost of Debt = 1+ (0.10)/1+0.06 = 1.10/1.06 = 1.0377
1 + Inflation Rate
Solution Real cost of debt = 103.77 - 100 = 3.77%
 A company issue 10000 10 % preference shares of Rs 100 each. Cost of issue is Rs
2 per share. Calculate cost of prefernce capital if these shares are issued (a) at par
Q.7 (b) at premium of 10 % and © at a discount of 5%

Cost of preference capital Kp = D/NP

Where,
D = Annual Preference Dividend
P = Preference Share Capital (Proceeds)

(a) Kp = 100,000/10,00,000-20000 = 10.2%

Solution (b) Kp = 1,00,000/10,00,000+100,000-2000 = 1,00,000/10,80,000 = 9.26%

{c} Kp = 1,00,000/9,30,000 = 10.75%

A company issues 10,000 10% preference shares of Rs 100 each redeemable after
Q. 8 10 years at a premium of 5%. The cost of issue is Rs 2 per share. Compute Cost of
preference capital.

Kp = D + ⅟n (MV-NP)

1/2 (MV+NP)
Where, D = Annual Dividend
n = no of years in which shares are to be redeemed
MV =
NP = Net Proceed
Solution

Kp = 100,000 + (10,50,000 - 9,80,000)/10

(10,50,000+ 9,80,000)/2

Kp = 1,07,000 = 10.54%

10,15,000

Class work
A Company issues 1000 7% preference shares of Rs 100 each at a premium of 10%
Q.9 redeemable after 5 years at par. Compute the cost of preference Capital
 A Company issues 1000 7% preference shares of Rs 100 each at a premium of 10%
Q.9 redeemable after 5 years at par. Compute the cost of preference Capital

Answer Kp = 4.76 %
Cost of equity is the 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. There are two types of Ke
(a) Dividiend yield method or dividend ratio method or price ratio method
(b) Dividend yield plus growth in dividend method

(a) Dividiend yield method or dividend ratio method or price ratio method: According to this method the cost
of equity capital is the ''discounting rate that equates the present value of expected future dividends per share
with the net proceeds. (or current market price) of a share.

Ke = D/P or D/MP
Where, Ke = Cost of equity Capital
D = Expected dividend per share
NP = Net Proceeds per share
MP = Market Price per share

Q. 10 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 future
also. Compute the cost of equity capital. If price of equity share is Rs 160 then compute Ke?
Solution: Ke = D/P or D/MP
Ke = 20/110 = 0.18* 100 = 18.18%

If the market price of the share is Rs 160

Ke = 20/160 = 0.125* 100 = 12.5%

(b) Dividiend yield plus growth in dividend method: When the dividend of the firm are expected to grow at a
constant rate and the dividend payout ratio is constant this method may be used to compute the cost of equity
capital. according to this method the cost of equity capital is based on the dividend and the growth rate,

Ke = D1 + G = D0(1+g) + G
NP NP
Where, Ke = Cost of equity Capital
D1 = Expected dividend per share at the end of the year
G = Rate of growth in dividend
D0 = Previous year's dividend

Q. 11 (a)A company plans to issue 1000 new shares of Rs 100 each at par. The flotation costs are expected to
be 5% of the share price. The company pays a dividend of Rs 10 per share initialy and the growth in dividend
is expected to be 5%. Compute the cost of new issue of equity shares.
(b) If the current market price of an equity shares is Rs 150, calculate the cost of existing cost equity share
capital?
Solution: (a)
Ke = D1 + G = D0(1+g) + G
MP NP
Ke = 10/100-5 + 5% 15.53%

Solution (b) Ke = 10/150 + 5% = 11.67%

Solution: (a)
Ke = D1 + G = D0(1+g) + G
MP NP
Ke = 10/100-5 + 5% 15.53%

Solution (b) Ke = 10/150 + 5% = 11.67%

Q. 12 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 Ke
(b) If the anticipated grwoth rate is 7 percent per annum , compute the indicated market price per share.

Solution:
(a) Ke = D0(1+g) + G = 4(1.05) / 40 + 5% = 15.5%
MP
(b) Ke = D0 (1+g) + G
MP
15.5 = 4 (1.07)/MP + 7%
MP = 50.35 Rs
Weighted average cost of capital is the average cost of the costs of various sources of financing. Weighted average cost of capti
also known as composit cost of capital, overall cost of capital or average cost of capital.
Kw = ∑ XW Where, Kw = Weighted average cost of capital
∑W X = Cost of specific source of finance
W = Weight, proportion of specific source of finance

A firm has the following capital strucutre and after tax costs for the difference source of
funds used:
Sources of funds Amount Proportion % After tax cost
Debt 1,500,000 25 5
Q. 14
Preference Shares 1,200,000 20 10
Equity Shares 1,800,000 30 12
Retained Earnings 1,500,000 25 11
Total 6000000 100

Sources of funds Amount Proportion % After tax cost

Debt 1,500,000 0.25 5
Preference Shares 1,200,000 0.2 10
Solution
Equity Shares 1,800,000 0.3 12
Retained Earnings 1,500,000 0.25 11
Total 6000000 100 WACC

Following is the capital structure of XYZ Limited.

Rs
Equity shares-20,000 shares of Rs 100 each 2,000,000
Q. 15
10% Preference Shares of Rs 100 each 800,000
12% Debentures 1,200,000
Total 4,000,000
The market price of the company's share is Rs 110 and it is expected that a dividend or Rs 10 per share
would be declared after 1 year. The dividend growth rate is 6%.
(i) If the company is in the 50% tax bracket, compute the WACC.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of Rs 20 Lacs bearing 14% rate
interest, what will be the company's revised WACC. This financing decision is expected to increase dividend from Rs 10 to Rs
share. However, the market price of equity share is expected to decline from Rs 110 to 105 per share.

Solution
Cost of eqity capital (Before) = D + G = 10/110 + 6% = 15.09%
MP
Cost of equity capital (After) = 12/105 + 6% = 17.43%
 Computation of WACC (Before raising term loan)
Source of fund Amount Proportion Cost (Before tax) Cost (after tax)
Equity Shares 2,000,000 0.5 15.09 15.09
10% Preference shares 800,000 0.2 10 10
12% Debentures 1,200,000 0.3 12 6
Total 4,000,000 Weighted Average Cost of Capital

Computation of WACC (After raising term loan)

Source of fund Amount Proportion Cost (Before tax) Cost (after tax)
Equity Shares 2,000,000 0.33 17.43 17.43
10% Preference shares 800,000 0.13 10 10
12% Debentures 1,200,000 0.2 12 6
14% Term Loan 2,000,000 0.33 14 7
Total 6,000,000 Weighted Average Cost of Capital
eighted average cost of captial is

After tax cost

5
10
12
11

After tax cost WACC

5 1.25
10 2
12 3.6
11 2.75
WACC 9.6

Rs
2,000,000
800,000
1,200,000
4,000,000
hare

Rs 20 Lacs bearing 14% rate of

dividend from Rs 10 to Rs 12
e.
WACC
7.545
2
1.8
11.345

WACC
5.7519
1.3
1.2
2.31
10.5619