CHAPTER

Cost of Capital
5
CHAPTER OUTLINE
Concept of Cost of Capital
Factors Affecting Cost of
Capital
Types of Cost of Capital
Specific and Overall Cost of Capital
Explicit and Implicit Cost of Capital
Measurement of Cost of
Cost of Long-Term Debts and Bonds
Capital
Cost of Preference Share
Capital
Cost of Equity Share
Capital1
Cost of Equity Capital under different
Dividend Assumptions
Cost of Retained Earnings
Weighted Average Cost of Capital
Historical, Marginal and Target Weights
Book Value Versus Market Value Weights
Graded Ilustrations in Cost
of Capital

INTRODUCTION
The concept of cost of capital is an important and fundamental concept of theory of
financial management. In particular, the concept of cost of capital has two applications. First,
in capital budgeting it is used to discount the future cash flows to obtain their present values,
and second, it is also used in optimization of the financial plan or capital structure of a firm.
The second aspect of the concept of cost of capital will be taken up in Chapter 8. In the
present chapter, an attempt has been made towards the determination and measurement of
this discount rate i.e., the cost of capital.

QcONCEPT OF CoST OF CAPITAL

The minimum rate of return that a firm must earn in order to satisfy the expectations of
its investors is called the cost of capital of the firm. In other words, the cost of capital is the
 124
BASIC FINANCIAL MANAG CoSTO F CAPITAL
125
rate of return.
the funds
a firm must earn in order to attract the
supplier of funds to make
GEMENT incinal repayment on maturity. Theoretically spenking, the risk-free interest
to the firc aat
well as principa
ailable T.depends upon the supply and demand consideration in financiai market for long
Theoretically speaking. the of market of demand and
cost
project must earn in order to cover the cost
capital is the minimum required rate of rotiur rate unds.
term
funds.
The market
The sources supply determines the , whieh is
financing of the proposal. This can be of raising funds being used by the fir
, a
Consisting
ot two
components:
investment proposal. it will also need substantiated as follows: If a firm P e a l interest rate: The real interest rate is the interest rate payable to the lender for
funds for its financing. These funds accents or in other words, for surrendering the funds for a partieular
from different
types of investors i.e., can be proe nolving the funds
holders. depositors. etc. These investorsequity shareholders, preference shareholders.
dehe
while period.
expectation of receiving a minimum return fromproviding the funds to the firm
the firm. The minimum
will have an
Purchasing power risk premium: When a lender lends money, he in fact lends his
the investors depends return expected by (A)
upon the risk in tavor of the other party i.e.,
borrower. Ater sometimes,
characteristics of the firm. Therefore, perception of the investors as well as on the
risk-return
present purchasing power
to the investors.
Obviously. this
in order to
procure funds, the firm must pay this when the lender gets the repayment, he recovers the same face value money But if
period, then he is not getting back the
would be earned out return
returm the
revenues generated payable
by the proposal wherein the funds are
to investors
of the
the prices have increased during same
earn at least that being used. So, the same purchasing power which he lent. Investors, in general, like to maintain their
much, which is sufficient proposal for the loss in purehasing
payable to investor is therefore,
to pay to the
investors of the firm. This must purchasing power and therefore, like to be compensated
the minimum return of lending or supply of funds. So, over and above the real
firm need not take up the
return the proposal must earn otherwise, the power over the period
minimum required rate of proposal.
In nutshell, therefore, the cost
of interest rate, the purchasing power risk premium
is added to find out the risk-free
return of the firm i.e, the cost of raising funds is the would be the purchasing
which the firm mast earn on the capital is the minimum return interest rate. Higher the expected rate of inflation, greater
The importance and
proposals in order to break-even. power risk premium and consequently higher
would be the risk-free interest rate, I.
the significance of the concept of cost of Business Risk: Another factor affecting the cost
is the risk associated with the
of capital
contribution it makes towards the achievement of the capital can be stated in terms of 2 investors. The business risk is related
wealth of the shareholders. If the objective of maximization of the firm's promise to pay interest and dividends to its
firm's return is more than Before Interest and Taxes, EBIT, to change in
investors will no doubt be its cost of capital, then the to the response of the firm's Earnings
receiving their expected rate of return from
portion of the returm will however the business risk of the firm. 1f a firm
be available to the firm the firm. The excess sales revenue. Every project has its effect on investor will
eg. i) for distribution and be than average present risk, the
among the shareholders in the form
can used in several ways accepts a proposal which is more risky inereased risk. This
and (ü) for of higher than to be compensated for the
reinvestment within the firm for expected dividends, probably raise the cost of funds so as
The cost of increasing further the subsequent returns. premium added for the business
risk compensation 1s also
known
a business risk
capital when used as a discount
rate in be a point at
investor will not like to supply
which the
only those proposals whose rate of return is more than
capital budgeting, helps accepting premium.)There would obviously firm would be ready to pay. T'he
firm might have
the funds, regardless of the return the
hence results in
increasing the value of the firm. Similarly,thethecost of capital of the firm and be noted that the business risk premium
is strictly
the rate of return on the proposal falls below the cost of firm's value is reduced when become too risky at this stage. It may interest rate, ; which depends upon
external
capital is consistent with the capital. Thus, the concept of cost of related tothe firm unlike the risk free
goal of maximization of
tool achieve this
to
goal. Further, the cost of
shareholders' wealth
and it works as a factors.
financial plan
or
capital capital
has a useful role to
play in risk is an other type of risk which can affect
the cost of
value of the
structure of the firm. It
may be noted that in
the deciding 3. Financial Risk:/The financial and mixing ot difterent
s o u r v e s of tinance,
firm, the cost of all the different sources of funds must be order to maximize the capital of the firm. The particular composition available to the
structure, c a n aitect the r e t u r n
capital of different sources usually varies and minimized. The cost of known as the financial plan
or the capital
these sources in such a way as the firm will like the likelihood that the tirm would not be
to have a
combination of is often defined as
to minimize the overall
cost of investors. The financial risk to the response of the firm's earningg
of capital the firm.
able to meet its fixed financial
charges. It Is related
FACTORS AFFECTING THE cOST OF CAPITAL OF per share to a variation
in EBIT. The tinancial
risk 1s atfected by the capital
structure o r
tixed cost securities in the overal
It is already stated that the cOst of
AFIRM the financial plan of the
firm. fligher the proportion ot
would be the tinanelal risk
/the invêstors in such a case require
capital
investors or suppliers of funds to the firm.
is the minimum expected rate of capital structure, greater tinancial risk premium over and
The expected return of the this ncrestu tis. he add
characteristics of the firm, risk
rate
of return depends upon the risk to be compensated for that the finaneial risk, like business
perception of the investors risk premium.
lt
may be noted
Following are some of the and a host of other above the busiuess the urm and is nut atYected by the
external factors.
the firm.
factors which are relevant 1or the
determnination of cost of
factors risk, is also particular
and related to
capital of
may also like to add premium a with reference to
4. Other Considerations:
The mvestorS
Risk-free Interest Rate: The risk-free Lhe liquidity or marketability of the
investment.
interest rate, l, is the such luctor may De
free and default-free
securities. For example, Lhe securities issuedinterest rate on the risk
by the Government of
other factors. One
Higher the liquidily ilva
lower would be the premium
ewnan nvestment, marketable, then the investors
India are taken as risk-free and delault-iree in respect of e nestinent is not easily
payment of periodic interest i 1S demanded by the investors.
for this also and consequently demand a higher
rate of return.
premiun
may add a
 126
BASIC FINANCIAL MANAGEMENT c o s TO FC A P I T A L
127
In view of the above, the cost of
capital may be defined Jharefore, it can be said that all debt holders have a less risky
as
and both of these bear less
position than
geneghareholders
areference
risk than equity sharehoiders. The
rate of rreturn of these
There. k Cost of capital of different 5.1) difterence
the in thethe required rate security truly reflect the differences in the
sources risklevels. The
The risk-return i relationship of an investor has been presented in Figure 5.1.
=
Risk-free interest rate.
b Retum
Business risk premium, and
f Financial risk premium.
Equation 5.1 indicates that the cost of capital of a
particular source of finance
upon the risk-free cost of depends
capital of that type of funds, the business risk Aisk
financial risk premium premium and the Premium
Euty Snara Capta
It already
is stated that the cost of Pref. Share Cattai
of the investors. If a firm capital of a firm is equal to the required rate
of returm
wants to raise funds by the issue of Bonds ard Dabantures
return in the security then it OFIGURE5.1
form of
Now. an investor before
interest or
redemption premium or expected dividends to themust offer a Risk and Retum of
different types Pvt. Sector Bonds
making a decision to invest the funds in the firm investors. of Securities Govt. Securties
returns offered
by the firm with the returns he can get elsewhere. In will compare the Risk-free
investor will be ready other words, Interest rate
to supply the funds an
equal to the opportunity cost of the investor.only
if the firm offers a return which is at least
defined as the return The opportunity cost of the
foregone by the investor on the investor may be
alternative
the same or
comparable risk. So, the cost of capital of the firminvestment opportunity of different risk. There is a pure
opportunity cost of the may be defined as the different types securities have of
suppliers of funds i.e., the investors. The Figure 5.1 shows that of interest, applicable to
Government
The opportunity cost of the also called the risk-free rate
investors depends the interest rate which is on increasing as the
offered by the firm. upon nature and type of security being of the return ie., the risk premium goes
Every investor has a risk Bonds. The other components shares and equity shares
have
different types of investment. As the perception regarding the risk inherent in risk increases. Different
securities i.e, bonds, preference
risk are also different. Higher
funds only if increases, an investor may be ready to supply the therefore the risk premium components
sufficiently comnpensated for the risk. That is why the
different risk levels and
and therefore higher is the required
rate of
investor is not the same for different types of securities. opportunity cost of the the risk, more is the risk premium component
firm is not same for different Therefore, the cost of capital of the return of the investors.
types of securities. The firm has to offer
investors depending upon the risk of the different returns to the
security.
RELATIONSEIP BETWEEN RISK AND REQUIRED RATE OF TYPES OF COST Or CAPITAL of time, the fim might
a particular point
Cost of Capital: At
The relation between the risk and RETURN
return is based
OSpecific and Overall
from various s o u r c e s i.e.,
short-term as well as long-term.
Conceptually,
the
on the
premise that the investors must total funds being used by
be
compensated for undertaking the additional risk, have raised funds the combined cost of cost of
otherwise, as a m e a s u r e represents the calculation of
funds. Obviously, no investor would like to învest in say 6%%
they will not supply the ne cost of capital short-term sources of funds are kept out side bill ete., a r e generally
company, if the rate of interest on commercial bank deposit debenture of a private sector nrms. However, the
bank credit, trade
credit,
the risk involved in commercial bank is equal to or more than 6% (as Capltal these short-term sources e.g.
as
a r e subject
to repayment in
the short-run.
in nature and
private sector company). The differencedeposits
is
in
almost nil or certainly less than that of a cOnsidered to be temporary firm is caleulated
as the combined
cost of long-term
sources
attractive. However, the risk makes the 6% bonds to be herefore, the cost of capital
of a
investor the funds for considerably
might be willhing to commit less cost of
interest offered by the company is higher than 6%. The these bond if the of funds. costs. The combined
investor demands a have their o w n specific
long-term sources is in fact, known
as
bearing risk. compensation for Moreover, all these combined cost of capital
costs. The the specific cost of
these specific a r e known as
Government Securities and Bonds Capital depends upon the firm, while
the specifie costs
categorized into
consequently generally, do not
these have the lowest return offered to the investor.
have
any inherent
risk and n e overall cost of capital of
long-term
s o u r c e s of
tunds can be broadly
and (iv)
s o u r c e . The
This return
called uih equity share capital,
the risk-free rate of return or the risk-free interest is also apital of a particular preference share capital s o u r c e s and on
the bonds issued by Government Departments e8. rate.
However, rate of
offered long-term debt and loans,
(ii) for each of these
return on ) has a specilic
cost of capital
firm can be
Railway's
rate. The rate of interest offered on he private sector
ete., is higher than
this risle.froa he retained
earnings. The firm the overall cost
of capital of the
cost of capital,
bonds and debenture is still hicho he basis of these specific
Similarly, a firm has to offer a still higher rate of dividend on preference share as t firm can also be
riskier than debts. The rate of return expected in case of equity shares will be determined. The cost of capital of a
equity share investment is considered to be most risky.
hichectas are the Explicit and
Implicit Cost of Capital:
The explicit cost of capital
of' a particular
cost of capital.
explieit cost and implicit
as
analyzed
128 BASIC FINANCIAL MANAGEMENT
129
Source may be defined in terms of the interest or-dividend that the firm has. ancial risk of the firm remains
Final Fold and then Seal--
suppliers of funds. There is an explicit fow ofcash payable by the firm to the tothe .- The implication is that the
funds. For example, the firm has to pay interest on capital, dividend at
These
fixeller
payments
of gresent. The financial risk
preference share capital and also some expected dividend on equity shares. These t e on
capital structure
refer to the explicit cost of capital. financing will be
Please
However, there is one source of funds which does not involve any payment or flow INLAND LETTER Affix
apital budgeting
retained earnings of the firm. The earned by the tirm but not cost of capital is
profits distributed amhe
equity shareholders are ploughed back and reinvested within the firm. Thesa Stamp al structure then
e
gradually result in a substantial 'source of funds to the firm. Had these
distributed to equity shareholders, they could have invested these funds profita been
(return for t the cash flows
elsewhere and would have earned some return. This return is
the profits are foregone by the investors them)
when Ser se cash flows are
ploughed back. Therefore, the firm has an implicit cost of these ld be noted that
earnings and this implicit cost is the opportunity cost.of investors. Thus, the implicitretained
retained earning is the return which could cost af SULTAN
also be after-tax
been distributed to them. have been earned by the investor,
had the profit '2001
be taken on an
s analyed in the
Except the retained earnings, all other
iaSULTAN CHAND & SONS
sources of stment to cost of
capital budgeting situations, it is funds have explicit cost of
capital. is tax deductible.
only the explicit cost of capital which is
determine or measure this explicit cost of relevant. How
capital-This is discussed in the following section.to EDUCATIONAL PUBLISHERS e capital do not
23, DARYA GANJ, NEW DELHI-110002
MEASUREMENT OF COST OF CAPITAL
The measurement of cost of capital refers to
to the firm. Once the process of
determined, it is in the lightdetermining
the cost has been the cost of funds of debt, involves
budgeting proposal will be evaluated.
of this cost that the
capital Third fold
ing to the rate of
cash flows is
merely an Although the cost of
capital selected for discounting the of capital for debt
the firm must estimation of the firm's true cost of capital, the
calculate this estimate as finance manager of securities of the
of
capital measurement precisely as possible. A haphazard
may result in
carefully estimate the relevant gross error of approach cost to n is required:
cash flows associated estimation. Just as the firm should e of issue of debt.
estimate the cost of with a proposal, it should
then the investmentcapital. also
If there is a mistake in carefülly
the determination of the
decision as well as other cost of capital,
ultimately affecting the profitability and decisions may be taken
wrongly and thus
Thus, utmost survival of the firm. m
care must be taken in the
unacceptable proposals measurement of cost of
Further, although the costmight
of
be selected and
acceptable proposals
capital, otherwise,
cost of funds over capital
the long-run
is measured at a
given point of time,might get rejected. bt
because it must reflect the of debt, and
involving expenditures providing benefits inthe cost of capital is used in
the long run. capital budgeting funds (including
Underlying
assumptions Assumptions:
The measurement xpenses.
of cost of capital is based on the liscount of 5% and
(a) The basic following
assumption of the
firm is unaffected by the cost of capital concept is that
0-Rs. 5-Rs. 5
the business 110 Rs. 5.50 =
implication of this proposal being evaluated risk of the
s.
risk as determined assumption is that at the cost of or the issuë price
particular capital.
by the every firm has a The
accepted then this businesspresent compoSifion of its assets. If
level of business
proposal accepted byrisk level a
the new
the firm
is not
going to be changed,new proposal is also ue of Zero interest
of those 1s
assumed to or, in other tinstruments. To
already held. possess the same
words,
level of risk as ned to be payable
on the face value
COST OFCAPITAL
129

A) Another assumption required to be made is that the financial risk of the firm
unchanged, whether a proposal is accepted or not. The implication is that remain5
the
financial mix of the firm is assumed to be the same as at present. The financial risk
of the firm depends upon the degree of debt financing in the overall capital structure
of the firm and this assumption implies that the same degree of debt financing will De
maintained. The purpose of
making this assumption is that for capital
decision situations, the average cost of capital is used. This average cost ofbudgeting
capital 1s
calculated for a given capital structure. If there is a change in capital structure tnen
this average cost of capital will also change.
Taxes and Cost of Capital: It is already discussed in Chapter 3 that the cash flows
Televant for capital budgeting decisions are taken on an after-tax basis. These cash flows are
then discounted at the cost of capital to find out their present value. It should be noted that
this cost of capital which is used to discount the cash flows (after-tax) should also be after-tax
y. If the firnm is using IRR technique, then the cut-off rate should also be taken on an
after-tax basis. This ensures consistency in the evaluation procedure. As analyed in the
falowing diseussion, it is only the debt financing for which the tax adjustment to cost of
capital is required. The reason being that interest on bonds and debentures is tax deductible.
The other sources i.e., the preference share capital and the equity share capital do not
require such tax adjustment.

coST OF BONDS AND DEBENTURES

The caleulation of cost of capital of bonds and debentures, i.e., cost of debt, involves
relatively simple procedure and is subject to the terms and conditions relating to the rate of
interest, timings of interest payment and repayment amount etc. The cost of capital for debt
may be defined as the returns expected by the potential investors of debt securities of the
firm. In order to find out the cost of capital of debts, the following information is required:
a) Net Proceeds from the Issue: This refers to the net cash inflow at the time of issue of debt.
This can be calculated as:
=
FV + Pm- D- F
Bo
where, Bo Net Proceeds
FV Face Value of Debt
Pm Premium Charged on the issue of debt
D Discount allowed at the time of issue of debt, and
F Flotation cost i.e., the cost ofraising funds (including
underwriting, brokerage and issue expenses.
For example, a debenture having a face value of Rs. 100 is issued at a discount of 5% and
otalissue of expenses are estimated at 5%, the net proceed i.e., Bo = Rs. 100- Rs. 5- Rs. 5 =
S.90. In case, the debenture is issued at a premium of 10%, then Bo = Rs. 110-Rs. 5.50 =
104.50 (note that the flotation cost has been calculated at face value or the issue price
whichever is higher).
9) Periodic Payments of Interest: In most of the cases (except in case of issue of Zero interest
Fully convertible debentures), the firm has to pay interest on debt instruments. To
Simplify the calculation of cost of debt, the interest amount is assumed to be payable
annually. It may be noted that interest on debt is always payable on the face value
 c o S TO F CAPITAL
BASIC FINANCIAL MANAGEME 131
O Cost of Capital
130 of
Redeemable Debt: The
Coed with the help of Equation5.3
ascertainedwith
cost of capital of redeemable debt may be
if the company issues debentures, than
l6%
irespective of the issue price. For example, the fact whether the na
the annual interest charge
will be Rs. 15, irrespective of net
more or even less. BBo =21+ kat COP COP 5.3)
proceeds, Bo, was Rs. 100 or
Sometimes, the bonds and
debentures as well as loans
from financial institutions requirs
of the princinal I
(14ka
Annual Interest Payment
(1+4
This periodic amortization
principal amount also.
where,
regular repayments of the interest payment for a particula
lar Bo Net Proceeds
amount is also considered cash outflow together with
as a
year. COP; =
Cash Outflow on account of
amount of the debt instrument or loan (i.e., the Amortisation
(c) Maturity Payment: The principal COP, Cash Outflow on account of
=
the firm on the maturitu
balancing figure after amortization, if
any) will be payable by Repayment at maturity
with the interest for the last year. ka After tax cost of
date. This may be paid together effect. As the interest on
capital of debt.
of cost of debt is the tax case, the debt 1s repayable only at the time of maturity and there is no annual
(d) Tax Adjustment: An important aspect in its tax liability. The interest works as a In
debt is tax deductible, the firm gets saving rtization then the Bquation 6.3 will not contain the second element ie., COP, / (1+kaf.
a
effective cost of debt is
the firm is reduced. Thus, the
tax-shield and the tax liability of tax savings and the
ation 5.3 is to be solved for the value of ka, which will be after tax cost of capital for debt.
debt investors. The amount of
lower than the interest paid to to be solved by trial and error procedure (as the IRR
effective cost of debt depend on
the tax rate. The net cost of
interest to the firm (at least This equation is equation was solved in
interest multiplied Chapter 4).
that are liable for taxes) is the annual
for those with sufficient profits after considering this
The real cost of debt is determined only
by a factor of (I Tax rate). Example 5.1
-
tax shield
(5.2)
ha k; (1 -t) ABC Ltd. issues 12.5% debentures of face value of Rs. 100 each, redeemable at the end of
ka Cost of Capital of Debt (after tax)
=
7 vears. The debentures
are issued at a discount of 5% and the flotation cost is estimated to
where,
=Cost of Capital of Debt (before tax) be 1%. Find out the cost of capital of debentures given that the firm has 40% tax rate.
k
tTax rate Solution:
is available only if the firm is
It may be noted that the tax benefit of interest deductibility For the given situatioF,
this tax adjustment
a profit making one. loss making firm or for a no-tax paying firm,
For a Bo= Rs. 100 - Rs. 5 -Rs. 1 = Rs. 94
is not required. I = Rs. 12.5 (1 - 4) = 7.50.
for debt can now be ascertained
On the basis of the above information, the cost of capital
Putting these values in Equation 5.3,
as follows: 94 7 . 5 (PVAFrn)+ 100 (PVPrn)
debt (i.e., debt
Cost of Capital of Perpetual Debt: The cost of capital of perpetual equal
The value of right hand side of the equation is to be made to the amount of Rs. 94
by the firm on a regular basis) may be ascertained as follows:
availed
and can be derived by trial and error procedure as follows:
I1 (5. 9%, 7.5 (5.033) + 100 (.547)
Bo at ka
=37.75 +64.70 = 92.45
where, Cost of Capital of Debt
Annual Interest Payable Since the amount is less than Rs. 94, the rate of discount may be reduced to 8% and
Tax rate therefore,
8%, 7.5 (5.206)+ 100 (.583)
Bo Net Proceeds at ka
39.05+ 58.30 97.35
A few point are worth noting in Equation 5.2.
to 8.68%. So, the cost of
the value of ka comes
1. Equation 5.2 calculates the cost of capital of debt on after tax basis. 5y interpolating between 8% and 9%,
2. The repayments (periodic amortization or maturity repayment) have not been capital (after tax) of debenture is 8.68%.
procedure of trial and error
to find out the value of ka
considered as the debt is taken as perpetual. It may be noted that the concept 0 the cumbersome
order to avoid give an approximation
to after-tax cost o
perpetual debt is theoretical in nature, otherwise debt, being a type ofa loan 8 5.4 may be used to
a t i o n 5.3, Equation
always repayable. Even if one debt is replaced by another, still there may De capital of debt.
difference in interest rate of two debt instruments or difference in redemption I(1-t)+(RV-BJ/N (5.4)
amount and the net proceeds. kka= (RV+Bo)/2
 132 BASIC FINANCIAL MANAGEMENT
c o S TO FCAPITAL 133

where, RV Redemption Value of debenture

Tax rate coST OFPREFERENCESHARE CAPTTAL
Life of debenture
N
75 57
Campanies canraisefunds by the issue ofpreference share capital also. The preference
Now, applying Equation 5.4 for Example 5.1, is differentiated from equity share capital on account of two basic features
hare capital is
sn ) the preference shares are entitled to receivedividends at fixed rate in priority over
12.5 (1-4) +(100 -94)/ 7 namely
and (i) in case of liquidation of the company, the preference shareholders
(100 + 94)/2 quity shares,
861 or 8.61%
tnot the capital repayment in priority overthe equity shareholders. It may be noted that
s Do obligation on the firm to compülsorily pay the preference dividend as the
So, the value of ka
given by Equation 5.4 provides an approximation to
as rence dividend is payable only when the sufficient profit are there and the company
"

value of ka can however, be calculated

only with the help of Equation ka. The exact
5.4 can be used only when the debenture is to be Moreover, Equation Pnts to pay dividendsunlike
to equity shareholdersalso.The preference dividend is payable
against profits.
as an

redeemed at maturity. Wropriation of profit interest on

debentures which
is a charge
the investors who invest
Example 5.2 A company has no legal obligation to pay preference dividend, but from the company.
ABC Ltd. issues 15% debentures of face Cthe funds in preference share, have an expectation of getting returns
value of Rs. 1000 each at a and thus, there is
per debenture. Find out the cost of flotation cost of Rs. 50 Therefore, a company should pay dividends to preference shareholders
installments of Rs. 200 each startingcapital
if the debenture is to be The understanding of
from the end of
redeemed in 5 annual acost of preference share capital in terms of the fixed rate of dividend.
1. The (as there is no legal binding
cost of capital of preference share capital conceptually difficult
30% year tax rate may be taken is
at
not pose much problem. The fixed rate of
Solution: to pay preference dividend) but the calculation does
calculation of cost of capital of
dividend on preference shares is the starting point for
In the given situation, or irredeemable,
the net share capital. As the preference shares may either be redeemable
debenture is to be proceeds
amortized in 5 installments
i.e., Bo is Rs. 1000 50 Rs. 950. As the preference
the cost of capital may also be ascertained accordingly.
payable only on the reduced balances as follows:of Rs. 200 per year, the interest @
15% will be
SHARE: If the preference
Year-ennd OcosT OF CAPITAL OF REDEEMABLE PREFERENCEcost of preference
Interest shares
of
redeemable at the end of a specific period, then the capital
Repayment After-tax cash flow shares
are

can be calculated by Equation 5.5 (which is very similar to Equation 5.3).

150 200 200+ 105 305 PD Pn_ (5.5)
120
90
200
200
200+84 284 Po k 1+k"
200 +63 = 263 Net Proceeds on issue of Preference Shares
60 200 where, Po
200+ 42= 242 PD Annual preference dividend at fixed rate of dividend
30 200 200+ 21 221
These after-tax cash
flows may be
=

P Amount payabBle at the time of redemption

to bemade equal to Rs. 950 discounted at an
appropriate rate,
i.e., say, 12% and Cost of Preference Share Capital, and
13%,
305 Redemption period of preference shares
Rs. 950 284 263 242 221 the value of
(1+k (1+k? (1+ k (1+k" (1+k)5 Equation 5.5 is also to be solved by the trial and error procedure to find out
as the preference
at ka the k, PD require any tax adjustment
p. In Equation 5.5, neither
nor
12%, the right hand side of the there is no tax shield to the
at ka equation gives a value of Rs. 965.18 aividend is payable out of profit after tax and consequently
13%, the right hand side of the
By interpolation equation gives a value of Rs. 943.91 company.
between 12% and 13%, value of SHARES: In
On the basis of ka comes to 12.71%. OF IRREDEEMABLE PREFERENCE
case
the above
discussion, it can be concluded coST OF CAPITAL
rate will be payable to the
kd, increases as the net rredeemable preference shares, the dividend at the fixed
that the cost of capital of debt,
paid less to get the fixed proceeds from the debt issue decreases because preference share
the preference shareholder perpetually. The cost of capital of the irredeemable
paying Rs. 950 only and interest payment and the investors have
principal can be calculated with the help of Equation 5.6.
acerues to them getting that Rs. 1,000, the investors
In
repayment. Example
5.2, by
proportionately
every year. The rate of interest onhave a capital gain which PD (5.6)
therefore, the after-tax cost of debt the
debenture is 15% and Po
Rs. 950 should
only, the cost of debt (after tax) be 10.5% only. However, due to net
comes to 12.71%. proceeds of PD Annual preference dividend
where,
shares
Po Net Proceeds on issue of preference
k Cost of capital of preference
shares
 134 BASIC FINANCIAL MANAGEMENT cOST OF CAPITAL 135

Lnalating between 15% and 16%, the value of k, comes to 15.63%.

It may be noted that no company in India can issue irredeemable
preference shara Byi
nst of capital is same at 15.63% as it was when the preference shares were
after 1988 (Section 80 of the Companies Act, 1956). he
so irredeemable. However,
treateda s This
it the preference shares are redeemable
This increase
15.83%. in cost of capital from 15.63% to 15.83% arises
at par i.e., Rs.
comes to l5.83%,.
to
Example5.3 100, thenofkp
Comes
premium of. Rs. 4 payable at the time of redemptión. This premium is a gain to
the company as indicated by the increase in cost of capital.
uders but reflect cost to
b e c a u s e

ABC Ltd. issues 15% Preference shares of the face value of Rs. 100 each at a

cost of 4%. Find out the cost of capital of Preference share if

a
flotation s h a r e h o

(i) the preference share

are to Rp: An approximation to kp can be quickly obtained by using the
irredeemable, and (ii) if the preference shares are redeemable after 10 years at a premium
Anproximation
of
following formulation:

10%.
Solution p
PD(Pa
+(P-Po)
+ Po)/ 2
/N
Ifthe preference shares are irredeemable then the cost of capital is 96 and is redeemable at par
the preference share is
issued at a net proceed of Rs.
15
96 15.63%
n case
then
at the
end of year 10,
If the preference shares are redeemable then
the cost of capital may be calculated by
15+(100-96)/10 15.71% -
solving the following equation ep (100 + 96)/2

Po
i=1 coST OF EQUITY SHARE CAPITALshare capital is by far the
most typical and
At kp 16%, the right hand side
of the equation may be written
of of cost of capital
measurement
equity
coupon rate in case of
of
15(PVAFa6%,10)+ 110 (PVFa6%, 10)
as The
The r e a s o n being that
there is no
conceptually a difñcult exercise.
of debt and preference share capital, the rate
154.833) +110 (.227) c a s e of cost of capital However, no such
Rs. 97.46
equity shares. In of dividend w e r e the starting
point respectively. commitment
interest and the rate Further, there is no
As the value is than Rs. 96, the rate of discount available for cost of equity shares capital. o r not to
Board of Directors to pay
more
may be increased to 17%. starting point is sole discretion of the
dividend and it is the
shareholders.
At kp = 17%, the right hand side of the equation may be written to pay equity dividend be paid to the equity
the
as:
to decide at what rate the profits of the company.
15PVAFa7%, 10+ 110(PVFa7%, 10) pay dividend or last claimant on
Moreover, the equity
sharehólders a r e the of capital a s such.
But ike
15(4.659) + 110(.208) the equity shares have no cost.
said that
Rs. 92.76. Therefore, it is often for equity share capital
preterence share capital,
it is also not true debt and
By interpolating between 16% and 17%, the value in the c a s e of
has a cost. Just a s
of kp «comes
of k, e
to 16.31% as follows share capital, like
other s o u r c e s ,
in the form of equity share.capital
of aa
497.46-9
6) Equity investors will invest
the funds
them for surrendering
kp 16%
preference shares, the which will compensate
(97.46 92.76)6.3 expect a return
from the firm,
be noted that, in
c a s e of debt
and preference
It may be noted that the cost of
capital of preference share, kp, is higher i.e., 16.31% when m onlyif they a s the risk
undertaken. It may rate.
the form of coupon
it is redeemed after 10
years at 10% premium. The reason for this is the ne funds as well from the firm w a s known in dividends from
premium payable at Snare capital, the return in the form of
the time of redemption. In the same available basically,
case, if the shares is must estimate the
redemption and the preference share is redeemable,premium
is not payable at the time
of
instead, at Rs. 96 only, then the cost of
return in c a s e of equity
The investors of equity
share capital

capital will be as follows: the potential dividend may then be discounted

une
firm. Therefore,dividend from the firm. This stream of which the expected
dividends
At 16%, the right hand side of the Equation 5.5 may be written as expected stream of value of such
stream. The rate of discount at
the cost of equity
share capital.
value is known a s
15(PVAFa6%, 10)) + 96(PVF16%, 10)) OEet the present their present by the
are discounted to determine function of the returns expected the
15(4.833) + 96(.227) share is a premise that
value of a market is based on the
Rs. 94.27 The present the share. This on the
the risk associated with value of all expected
future d i v i d e n d s
As the renolders and to the present Equation
value is less than Rs. 96, the rate of discount of share is equal share is sold. This
is represented by
may be decreased to 15 narket price when the
At realised
15%, the right hand side of the equation may be written sale proceeds
as: nare plus the
15(PVAFa6%, 10) +96(PVF(16%, 10) 6.7. Pa
Da
5.7)
15(5.019) + 96(.247) D . ( 1 4 * (14k,)
=
Rs. 98.99. Po 1+k* (1+k
 136
BASIC FINANCIAL MANAGEME
COSTOF CAPITAL

where. 137
Po Current Market Price of Equity Share
P Share market price after year n D
D, Dividends receivable over different
years
k Required rate of return of the shareholder or cost
of or,
= Da1g- D (5.11)
Equity Share Capital
In
Equation 5.7 and the subsequent discussion, it has been
dividends are payable only
annually. assumed that Example5.4
requires to ascertain the market priceEquation
5.7 does not seem to be equity
at the end of practical onea ABC Ltd. has just declared and paid a dividend at the rate 15% on the equity share of
year n, when
sold. However, the share
price at year n is itself the present value ofthe share is eventuol
atually expected future growth rate in dividends is 12%. Find out the cost of
100 each. Theshares
dividends plus the subsequent sale all th future expected Rs.
market value of the share is Rs. 168.
Equation 5.8. proceeds. Thus, Equation 5.7 may be modified eapital of equity that the
given present
to write ae
Solution:
Po = D D D, The cost of equity capital
in the case may be ascertained by using the Equation 5.11.

In Equation 5.8, the value

(1+k (1+k,2***sust (1+k.n t.....t D
(5.8) Do (1+8 +g
of k, is the cost of (1+k)
which will equate the discounted
value
equity share
of all future dividends capital i.e., the discount rate
Po
of the share. Now, the
estimation of future expected dividendswith the present market 16.8+ .12
value
required for calculation of ke- Different is the most 168
dividends. These assumptions and assumptions can be made about important
future
input = 22 or 22%
the caleulation
of k, have been taken up as follows:expected subject to the following
Zero-Growth
current level for
Dividends : It may be assumed that
dividends will remain
The formulations given in Equations
5.10 and 5.11 are

the assumed constant at the

treated perpetual life of the firm. In such a case, the dividend assumptions:
function of future expected dividends.
as a
perpetuity of dividends and the cost of equity share stream is 1. That the current market price of the share is a
with the help of capital, k, can be ascertained
Equation 5.9. 2. Do is> 0, i.e., the present dividend is positive.
= 3. The dividend pay out ratio is constant.
assumed to grow at
Po Dividends may also be
where, 5.9) Growth Rates in Dividends. 10%
e Cost OVarying 5 the growth rate may be
of Equity Share Capital different rates for different years.
For example, for first years,
be 15% per a n n u m and
thereafter
D= Expected dividend at the end of next 5 years the growth
rate may
year 1 per annum, then for the This means that the
dividend will grow
Po a n n u m infinitely.
Current market price the dividends may grow at 20% per for the year 11
Impliedly, zero-growth dividend of the share to 5, and at 15% for years 6 to 10 and at 20%
means that the firm is at 10% per annum for years 1 situations of dividend
take care of such
ratio and no profits are retained by the firm. Under such following policy of 100% pay out and thereafter. Equation 5.10
can be
modified to
with the help of Equation
5.12.
EPS, of the firm. In other words, when a
situation, the Di will be equal to therefore be calculated
Stream and the cost of capital may -10 (5.12)
is 100% then, earnings are constant and the dividend pay out ratio Po Ds(+8=5 (1+k
E =
E2 =
E3 ..... (1+k i= 6 (1+k
E,n and share
D =D2 Dg. =
Current market price of the equity
On the basis of .. D, and therefore, E = D. where, Po =

Equation 5.9, and E =

D, Do = Dividend just paid by the company
E Dividend payable at
the end ofyear 5
k Po D =

Dividend payable at
the end of year 10
If may be noted on the
basis of this equation that D10 =

rates, and
also be defined as inverse of
the PE ratio.
k, =
1 (P/E1) and
therefore, k, 8182 andg3 =
Different growth
may Share Capital.
Constant Growth Rate
constant rate, say, 'g per cent in Dividends: Dividends may be assumed to
k = Cost of Equity
solved by trial
and error procedure to find out the value of k.
Equation 5.12 can be face a
the help of per annum. In such a case, cost of grow at a
equity can be found with o r External Equity : A firm may
Equations 5.10 and 5.11 as follows: OCost of Capital of Newly Issued Capital
issue of fresh equity capital in
order to finance the
raise funds by fresh issue to
Po o (1 +g) Situation where it needs to these funds raised by
must be earned on
new projects. If so, then
what return the firm to pay a
k-8 (5.110) worthwhile. The existing equity share capital expect
make the project
 BASIC FINANCIAL MANAGEM
138 MENT cOSTOF CAPITAL

139
from the existing assets. Th
stream of dividends and this stream of dividends is earned The for Fresh Equity:
receive the same quantum of returns. Obvious
ev of Capital
equity capital will also likewise expect to Cost
D
new shares to obtain the same stream as that on existing shares, the new funds obtai
a return high enough to provid
kNP8
from the issue of fresh capital must be utilised to produce
dividend stream, whose present value is just equal to the net proceeds of fresh issue. In ot
other 48-50+08 = 1625 or 16-25%
words, the minimum rate of return which the new shares expect in order to prevent a deol.
in the market price of existing shares, is the cost of fresh equity.
cline
Theoretically speaking, the firm should therefore, sell the new shares at the curren cOST OF RETAINED EARNINGS
market price of existing equity shares. However, in the net to the firm
current Darnings generated by a firm should be ultimately distributed among the equity
practice, proceeds
will w
be reduced as the firm will be required to bear additional expenses of flotation includine areholders. However, if the entire earnings are not distributed and a part is retained by
underwriting expenses, brokerage, issue expenses, advertisement and above all a discount oe he firm, then these retained earnings are available for reinvestment within the firm. As the
potential investor to induce them to subscribe all the shares
the current price to the
offered tained earnings increase the shareholders equity in the same way as the new issue of
The cost of new equity shares can be estimated on the basis of Equation
5.11 bu iy share capital would do, the retained earnings are often considered as subscription to
determining the net proceeds after flotation cost, etc., and taking the assumption of constant
Ant
aditional share capital byexisting equity shareholders. However, the firm is not required to
nav dividend on this pat of' shareholders funds (i.e., the retained earnings portion), so it may
growth rate as follows:
heargued that the retained earnings have no cost as such. But this is not true. The cost of
h NP+8
N
retained earnings must be considered as the opportunity cost of the foregone dividends. Arom
where, NP = Net Proceeds from fresh issue, and
the point of view of equity shareholders, any-earning retained by the firm could have been
k=Cost of new equity. proitably invested by the equity shareholders themselves, had these been distributed to
them. Thus, there is an opportunity cost involved in the firms retaining the earnings and an
It may be noted that this
equation is almost the same as
replaced by NP and NP is Po because of flotation cost. The Equation
5.11 except that Po is estimation of this cost can be taken up as a measure of cost of capital of retained earningS,
«
the net proceeds from fresh k, wil be higher than k, because The cost of retained earnings, k,, is often taken as equal to the cost of equity share
capital, NP, will be lower than the current market
price, Po. equity
capital, ke, since the retained earnings are viewed as the fresh subscription to the
EXAMPLE 5.5 share capital. If a firm has to decide whether to raise funds by issuing new equity shares or
by retaining the earnings, it will have to find out the rate of return at which the investors
The share of ABC Ltd. is will be indifferent between whether the firm distribute the earnings or reinvests
dividends of Rs. 4 per share with
presently traded at Rs. 50 and the
company is expected to pay these
of the share which is used to
a growth rate
expected at 8% per annum. It plans to raise earnings for future growth. This is reflected in market price
freshequity share capital. The merchant banker has suggested that an determine the cost of equity. If the investors are not getting the expected returns from the
besides involving a cost of 50under-pricing
Rupee 1 is necessary in pricing the new shares of
firm's reinvestment, they will tend to sell their holding, forcing down the price until they get
miscellaneous expenses. Find out the cost
of existing equity shares as paisa per
on share ne expected return. By lowering the share price, the investors maintain the required rateof
equity given that the dividend rate and wel as the new returns. Therefore, the share price fully reflects the cost of capital of the retained earnings.
Solution: growth rate are not
expected change.
to
do, k,= ke.It may be noted that the cost of retained earnings is not to be adjusted for tax, for
In the Iotation cost and for the under-pricing. While retaining the earnings, the firm does not in
given case, the following information is available:
Market price, Po any way incur any such cost and the earnings to be retained are already after tax.
=
Rs. 50 per share
Under-pricing =
Re. l per share
WEIGHTED AVERAGE COST OF CAPITAL
Plotation cost
Net proceed, NP
=
Paise 50 per share Once the specific cost of capital of the long-term sources i.e., the debt, the preference
Rs. 50-1- .50 have been ascertained, then
Growth rate, g
8%
= Rs. 48:50 are capital, the equity share capital and the retainedofearnings
of capital the firm. The overall cost of capital
D Rs. 4
ext step is to calculate the overall cost be earned by the firm in order to satisfy the
Cost of Capital of y De defined as the rate of return that must
existing Equity : rements of the different investors. This overall cost
of capital should take care of the
structure of the firm. Therefore, this
V e proportion of different sources in ascapital
the
the weighted average rather than simple
c o s t of capital should be calculated cost of capital (WACC) 1s
g e of different specific cost of capital. The weighted average and may be described
as
KO+08 =16 or 16% fl as the weighted average of the cost
of different sources

follows:
WACC = ke. we + ka. Wat kp. Wp
 BASIC FINANCIAL MANAGEMET coST OF CAPITAL
140 141

WACC Weighted average cost of capital

et Value Weights: The weights may also be calculated on the basis of the
where, =

(b)
Cost of equity capital
s of different sources i.e., the proportion of each market
ke the market value weights, the firn has source at its market value. In order
=

After tax cost of debt

vleulate to find out the current market price
ka =

the securities in each

categories. The
kp = Cost of preference shares of th
advantages of using the market value weights
are
w, =
Proportion of equity capital in capital structure i) The market value weights are consistent with the
wa =
Proportion of debt in capital structure market value in the definition of the overall cost of concept of maintaining
w Proportion of preference capital in capital structure. capital.
(i) The market value weights provide current estimate
=

rate of return.
of the investor's required
In order to calculate the WACC, there must be a system of assigning weights to dito
specific cost of capital. Thefollowing considerations are worth noting while assigningu erent (iii) The market value weights yield good estimate of the cost of capital that would
to specific cost of capital to find out the WACC. weights be incurred if the firm requires additional funds from the
market.
However, the market values weights suffer from some limitations as follows
Historical, Marginal and Target Weights:
As already noted, the WACC is found
und by
weighing the
specific
cost of capital for each type of financing by its proportion in the ova () Not only that the market values of all types of securities issued have to be
capital structure. The weights which may be assigned and used to find out the overall obtained but also that the market value of equity share is to be segregated into
WACC
asfollows may be capital and retained earnings.
(a) Historical or Existing (ii) The market values are subject to change from time to time and so the concept of
Weights : Historical or existing weights are the
on the
actual or existing proportions of different sources in the overall weights based structure in terms of market values does not remain relevant
Such weighing system is based on the actual capital structure optimal capital
any longer.
being caleulated. In other words, proportions at the time when the
WACC is
the weighing system
funds have already been raised by the firm. The use
is the
proportions in which the
of historical weights is
(ii) External factors which affect the market value, will affect the
the investment decision
of capitalcost

important assumptions namely (i) that the firm would raise

the additional
based on two also and therefore,
external factors.
will be influenced
process the by
required for financing the investment resources
proposals, in the same proportions in which to between the book value and market value weights, the
are
appearing at present in the
structure is optimal and therefore capital structure, and (iü) that the present
they With respect
followingpoints are worth noting:
the choice
future also.
the firm wants to continue capital
with the same pattern in (a) It is argued that the book value is more reliable than market value because the former
(6) Marginal Weights : The is not as volatile.
wants to raise funds from marginal weights refer to the proportions in which (6) The WACC based on market value w
the firm generally be greater than the WACC based on
additional funds required to different sources. In other words the
finance the investment proportions in which book values. The reason being that the equity capital having higher specific cost of
marginàl weights. So, in case of proposals will be raised are known
WACC of the incremental
funds.
marginal weights, the firm in fact, calculates
the
a capital usually has market value above the book value. However, this is not the rule.
(c)
Target Weights: The target weights refer to
actua
(c)The choice between the bookInvaluesofand the market values is relevant only for
raise the funds from various the
proportion in which the historical and target weights.
not arise at all and the
case of choice does
marginal weights, the question
system reflects the desired sources in the long run. In other words, the firm plans to weighing system will be market value based only.
target weights system, thelong-term financial plans or target heisprocedure
capital structure of a firm.weights
of WACC has been explained with the help of Example
optimal capital structure firm in the first WACC for calculation
denoted by the term ko
56.
and instance, decides about
In tne
structure. This, then, will be proportion of different the shape of the
time, the actual achieved by the firm in sources in this
optimal EKAMPLLE 5.6
long run, the firmcapital structure may not be the the long run. At a particular caplta
O Book Value versus
intends to shape it as optimal capital structure, butpoln The following is the capital structure of ABC Ltd.
Market Value
an
optimal capital structure. in e

WACC can either be

different sources. based Weights : The
Source Amount Specifie CIC
on the book values or the weights to be
(a) Book Value market values of used for
the fundscalculation
Equity Share Capital Rs. 20,00,000 11%
of Weights: The raised (2,00,000 shares of Rs. 10 each)
different sources are weights are said to be book Preference Share Capital Rs. 5,00,000 8%
values. The book ascertained on the value weights if the propo rtions
information from thevalue weights can be basis of the face values . (50,000 shares of Rs. 10 each)
capital structure as easily calculated by i.e., the account inting
Retained Earnings Rs. 10,00,000 11%
given in the balance taking the
sheet of the firm. re
van
5% Debentures of Rs. 1,000 each Rs. 15,00,000 4-5%
 BASIC FINANCIAL MANAGENE c o S TO F CAPITA
TAL 143
142

at 94%, Preference shares at of Market Values

are being traded par Calculation
Presently, the Debentures
Equity shares at Rs. 13 per
share. Find out the WACC based on book value value weightand a
e
Jate :
Total market value of Equity 2,00,000 =
13 =
Rs. 26,00,000
market value weights. ut
Rs.
of Rs 26,00,000, Equity Share Capital proportion is 26,00,000 (2/3) = Rs. 17,33,333
Solution: ortion of Retained Earnings is Rs. 26,00,000 (1/3) = Rs. 8,66,567. (Because equit
and i t a l and the Retained Earnings are in the ratio of 2: 1 in the capital structure).
L WACC based on Book Value Weights:
Source BV (Rs.) Weights CIC
Weighted CIo SD T o t a l .market
value ofPreference
Share Capital is 50,00 10 Rs. 5,00,000.

Pref. Share Capital 5,00,000 080 0080

al market value of 75% Debentures is Rs. 15,00,000x 94 Rs. 14,10,000.
of the
the WACC has been defined as the weighted average
Equity Share Capital 20,00,000 4 110 0440 Tn the above discuss1on,
of sources of funds. Suppose, a firm has raised total funds by
Retained Earnings 10,00,000 2 110 0220 ific cost of capital difterent derived as
Share Capital (E) and Debt (D). The WACC for the firm can be
specifio

15,00,000 3 045 he issue of Equity

7:5% Debentures 0135
50,00,000 1-0 0875 follows WACC [D/D + E)] x ky + [E//D + E)] x ,

So, the WACC based on book values is 8:75%. The WACC can also be calculated a where, ka = After tax cost of debt, and
follows k, = Cost of Equity Share Capital
funds by the issue of Equity
BV (Rs.) which has raised 70% and 30% of its total
Source CIC BVx C/C Consider a firm rate of return for Equity capital
is 16%. The
12% Debentures. The required
Pref. Share Capital 5,00,000 080 Shares and calculated as follows (assume that
the tax rate is 30%):
40,000 firm can be
Equity Share Capital 20,00,000 110 2,20,000 WACC of the
-12 (1-3) 084
Retained Earnings 10,00,000 110 1,10,000 ka = =

7-5% Debentures 045 k 16

15,00,000 67,500 16
50,00,000 WACC = [-3/3 + 7)] x -084 +
[ 7/3+ 7)] x

4,37,500 13 72%.
4,37,500 * 100 =8 75%
WACC 50,00,000
P O I N T S TO REMEMBER

2. WACC based on Market Value Weights which firm must earn on

its funds in
required rate of
return
is the minimum from capital budgeting
T h e cost of capital funds. If the return
Source its supplier of the wealth of the
MV (Rs.) Weights CIC Weighted Cc order
to satisfy the expectation of
than the cost of capital,
then the diflerence
will be added to
Pref. Share Capital 5,00,000 111 080 0089 proposals is m o r e

shareholders. as well as in
finalizing the
Equity Share Capital 17,33,333 384 110 0422 in capital budgeting and the
has a role to play risk-free interest rate
Retained Earnings concept of cost of capital depends upon the
8,66,667 192 110 0211 The The cost
for the firm.
of capital
7-5% Debentures capital structure
investment.
14,10,000 the risk of the
313 045 0141 risk premium which depends upon the tirm pays to the
cost, whichfirm. The cost of capital
45,10,000 1-00 0863 be defined in of (1) Explicit
terms
the funds to the
The
cost of capital may
cost i.e., the
opportunity
cost of

So, the WACC based on market values is 8-63%. The WACC can also be calculated as Supplier and (2) Implicit
is calculated in after tax
terms. Debt, Pref. share capital,
follows: be grouped into cost of capital.
to the firm may have their specifie
s o u r c e s of
funds available and these s o u r c e s average of
Different Retained Earnings as the weighted
Source MV (Rs.) share capital and be a s c e r t a i n e d
CIC Weighted CIC quty overall cost of capital
of the firm may

Pref. Share Capital iowever, the upon the

rate
of
Equity Share Capital
5,00,000 080 40,000 these specific cost of capital.
Share Capital
basieally depend
Rate of Interest
(1- t)
cost of Pref. detined a s k
=

17,33,333 110 1,90,667 T h e cost

of Debt and values ünd are
Retained Earnings and the
issue/redemption

7-5 Debentures 8,66,667 110 95,333 nterest/dividend

+ g. The
cost of retained
and Rate of Dividend.
kp DP, o r k, D,P,
=

14,10,000 is deined as k,
=

045 63,450
capital, k,, have any
=
tlotation cost.
share does not value
45,10,000 3,89,450
h e
cost of equity of equity a s
the lormer
ascertained by applying
book
lower than cost
caurning is WACC, may be WACC is denoted
as
kg
of Capital, of tunds. The
Avernge Cost sources

WACC = 3,89,450 T h e Weighted different

market value
weights of
X 100 =
863%. weghts or
45,10,000
 c O S TO F C A P I T A L
145

144
BASIC FINANCIAL MANAGEMER
ar required to compute a weighted average cost of capital on existing capital
Yo
GRADED ILLUSTRATIONS structure.

Solution:

Illustration5.1 Cost of Debt

(after tax):

tax at 40%o, compute the after-tax

cost of capital in k = 10 (1-.3) = 7%
Assuming that the firm pays
following cases at share capital : k,=+g
(i) A14-5% Preference share sold par. Cost ofEquity
rate being 11:25%.
(ii) A Perpetual bond sold at par, coupon Rs.2 15%
08+ 07
(ii) A ten year 8% Rs. 1,000 per bond sold
at Rs. 950 less 5% underwriting commission.
Rs. 25 +07
120 and paying a current dividend of
(iv) An Equity share selling at a market price of Rs.
Rs. 9 per share which is expected to grow at a rate of 8%. Calculation of WACC:
Specific C/C Wx CIC
Solution: Source
Amount Weight
15. 07500
i) The Cost of Preference Shares (after tax) is 14-5%. Equity Share Capital Rs. 80,00,000 500
10 01250
Gi) The Cost of debt is Rs. 20,00,000 125
Share Capital 07 02625
ka=11-25% (1- 4) = 675% 10%Pref. Rs.60,00,000 375
ii) Approximate kais:
10% Debentures
1,60,00,000 1.000 11375
t Tax rate
The WACC
is 11-375%
RV = Redemption Value of the bond
Bo = Net Issue price of the bond

N Life of the bond

Illustration 5.3 The company has paid
market at Rs. 20 currently.
share is quoted in the rate of 5 per cent per
Your company's growth
k 80(1-.4)+ (1000-950)+10 a
investor's market expects
share and the
(1000-950)+2 dividend of Re. 1 per

48 +5 year.
0543 or 5-43% are required to compute
975 You
Cost of Capital. rate is 5 per
(iv) Po 120 The company's Equity the anticipated growth
(i) is 8 per cent and be paid at the
cost of capital of Re. 1 is to
Do =9 iü) If the company's price if the
dividend
cent per annum,
calculate market
8 8%
end of one year.
So, D = 9 (1+ 08) =9-72
D. 9.72, o9- Solution:
Now, k is:
P +8120+ 08 161 i) The Equity cost of capital, k,
= =
or
161
Illustration 5.2
Satija company has following capital structure on 1 July 2008
10505 =10-25%
20
Equity Shares (4,00,000)
Rs.80,00,000 5% and Di = 1:
10% Preference Shares
20,00,000
) Ifk =8%,g =

10% Debentures D
Po k-8
60,00,000
1,60,00,000 = Rs. 3333
The Equity shares of a -08- 05
will pay a dividend of Rs. 2 company currently sell for Rs. 25. It is expected that the company would be Rs. 33-33.
per share which will grow at 7 share at present
cent tax rate. Preference Shares per cent forever. Assume a 30 per 0, the market price of the
and Debentures are traded at
par,
146 BASIC FINANCIAL MANAGEM
NENT c o S TO F CAPITAL
147
Illustration 5.4 S o l u t i o n :
In the ven case, the cost of debt is : Rate of interest (1-t)
The following figures are taken from the current balance sheet of Deleware & Co.
12% Debentures 12 x 0-60
Capital Rs. 8,00,000 7-2%
18% Term Loan 18 x 0.60
Share Premium 2,00,000 10-8%
6,00,000 The cost of capital (as per premise-a):
Reserves
Shareholder's funds 16,00,000 Cost
Sources
Proportion Weighted cost (Rs.|
126 Perpetual debentures 4,00,000 Equity Share Capital 20% 4/20 4-00
An annual ordinary dividend of Rs. 2 per share has just been paid. In the
past, ordinar 129%Debentures 7-2% /20 1-44
dividends have grown at a rate of 10 per cent per annum and this rate of growth is expecta 189% Term loan 8% 12/20
to continue. Annual interest has recently been paid on the debentures. The ordinary
shares 648
are currently quoted at Rs. 27-50 and the debentures at 80
per cent. Ignore taxation.
Weighted average cost (%) 11-92
You required to estimate the Weighted Average Cost of Capital (based on
are
The cost of capital (as per premise-b):
values) market
In this case, the cost of debt is as above, and the cost of equity is : k, = 20
1O 125%.
Solution:
In order to calculate the WACC, the specific cost of equity capital and debt capital are to Cost Weighted cost (Rs.)
be calculated as follows: Sources Proportion
Rs. 2 x11 Equity Share Capital 12-5% 4/20 2-50
Rs. 27-50 10 18% 12% Debentures 7-2% 4/20 1-44
The market value of
equity is 80,000 x Rs. 27-50 Rs. 22,00,000 18% Term loan 10 8% 12/20 648
ka
R4 Rs.12 Weighted average cost (%) 10-42
Bo Rs. 80 1
The market value of debt is
4,00,000 x .80 =
Rs. 3,20,000.
Now, the WACC is: Illustration 5.6
(22,00,000/25,20,000) 18+ (3,20,000/25,20,000)
x
x 15 =
176 17-6% The following information is available from the Balance Sheet of a Company:
Note In: this case, the dividend
of Rs. 2 has just been
expected after one year from now will be Do (1 paid. So, Do= Rs. 2
i.e., dividend and the Equity Share Capital-20,000 shares of Rs. 10 each Rs. 2,00,000
D
+g) Rs. 2 1:10.
x =
x
Reserves and Surplus Rs. 1.30,000
Illustration 5.5 8% Debentures Rs. 1,70,000
The following information The rate of tax for the company is 30%. Current level of Equity Dividend is
has been extracted from the
balance sheet of Fashion Ltd. 12.
on31.12.2008: as
Caleulate the Weighted Average Cost of Capital using the above figures.
Rs. in Lacs
Equity Share Capital Solution:
12% Debentures 400 Proportion of Capital
Capital Structure Amount
18% Term-loan 400 Structure
1,200
Equity Share Capital Rs. 2,00,000 40
(a) Determine the 2,000
Weighted Average Cost of Capital of the
Reserves and Surplus 1,30,000 26%
dividends at a consistent
at par. Tax rate is
40%.
rate of 20% per annum. company. It
Shares and debentures are
had been paylu
being traaeu
Net Worth 3,30,000 66%
(6) What difference will it make if the current price of the Rs. 100
89% Debentures 1,70,000
--

34
share is Rs. 160? 5,00,000 100%
 BASIC FINANCIAL MANAGEME c o S T OF CAPITAL 149
148 ET
Amount
Proportion After-tax
Weighted Aut of different
is 40%
roportion is 40%.
debt proportion8, the
firm has the minimum WACC when the debt
So, the Optimal Capital structure is consisting of 40% Debt and b0o
Cost
Capital
Rs. (weight) Cost would be 3-4%.
Structure theWACC
40% 12% 12% x 40% Equity and
Equity 2,00,000
26% 12% 12% x 26%
=
4-80 Illustration 5.8
Reserves and Surplus 1,30,000
5-6%
3
5-6% 34% 12%
x
=
34%
8% Debentures 1,70,000 190% =
POR& Co. has the tollowing capital structure as on Dec. 31, 2008
100% Equity Share Capital (5000 shares of 100 each) Rs. 5,00,000
Total 5,00,000 9-82
is not given, the cost of capital of equitv ch. 9% Preference Share Capital Rs. 2,00,000
As the current market price of equity
dividend and the tace value of the share. 10% Debentures Rs. 3,00,000
been taken with reference to the rate of
12/100 12%. are quoted at Rs. 102 and the company is expected to
The equity shares of the company
The opportunity cost of retained earnings is the dividends foregone by sharehola. company has registered a
Therefore, the firm must earn the same rate of return on retained earnings as on the Eonit
declare a dividend
ot
Ks. s per share for the benext year. The
Share Capital. Thus, the cost of retained earnings is equal to the cost of equity capital ie
dividend growth rate of 5% which is expected to maintained.
the
tax rate applicable to the company at 30%, calculate the Weighted
() Assuming
Average Cost of Capital, and
can raise additional Term loan at 12% for Rs. 5,00,000
to
Tlustration 5.7 (i) Assuming that the company is that
finance its expansion, calculate the revised WACC. The company's expectation
In considering the most desirable capital structure for a down the market price
company, the following the business risk associated with new financing may bring
estimates of the cost of debt capital (after tax) have been made at various from Rs. 102 to Rs. 96 per share.
levels of debt.
equitymix:
Debt as percentage of Total Solution:
Cost of Debt Cost of Equity The present WACC may be calculated as follows:
Capital employed = k = (Di/Po) + 8
(To) (%) Cost of Equity capital
0 (9/102) + 05 1 3 8 or 13-8%
7-0 15-0
10
20
7-0 15-0 Source Weight CIC Weighted C/C
7-0 155 13-8% 6-9%
30
7-5 Equity Share Capital 1-8%
40 16-0 9%Preference Share Capital 2 9-0%
8:0 17-0 10% Debentures 7-0% 2:1%
50
8-5 19-0 WACC 10-8%
30
9-5
20-0
You are
required the company decides to raise Rs. 5,00,000 by the issue of 12% Loan and the market
to find the It
proportions of debt. weighted average cost of capital of the firm for of theshare is expected to go down to Rs. 96, then the WACC may be calculated a s
Solution: diriere Prce
follows:
The WACC of =k = (D,/Po) +S
the firm may be Cost of Equity Capital
Debt % kao
ascertained as follows: = (9/96) + 05
CICx Debt% = 144 or 14-4%
7-0
Equity % ke o CIC x Equity % WACC%
10 7-0 100 15-0 Source Weight CIC Weighted C/C
70 15:0 15-00
20 90 144 475%
7-0 1-40 15-0 Equity Share Capital 33
30 7-5 80 155
13-5b1 14-20 9% Preference Share Capital 14 9-0% 1-26%
2-25 124 13-80
40 8-0 70 10% Debentures 20 7-0% 1-40%
3-20 16-0 11-2 1345
50 60 2:77%
8.5 4-25 17-0 13-40
12% Loan 33 8:4
60 50 10-2
9-5 5-70 190 WACC 1-00 10-18%
40 9.5 13-75
20-0 13-70
8-0 D0, the new WACC of the company would be 10-18%.
150
BASIC FINANCIAL MANAGEME
MENT
c o S TO F CAPITAL
151

Statement Showing Weighted Average Cost of

llustration 5.9 Capital
Amount After-tax
structure: Weights Weighted
A Limited has the following capital Cost
Cost
Rs. 40,00,000 Equity share capital 40,00,000
Equity capital (2,00,000 shares)
share 270 40 i08
share capital 10,00,000
6% Preference share capital 10,00,000 6%
Preference 060 10 006
30,00,000 8%Debentures 30,00,000 056 30 017
8 Debentures 20,00,000
10% Debentures
070 20 014
80,00,000 145
Rs. 20. lt is expected that comnar
The market price of the company's Equity share is
will pay a dividend of Rs. 2 per share at the end of current year, which will grow at 7 per o So, Weighted Average cost of capital (ko) 14-50%
cent Rs. 3
for ever
C)
k R. 10
The tax rate is 30 per cent. You are required to compute the following:
20+ 10 =
30 or 30%.
(a) A weighted average cost of capital based on existing capital structure.
Statement Showing Weighted Average Cost of Capital
6) the new weighted average cost of capital if the company raises an additional
Rs. 20,00,000 debt by issuing 10 per cent debentures. This would result in increasing Amount After-tax Weights Weighted
the expected dividend to Rs. 3 and leave the growth rate unchanged but the price of Cost Cost
Equity share capital 40,00,000 300 40 120
share will fall to Rs. 15 per share.
6% Preference share capital 10,00,000 060 10 006
(c) The cost of capital if in (6) above, growth rate increases to 10 per cent. 30,00,000 056 30 017
8% Debentures
10%Debentures 20,00,000 070 20 014
Solution:
1.00 157
(a) The cost of Equity capital is
Rs. 2 cost of capital (ko) is 15-70%.
, Rs. 20+70 So, Weighted Average
= 01+07 = 17 or 17%. | Illustration 5.10
The cost of 8% Debentures, after tax, is 8 (1- .3) 5-6% 8-57% Debentures, 9% Preference
capital structure of XYZ & Co. is comprising of
=

The
The
of 3:2:5. is
company
Statement Shares and some Equity shares of Rs. 100 each in the ratio
Showing Weighted Cost of Capital meet the needs of expansion plans by raising
Considering to introduce additional capital to of this proposal, the proportions of different
After-tax Weights Weighted Uo Loan from financial institutions. As a
result
Amount Cost Cost a0Ove sources would go down by 1/10, 1/15 and 1/6 respectively.
the firm given that
Equity share capital find out the impact on the WACC of
40,00,000 170 500 0850 n the light of the above proposal, of Rs. 9 at the end of the year
and (ii) the growth
6% Preference share capital 10,00,000 060
tax rate is 30%, (ii) expected dividendis expected in dividends, growth rate, market price of
125 0075
, may be taken at 5%. No change
89% Debentures loan.
30,00,000 056 375 0210 e share, etc., after availing the proposed
1.00
- -- Solution: Weighted1
.1135 CIC Weighted Weight CIC
Source Weight CIC
So, Weighted Average Cost of Capital, k, is 11-35%. (Existing)
CIC (New)
5/15 14% 4-62%
Rs. 3 14% 7-00%
(6) ka Equity share capital 5/10 1-26%
Pa Re. 1507 Pref. share capital 2/10 9% 80% 2/15
3/15
9%
6% 1-20%
180%
20+07 27 or 27%. 8:5% Debentures 3/10 6%
5/15 7% 2 19%
10% Loan (New) 9-39%
The cost capital of new Debentures (after tax) is 10% (1 -

.3) =7%. WACC 10-60 ---

 BASIC FINANCIAL MANAGEME
coSTOF CAPITAL
153
152
from 10-60% (present level) to 9-39q Source Weights Specific cost Weighted cost
So, the new WACC of the company would change
funds 12,15 16,h0,00/3055 1800 0-0990
Working Notes follows
shares
, , 0 do015 1530 0-0229
The new weights of different sources have been calculated as
16%Preference 0-30
5/15 14%Debentures 0-0931 0-0279
Capital (5/10 1/6) 1/3
=
Equity Share
=
2/15 1.00
Preference Share Capital (2/10 -1/15) =
0-1498
12% Debenture (3/10-1/10) = 1/5 = 3/15
Cost of Capital, (kg), is
5/15. So, Weighted Average 14.98%.
Loan(New) (1/10 + 1/15+ 1/6) =
Illustration 5.12
Illustration5.11
An electric equipment manufacturing company wishes to determine the Weighted The latest Balance
sheet
of D Ltd. is given below
Average Cost of Capital for evaluating capital budgeting projects. You have been supplied (Rs. '000)
Equity Shares (50,000 shares)
with the following information 500
100
Share Premium
BALANCE SHEET (Retained Profits) 600
Liabilities Amount Assets
Amount 1,200
Equity shares capital1 Rs.
12,00,000 Fixed Assets Rs. 25,00,000 8% Preference Shares 400
Preference share capital 4,50,000 Current Assets 13% Perpetual Debt (Face value Rs. 100 each) 600
Retained Earningss 4,50,000
15,00,000
Debentures 9,00,000 2,200
Current Liabilities The Equity shares are currently priced at Rs. 39 ex-dividend each and Rs. 25 Preference
10,00,000 share is priced at Rs. 18 cum-dividend. The Debentures are selling at 110 per cent ex-interest
40,00,000 40,00,000 and tax is paid by D Ltd. at 40 per cent. D Ltd's Cost of Equity has been estimated at 19-per
Additional Information: cent.
() 20 years 14% Debentures of Rs. Calculate the Weighted Average Cost of Capital, WACC (based on market value) of D
2,500 face value, redeemable at 5%
sold at par, 2% flotation costs. premium can be Ltd.
(ii) 15% Preference shares Sale price Rs. 100 per
share, 2% flotation costs. Solution:
(ii) Equity shares: Sale The WACC can be caleulated on the basis of specific cost of capital of the firm as follows
The corporate tax rate is
price Rs. 115 per share, flotation costs, Rs. 5 per share.
35%. The Cost of Equity capital =k = 19% (given)
growth rate in equity dividends is 8% p.a.expected dividend after one year is Rs. 11 and the
Cost of Preference share.:
Solution:
Rs.
Specific costs: kpPoRs. 18-2 125%
Cost of Perpetual debt
=I(1-t)+ (RV- Bo/N
(RV+B/2 I(1-t) Rs.R13s .(1-
110 7-1%
Rs. 350 (0-65) +(2,625-2,450/20 Bo
(Rs. 2,625 +2,450)/2 Calculation of WACC:
Rs. 227-50 +8-75 Source Market Value Weight C/C% Wx CIC%
Rs. 2,537-50 9-31%
. 15 Equity capital (50,000 x 39) Rs. 19,50,000 68 19-0 12-92
RpRs. 100-2 =15-30%
8% Preference share (16,000x 16) Rs. 2,56,000 09 12.5 1-12
13% Perpetual debt (6,000x 110) Rs. 6,60,000 23 7-1 1-63
k,
Pa-+8 Re. 110+8%= 18% 28,66,000 1.00 15.67
Therefore, the WACC of the firm is 15-67%.
154
BASIC FINANCIAL MANAG c O S TO F CAPITAL
AEMENT 155
(xviii) ained
Retained earn earnings have no market value, so these
llustration 5.13 are not included in WACC (based on market
value).
The following information is provided in respect of the specific cost of capital oc
(Answers (i) T, (u) 1, u) P, (u)T, (v) P, (vi) F, (vii) F, (oii) F, (ix) F, )
Sources along with the book value (BV) and market value (MV) weights.
CIC BV
forent T. Cxiu) F, (xv) T, (xvi) P, (ruii) F, (zvii) FJ T, (xi) F, (xii) T, ziii)
Source MV Theoretical Questions
Equity share capital 18% 50
58 L
short notes on
Preference share 15% 20 1. Write
17 (a) Market Value Weights.
Long-term Debts 7% 30
Calculate the Weighted Average Cost of Capital,
25 (b) Implicit cost of capital.
WACC, using both the BV and
thae le
veights. MV (c) Target weights.
. Why is the cost of capital most appropriately measured on after-tax basis? What effect does
Solution:
this have on specific cost of capital.
The WACC on the basis
of BV and MV weights may be calculated as follows: 3. What is the relevance and significance of cost of capital in capital budgeting? How does the
Source BV MV cost of capital enter the capital budgeting process?
CIC BVx CIC
Equity share capital 50 58
MVx CIC 4. The Cost of Preference capital is generally lower than the Cost of Equity. State the reasons.
18 090 5. Why is that the debtcheapest source of finance for a profit making firm?
Preference shares 20 17
1044
15 030 6. How can you determine the coat ofequity capital in a growth firm?
Long-term debt 25
0255
07 021 7. "As there is no explicit cost of retained earnings, these funds are free of cost". Critically
1.00
********
0175
1.00 ***** comment
The WACC based on BV ------ -
141 1474 8. "New issue of capital is costlier than the retained earnings". How and what makes these two to
The WACC based on MV weights 14-1%, and
is
*****--
*****-
differ ?
weights is 14:74%.
PROBLEMS
ASSIGNMENTS P5-1. Calculate the cost of capital in each ofthe following cases
Objective Type Qnestions ) A 7-years Rs. 100 bond of a firm can be sold fora net price of Rs. 97-75 and is redeemable
State whether each at a premium of 5%. The coupon rate of interest is 15% and the tax rate is 55%.
of the following
i) The cost of statements is True (T) or False
capital is the (F): ) A company issues 10% Irredeemable Preference Shares at Rs. 105 each (FV = 100).
(i) Different sources required rate of return to
maintain the value of the (i) The current market price of share is Rs. 90 and the expected dividend at the end of
of funds have firm.
(ii) Cost of
capital does
a
specific cost of capital related to that source current year is 4-50 with a growth rate of 8%.
not
(iv) Cost of comprise any risk premium. only. (iv) The current market price of a share is Rs. 134. The company has just paid a dividend of
capital is basic data for NPV
rate and cost of technique.
(u) Risk-free interest 3-50 with expected growth of 15% over next 6 years and a growth rate of 8%
Rs.
(vi) Different sources capital are same things. thereafter.
have same cost of capital. (u) The current market price of shares is Rs. 100. The firm needs Rs. 1,00,000 for expansion
(vii) Tax iability of the
firm is relevant and the new shares can be sold only at Rs. 95. The expected dividend at the end of
(viii) Cost of Debt for cost of
and Cost of Pref. share capital of all the sources of current year is Rs. 475 with a growth rate of 6%. Also calculate the cost of capital of new
(ix) Every source of capital, both, funds.
explicit cost of capital.require tax adjustment.
fund has an equity.
Ct) WACC is the A company is about to pay a dividend of Rs. 1-40 per share having a market
overall cost of (U price of
(axi) Cost of Debt is
the same as
capital of the firm. Rs. 19-50. The expected future growth in dividends is estimated at 12%.
xii) Cost of Pref. share the rate of
(riii) Cost of capital is determinedinterest.
Answer: ) 7-74%, (i) 9:525%, (ii) 13%, iv) 12°%, (v) and 11% (vi)10 75%
o . ( a ) A company raised preference share capital of Rs. 1,00,000 by the issue of 10% Preference
20-66%,
Equity share capital by the rate of
fixed dividend.
(xiv) Cost of
existing share depends upon the share of Rs. 10 each. Find out the cost of preference share capital when it is issued at (i)
(xu) Retained capital and fresh issue ofmarket price of the share. 10% premium, and (üi) 10% discount.
(xui)
earnings have implicit cost capital are same. (6) A company has 10% Redeemable preference share which are redeemable at the end of
WACC is always calculated with only. 10th year from the date of issue. The underwriting expenses are expected to be 2%. Find
cvii) Book value & Market Value reference to book out the effective cost of preference share capital.
weights are always values of different c) entire share capital of acompany consists of 1,00,000 equity share of Rs. 100 each.
different. sources of funds. The
Its current earnings are Rs. 10,00,000 p.a. The company wants to raise additional funds
of Rs. 25,00,000 by issuing new shares. The flotation cost is expected to be 10% of the
 BASIC FINANCIAL MANAGEMENT OF CAPITAL 157
156
face value. Find out the
cost of equity capital given nings are
that the earnings are.
expected Calculate the Weighted Average Cost of Capital, ky, using Book value weights, and Market
remain same for coming years.
t value weights.
(c) 11.1%.]
Answer: (a) 9-09% and 11-11%, (6) 10-3%, [Answer: WACC (BV) is 13-796 and WACC (Mv) is 14-5%.]
funds of about Rs. 100 lakhs by one of two
P5:3. A company is considering raising of
loan or 13% Non-convertible debentures. The Tative
altern
s
has the following amount and specific costs of each type of capital
method, viz, 14% Institutional term would have l0an to be is
P5-9. A company
would attract no
major incidental cost. "The debentures
option of 2-5% and would involve cost of issue of Rs. 1,00,000. Type of capital Book Value Market Value Specific Costs
discount
Advise the company as to the better option based on the eitectave cost of capital in each Preference Rs. 1,00,000 Rs. 1,10,000 8-0%
Assume a tax rate of 50%. case 6,00,000 12,00,000 13-0%
13% NCD has an effective cost and hence is
of 6-74% better. Equity
Answer:
P5-4. The shares of a
company are at Rs. 20 per share. It has
being currently sold just Retained earnings 2,00,000
dividend of Rs. 2 for the last year. The of
profits
the paid a
company are expected
to show
a
10% p.a. and the company maintains a 100% payout ratio. Determine the cost of eguie
growth of
Debt 4,00,000 3,80,000 5-0%
of the company. Total
What should be the expected current price of the share if the
13,00,000 16,90,000
growth rate is () 8% or (i) 12
[Answer: ke = 21%, Expected price would be (1) Rs. 16-61 or (ti) Rs. Determine the weighted average cost of capital using (a) Book value weights and, (6) Market
P5-5. The
24-88]
following is the capital structure of a firm: value weights. How are they different ? Can you think of a situation where the weighteed
average cost of capital would be the same using either of the weights ?
Source of finance Amount (Rs:)
11% Preference share
capital CIC Answer : WACC(BV) 10-1% and WACC(MV) 10-9%.1
Equity share capital 1,00,000 11% P5-10. ABC Ltd. has the following capital structure:
Retained earnings (Reserves) 4,50,000 18% 4,000 Equity shares of Rs. 100 each Rs. 4,00,000
16%Debt 1,50,000 18% 10% Preference shares 1,00,000
Calculate the weighted
average cost of capital of the firm, based on
3,00,000 8% 11% Debentures 5,00,000
[Answer:WACC is 14-3%.]
P5-6. The
the book value
weights. The current market price of the share is Rs. 102. The company is expected
to a
declare
following is the extract from the financial dividend of Rs. 10 at the end of the current year, with a n expected growth rate of 10%. The
Operating Profit statements of ABC Ltd. applicable tax rate is 50%.
-Interest on Debentures Rs. 105 lacs () Find out the cost of equity capital and the WACC, and
-Income tax Rs. 33 lacs
Net Profit (1) Assuming that the company can raise Rs. 3,00,000 12% Debentures, find out the new
Rs. 36 lacs is
Equity share capital (of Rs. WACC if (a) dividend rate increased from 10 to growth rate is reduced fromn
12%, (6)
10 each) Rs. 361lacs 10 to 8% and (c) market price is reduced to Rs. 98.
Reserve and Surplus
15% Rs. 200 lacs Answer: (i) k, 19 8%, WACC 11-7%, Gi) k, 20-2%, WACC 105%.]
Debentures (Rs. 100 each)) Rs. 100 1acs
Total Rs. 220 lacs
The market price of equity Rs. 520 lacs
out (0)
EPS, (ti) % cost of shares and debentrues is Rs.
P5-7. Answer: BPsis Rs. 1-80;capital of equity and debentures.
XYZ Ltd. , = 15% and ka= 8%.]
12 and Rs.
93-75
respectively. P ind
is 10%. It has
is
an annual profit of Rs.
50,000 and the
dividends further expected that the required rate
receivedtoand invested
retained earnings shareholders will
by them
of
have to incurreturn ot the sna -holder
LAnswer:k,=6:79%.)the firm given that thefortaxmaking new
3%o
brokerage af the
P5-8. The
following is the capital rate investments.
applicable Find out cos
to the
shareholders 300
structure of XYZ 1s
Ltd.
Source
14% Preference capital
Cquity capital Amount Market Value
Rs. 2,00,000 CIC
16%Debt Rs. 2,30,000
Total 5,00,000 14%
3,00,000 7,50,000 17%
10,00,000 2,70,000 8%
12,50,000