CHAPTER 3

THE COST OF CAPITAL

1.1. The Concept of Capital
The term capital refers to the total investment of the company in terms of money, and assets. It is
also called as total wealth of the company. When the company is going to invest large amount of
finance into the business, it is called as capital. Capital is the initial and integral part of new and
existing business concern.
The capital requirements of the business concern may be classified into two categories:
(a) Fixed capital
(b) Working capital
Fixed capital: is the capital, which is needed for meeting the permanent or long-term purpose of
the business concern. Fixed capital is required mainly for the purpose of meeting capital
expenditure of the business concern and it is used over a long period. It is the amount invested in
various fixed or permanent assets, which are necessary for a business concern. Fixed capital is
comparatively easily defined to include land, building, machinery and other assets having a
relatively permanent existence and characterize as:
 Fixed capital is used to acquire the fixed assets of the business concern.
 Fixed capital meets the capital expenditure of the business concern.
 Fixed capital normally consists of long period.
 Fixed capital expenditure is of nonrecurring nature.
 Fixed capital can be raised only with the help of long-term sources of finance.
Working capital: is the capital which is needed to meet the day-to-day transaction of the
business concern. It may cross working capital and net working capital. Normally working
capital consists of various compositions of current assets such as inventories, bills, receivable,
debtors, cash, and bank balance and prepaid expenses. Working capital is needed to meet the
following purpose:
 Purchase of raw material
 Payment of wages to workers
 Payment of day-to-day expenses
 Maintenance expenditure etc.

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1.2. Definitions of Cost of Capital
Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance manager must take careful
decision with regard to the cost of capital; because it is closely associated with the value of the
firm and the earning capacity of the firm. Cost of capital is the required rate of return on its
investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at
the expected rate, the market value of the shares will fall and it will result in the reduction of
overall wealth of the shareholders.
The cost of capital is an extremely important financial concept. It acts as a major link between
the firm’s long-term investment decisions and the wealth of the owners as determined by
investors in the market place. The cost of capital is the ‘magic number’ that is used to decide
whether a proposed investment will increase or decrease the firm’s stock price.

Every business organization has its own risk-return characteristics. Investors (bondholders,
preferred stockholders, and common stockholders) require a minimum rate of return
commensurate with the risk it accepts by investing in the firm. From the standpoint of the
corporation investors provide the capital needed to finance the firm’s investment. The minimum
rate of return that the firm must earn in order to satisfy its investors for a given level of risk is
called cost of capital.

Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally
long- term finance such as equity and debt consist of fixed cost while mobilization. When the
cost of capital increases, value of the firm will also decrease. Assumption of Cost of Capital

Cost of capital is based on certain assumptions which are closely associated while calculating
and measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and financial risk.

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Cost of capital can be measured with the help of the following equation.
K = rj + b + f.
Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = the business risk premium.
f = the financial risk premium.
1.3. Significance of Cost of Capital
Computation of cost of capital is a very important part of the financial management to decide the
capital structure of the business concern.
(i) Importance to Capital Budgeting Decision: Capital budget decision largely depends on
the cost of capital of each source. According to net present value method, present value of
cash inflow must be more than the present value of cash outflow. Hence, cost of capital is
used to capital budgeting decision.
(ii) Importance to Structure Decision: Capital structure is the mix or proportion of the
different kinds of long term securities. A firm uses particular type of sources if the cost of
capital is suitable. Hence, cost of capital helps to take decision regarding structure.
(iii) Importance to Evolution of Financial Performance: Cost of capital is one of the
important determining which affects the capital budgeting, capital structure and value of the
firm. Hence, it helps to evaluate the financial performance of the firm.
(iv)Importance to Other Financial Decisions: Apart from the above points, cost of capital is
also used in some other areas such as, market value of share, earning capacity of securities
etc. hence; it plays a major part in the financial management.
1.4. Computation of Cost of Capital
Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
1.4.1. Measurement of specific Costs of Capital
From the shareholder’s point of view, the company’s cost of capital is the rate of return required
by them for financing the company’s investment projects by buying various securities of the
company. The market determines the required rate of return (RRR) through demand and supply
forces by the actions of competing investors.

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A company obtains its capital from four basic sources- debt, preferred stock, common stock and
retained earnings. Determining the cost of a specific source of capital is important because of the
differences in risk of various securities. Debt holders have a prior claim over equity holders on
the firm’s assets and cash flows because the firm is under a legal obligation to pay interest and its
principal to bond holders. Preference shareholders have a claim prior to equity holders but after
bondholders. Equity shareholders claim the residual assets and cash flows. They may be paid
dividend from the cash remaining after interest and preference dividends are paid. Thus equity
share is more risky that both securities. Since the securities have risk differences, investors will
want different rates of return.

1.4.1.1. Cost of debt

A firm may borrow funds from financial institutions or public center either in the form of public
depositors of bond for specific period of time at a certain rate of return. The firm’s cost of debt is
the investor’s required rate of return (RRR) on debt adjusted for tax and flotation cost. This is
because interest payment on debt is a tax-deductible expense; it reduces the firm’s taxable
income by the amount deductible interest. Flotation cost is the cost incurred in issuing debt
securities that increases the cost of debt. If commissions, legal and accounting fees are incurred
in issuing the security the company will not receive the full market price rather the selling
expenses are deducted from the selling price to give the amount called Net Proceed (NP). A bond
may be issued at par, a discount or at a premium as compared to its face value.

The specific cost of debt can be found by the following formula:

Kd = Ki(1−T) ≈ Kd = Interest rate(1−T) [to obtain after tax cost of debt]

Where:

Ki = Cost of debt before taxes I = Interest Payment

Kd = After taxes cost of debt T= Tax rate

Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at
par, at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par
Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with
the help of the following formula.
Kd = (1 – t) R
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Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount
If the debt is issued at premium or discount, the cost of debt is calculated with the help of the
following formula.
I x(1−t)
Kd=
NP
Where,
Kd = Cost of debt capital
I = Annual interest payable
NP = Net proceeds of debenture
t = Tax rate
Exercise 5
(a) A Ltd. issues Rs. 1,000,000, 8% debentures at par. The tax rate applicable to the company is
50%. Compute the cost of debt capital.
(b) B Ltd. issues Rs. 100,000, 8% debentures at a premium of 10%. The tax rate applicable to the
company is 60%. Compute the cost of debt capital.
(c) A Ltd. issues Rs. 100,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute
the cost of debt capital.
(d) B Ltd. issues Rs. 1,000,000, 9% debentures at a premium of 10%. The costs of floatation are
2%. The tax rate applicable is 50%. Compute the cost of debt-capital.
In all cases, we have computed the after-tax cost of debt as the firm saves on account of tax by
using debt as a source of finance.
Solution
I x( 1−t)
(a) Kd=
NP
= 8,000 × (1 – 0.5) = 4%
100,000
(b) Np= Face Value + Premium = 100,000+10,000=110,000
= 8,000 × (1 – 0.6) = 2.91%
110,000

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(c) Kd = 8,000 × (1 – t) = 3.37%
95,000
(d) Kd = Rs. (1,000,000 + 100,000)- 20,000
= 90,000 × (1 – 0.5) = 4.17%
1,080,000
Where; NP = 1,100,000 – 20,000 = Rs. 1,080,000
1.4.1.2. Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the firm to
determine its share value. Conceptually the cost of equity capital (Ke) defined as the “Minimum
rate of return that a firm must earn on the equity financed portion of an investment project in
order to leave unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.
Dividend Price Approach
The cost of equity capital will be that rate of expected dividend which will maintain the present
market price of equity shares. Dividend price approach can be measured with the help of the
following formula:
D
Ke=
NP
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Exercise 1
A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The company has
been paying 25% dividend to equity shareholders for the past five years and expects to maintain
the same in the future also. Compute the cost of equity capital. Will it make any difference if the
market price of equity share is Rs. 175?
Solution

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 D
Ke=
NP
= 25 x 100= 22.72%
110
If the market price of equity share is Rs. 175.
Ke = D = 25 x 100 =14.28%
N 175
Dividend Price plus Growth Approach
The cost of equity is calculated on the basis of the expected dividend rate per share plusgrowth in
dividend. It can be measured with the help of the following formula:
D
Ke= +g
NP
Where;
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
Exercise 2
(a) A company plans to issue 10, 000 new shares of Rs. 100 each at a par. The floatation costs
are expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share
initially and growth in dividends is expected to be 5%.Compute the cost of new issue of
equity shares.
(b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity
share capital
Solution
D 12
(a) Ke= +g Ke= +5=17.5 %
NP 100−4
D 12
(b) Ke= + g = Ke= +5 %=15 %
NP 120

Exercise 3
The current market price of the shares of A Ltd. is Rs. 95. The floatation cost is Rs. 5 per share
amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are required to calculate the
cost of equity share capital.
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Solution
Market price Rs. 95
Dividend Rs. 4.50
Growth 7%
D 4.5
Ke= +g Ke= +7 %=11.73 %
Np 95
Earning Price Approach
Cost of equity determines the market price of the shares. It is based on the future earnings
prospects of the equity. The formula for calculating the cost of equity according to this approach
is as follows.
E
Ke=
NP
Where,
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share
Exercise 4
A firm is considering an expenditure of Rs. 75 lakhs for expanding its operations.
The relevant information is as follows:
Number of existing equity shares =10 lakhs
Market value of existing share =Rs.100
Net earnings =Rs.100 lakhs; Compute the cost of existing equity share capital and of new equity
capital assuming that new shares will be issued at a price of Rs. 92 per share and the costs of new
issue will be Rs. 2 per share.
Solution
Cost of existing equity share capital:
E
Ke=
NP
Earnings per Share (EPS) =100lakhs = Rs.10
10lakhs
Ke =10 × 100= 10%
100
Cost of new Equity Capital

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 E 10
Ke= Ke= x 100=11.11 %
NP 92−2
Realized Yield Approach
It is the easy method for calculating cost of equity capital. Under this method, cost of equity is
calculated on the basis of return actually realized by the investor in a company on their equity
capital.
Ke = PVf×D
Where,
Ke = Cost of equity capital.
PVƒ = Present value of discount factor.
D = Dividend per share.
Example: A co. issues 100 equity shares of $1000 each. The company is expected to pay 400 per
share dividend after a year from now. Calculate the cost of equity shares if the market/prevailing
interest rate is 10 percent?
1 1
D= 400 , = pvf = ¿ = 1/1.1 = 0.90909
( 1+i ) n (1+ 0.1 )
Ke= 0.909x400= 363.363/share
Cost of preferred stock

It is the rate of return that must be earned on the preferred stockholders’ investment to satisfy
their requirement (fixed dividend payment). When a corporation sells preferred stock, it expects
to pay dividends to investors in return for their money capital. The dividend payments are costs
to the firms issuing preferred stock. In order to express this dividend cost as yearly rate, the firm
uses the selling price it receives after deducting flotation costs incurred in issuing the preferred
stocks. The cost of preferred stock can be estimated by dividing the annual preference dividend
by the current market price per share or net proceed; as the dividend can be considered a
continuous (stable) level of payment.

- Preferred stock dividends are either expressed as a stated birr amount or annual percentage.
- Preference capital is never issued with an intention not to pay dividends.
- The cost of preferred stock is not adjusted for taxes, because preference dividend is paid after
corporate tax is paid.
- The cost of preferred stock (Kp) can be estimated through the following formula;

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 dividendpers h are Dp
Kp = netproceed ( NP) = NP

Example: A preferred stock selling for Br.500 with an annual stated dividend per share of Br.50
requires a flotation cost of Br.10 per share. Determine the specific cost of the preferred stock if
the corporate tax rate is 40%.

Solution

Dp = Br.50, NP = market price minus flotation cost = Br.500 – Br.10 = Br.490

Dp Br .50
Thus, Kp = = = 10.2%
NP Br .490

 It implies that the firm must earn 10.2% on preferred stock investment to satisfy the preferred
stock holders’ interest.

The Cost of Common Stock

Cost of common stock is a minimum rate of return that the corporation must earn for its common
stock holders in order to maintain the market value of the firm’s equity. However, cost of equity
share is more difficult to calculate than the cost debt or the cost of preferred shares because there
are no fixed contractual payments for equity shares. The cost of equity share capital is
determined by the present value of all future dividends expected to be paid on their share. In case
of equity shares, it is difficult to determine the expected future value. This occurs due to that
many firms do not pay dividends for long period of time either because they choose to finance
their investment or they are not profitable enough.

There are two important techniques to estimate the cost of common stock.

a. The Dividend–Growth Model

I. Normal dividend-growth: whose dividends are expected to grow at a constant rate of g.
In this case the cost of common stock (Kc) can be found by applying the following
formula.
Do(1+ g) D1
Kc = +g= +g
NP Np
Where:

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 Kc = cost of common stock g = dividend growth rate
D1 = dividend at the end of 1st year
Do = current dividend per share

NP = Net Proceed

 Dividend for n period with normal growth rate can be estimated using the formula
Dn = Do (1+ g ¿ ¿n

Example 1: a company’s common stock has recent dividend per share of Br.12. It is found that
the company dividend per share should continue to increase at 6% growth rate. What is the cost
of common stock if a market price of Br.100 with a flotation cost of per share Br.8 is expected
up on selling the stocks?

Do(1+ g) 12(1+6 %)
Kc = +g= + 6% = 0.1383 + 0.06 = 19.83%
NP 92

Example 2: suppose that the current market price of company’s share is Br.90 and the expected
dividend per share next year is Br.4.50. If the dividends are expected to growth at a constant rate
of 8%, the shareholders’ required rate of return is

D1 Br .4 .50
Kc= +g = + 0.08=13 %
NP Br .90

II. Zero-Growth Rate:- The dividend valuation method can also be used to estimate the cost
of equity of no-growth. The growth rate will be zero if the firm does not retain any of its
earnings; i.e. the firm follows a policy of 100% pay out dividend policy. In this case,
D1 EPS
Kc = = , which implies that in a no-growth situation, the expected earnings-
NP NP
price (E/P) ratio may be used as the measure of the cost of equity (where, EPS = Earnings
Per Share).

Example: a firm is currently earning Br.100,000 and its share is sold at a market price of Br.80.
the firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to
remain stable, and it has a payout ratio of 100%. What is the cost of equity? If the firm’s payout
ratio is assumed to be 60% and that it earns 15% of rate of return on its investment opportunities,
then what would be the firm’s cost of equity?

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Solution:

Case 1: The expected growth rate is zero.

D1 EPS Br .10 Br .100,000

Kc = = = = 12.5% , where EPS = =Br .10
NP NP Br .80 10,000

Case 2: The dividend will grow at a normal growth rate. If the firm pays out 60% of its earnings,
the dividend per share will be Br.10 X 0.6 = Br.6 and the retention will be 40%. If the expected
return on internal investment opportunities are 15%, then the firm’s expected growth is 40% X
0.15 = 0.06. Thus the firm’s cost of equity will be

D1 Br .6
Kc= +g = + 0.06=13.5 %
NP Br .80

b. The Capital Asset Model (CAPM):- as per the CAPM, the required rate of return on
equity is given by Kc = Rf + (Rm − Rf)βj.

Where:

Kc = cost of equity Rm = market return

Rf = Risk free rate βj = beta of firm’s share

- Risk free rate (Rf) is the rate obtained on the government treasury securities.
- Market risk premium (Rm −Rf) is measured as the difference between long-term historical
arithmetic averages of market return and the risk free rate.
- Beta j (βj) is the systematic risk of an ordinary share in relation to the overall market.

Example: Assume that the risk free rate is 7%, the expected return in the market is 16% and the
beta for the firm’s common stock is 0.82. Compute the cost of equity using CAPM.

Kc = Rf + (Rm − Rf)βj = 0.07 + (0.16 − 0.07)0.82 = 14.38%

Cost of Retained Earnings

Retained Earnings (RE) represents profit available to common stockholders that the corporation
chooses to reinvest. The cost of RE is costly related to the use of equity shares. If earnings were
not retained, they will be paid out to the common stockholders in dividend form. The cost of
retained earnings is the opportunity cost of forgone dividends to the existing shareholders. Thus,

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its cost is the same as that of equity shares. Since retained earnings represent the internal source
of capital, it is not necessary to adjust the cost of it for flotation costs. So, specific cost of RE
(KRE) is equated in the same way as the cost of equity was equated. That is,

D1
KRE¿ + g , where MP = market price of existing common stock.
MP

Example: a company’s common stock has recent dividend per share of Br.12. It is found that the
company dividend per share should continue to increase at 6% growth rate. What is the cost of
retained earnings if a market price of Br.100 with a flotation cost of per share Br.8 is expected
up on selling the common stocks?

Do(1+ g) Br .12(1+ 0.06)

KRE¿ +g = +0.06 = 18.72%
MP Br .100

1.6.2. Measurement of Overall Cost of Capital

It is also called as weighted average cost of capital and composite cost of capital. Weighted
average cost of capital is the expected average future cost of funds over the long run found by
weighting the cost of each specific type of capital by its proportion in the firm’s capital structure.
The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the help of the following formula;
Ko= Kd Wd + Kp Wp + Ke We + Kr Wr
Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings

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1.6.2.1. The Weighted Average Cost of Capital (WACC)

WACC estimates the cost of capital structure financed from different sources of finance like
debt, common stock, preferred stock or retained earnings. It is a function of the individual cost of
capital and the percentage of funds provided by different securities holders. The capital structure
weights can be estimated from book value, market value, historical weight or target weight.

 Book value weight- uses accounting book value to measure the proportion of each type of
capital in the firm’s capital structure.
 Market value weight- measures the proportion at its market value.
 Historical weights-can be either book value or market value weights based on actual capital
structure proportion. Such weights however, would represent actual rather than desired
proportions of various types of capital in the capital structure.
 Target weights- can be either book value or market value weights that reflect the firm’s
desired capital structure proportion. However, from strictly theoretical point of view, the
target market value weighting scheme (program) should be preferred.

The following steps are involved for calculating the firm’s WACC.

i. Calculate the cost of specific sources of funds.

ii. Multiply the cost of each source by its proportion in the capital structure.
iii. Add the weighted component costs to get the WACC.

n
Thus, WACC = W1K1 + W2K2 + … + WnKn = ∑ WiKi
t =1

Where: Ki = cost of capital for the ith source.

Wi = percentage of total capital supplied by ith source.

n = number of long-term capital sources.

Example: assume that you are provided with the following information regarding the capital
structure of a corporation found in your locality.

Source of finance Market value Specific cost of capital

Debt Br.300,000 8%
Preferred stock 100.000 11%
Common stock 450,000 18%
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 Retained earnings 150,000 15%
Total Br.1,000,000

Br .300,000 Br .100,000
Debt = =30 % Preferred stock = =10 %
Br .1,000,000 Br .1,000,000

Br .450,000
Common stock = =45 % Retained earnings =
Br .1,000,000
Br .150,000
=15 %
Br .1,000,000

WACC = 0.3(0.08) + 0.1(0.11) + 0.45(0.18) + 0.15(0.15) = 13.85%

Interpretation – to satisfy its shareholders or creditors the corporation should get at least 13.85%
annual return from the investment.

The Weighted Marginal Cost of Capital (WMCC)

It is the cost of additional (new) capital raised by a firm from different sources of finance.
WMCC is simply the firm’s WACC associated with its next birr of total new financing. It
reflects the WACC of the last birr raised by the firm. The WMCC increases as more and more
capital is raised during a period. The WMCC is always equal to or greater than, the WACC.

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Because the costs of the new financing components rise as larger amounts are raised, the WMCC
is an increasing function of the level of total new financing. Risk rises in response to the
increased uncertainty as to the outcomes of the investments financed with these funds. In other
words, fund suppliers require greater returns in the form of interest, dividend, or growth as
compensation for the increased risk introduced as larger volumes of new financing are incurred.

Example: the corporation in your locality (see the previous example) wanted to raise additional
funds of Br.100, 000 to finance its plant. The corporation raised the Br.100,000 from different
sources such as: Br.20,000 debt, Br.30,000 common stock, Br.30,000 preferred stock and
Br.20,000 retained earnings. The specific cost of capital for each source remains the same.
Compute the WMCC.

Br .20,000 Br .30,000
Debt = = 20% Preferred stock = = 30%
Br .100,000 Br .100,000

Br .30,000 Br .20,000
Common stock = = 30% Retained earnings = = 20%
Br .100,000 Br .100,000

WMCC = WdKd + WpKp + WcKc + WREKRE

= 0.2(0.08) + 0.3(0.15) + 0.3(0.18) + 0.2(0.15) = 14.5%

Interpretation – to satisfy its shareholders or creditors the corporation should earn at least 14.5%
annual return from the investment financed by additional raised funds.

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