Cost of Capital

Corporate Finance
Cost of Capital
By
Sumit Gulati
Author of the book on ‘Financial Management’
Published by McGraw Hill Education
Founder: FINEXCELACADEMY
Instagram: https://www.instagram.com/sumit.gulati80/
Facebook Page: www.facebook.com/SumitKiPaathshala
Introduction
 Money used to finance any business, or any projects in the
business is always available at a cost which we call cost of
capital.
 The required rate of return (cost of capital) as discount rate

depends on the riskiness in cash flow of a project.
Importance of Cost of Capital
 The concept of cost of capital is considered as a standard for
different business and financial decision making.
 The examples of areas which require the cost of capital as a

standard for decision making are:
➢ Evaluating Investment Decision
➢ Designing Capital Structure:
➢ Formulating Dividend Policy:

Opportunity Cost of Capital
 There are always various opportunities (options) to use the
capital.
 The firms generally fix a value for the required rate of return
called hurdle rate as the acceptance criteria.
Component or Specific Cost of Capital
 The cost of capital of individual sources is called component or

specific cost of capital.
 This overall cost is known as Weighted Average Cost of Capital

(WACC).
 Cost of Debt
 A firm can raise debt in a variety of ways. It may borrow from banks,
financial institutions, or it may raise debt from public in the form of fixed
deposits or bonds (debentures).
 Debt is generally raised at fixed rate of interest for specified period of

time.
If debt issued at par.
Where,
 kd is the cost of debt (No Taxes)
 INT is the amount of interest
 P0 is the issue price of the debt (bond).
In this case the contracted rate of interest is the cost of debt.

Redeemable Debt issued at discount or premium:
The equation to determine before tax cost of debt in such cases is
Where,
 P0 = Face Value (+ or –) premium or discount respectively.
 Pn is the repayment of debt on maturity.
Example:
A firm issues 7 year 12% bond at a discount of 5% i.e.

at Rs 95. FaceValue/ Par Value = 100
Determine the cost of debt.

Example:
A firm issues 7 year 12% bond at a discount of 5% i.e. at Rs 95. Determine the
cost of debt.
Solution:
Example:
A firm issues 7 year 12% bond at a discount of 5% i.e. at Rs 95. Determine the
cost of debt.
Solution:
i.e. 95 = 12 * PVIFA (7, kd) + 100 * PVIF(7, kd)

 Using trial and error we find that if we take kd as 13% we get
right hand side as
=12 * 4.4226 + 100 * 0.4251 = 95.581
 If we take kd as 14%, we get right hand side as

= 12 * 4.2883 + 100 * 0.3996 = 91.420
 It means that value of kd lies between 13% and 14%. We can
use interpolation as below to find out the exact value:
= 13 + 0.140 = 13.140%
The cost of debt in the case of 5% discount on issue is 13.14%

Perpetual debt:
The following equation can be used to determine the cost of
perpetual debt:
Treatment of floatation cost in debt
 The effect is similar to that of discount as if the bond of face
value Rs 100 was sold at Rs 98.
 P0 = Face Value (+ or –) for premium or discount respectively –

floatation cost (cost of issue).
Tax Implications in Cost of Debt:
For perpetual debt:
 After tax cost of debt = before tax cost of debt (kd) * (1 – T)
Where,
 T is the applicable tax rate (also called marginal tax rate)
For redeemable debt:

 After tax cost of debt can be calculated as:
Example:
ABC Ltd. needs funds for a new project and decides to issue bonds
with the following details:
Face value/ Par Value = Rs100
Coupon rate = 10 per cent
Repayment after 3 years with premium of 5 per cent.
Flotation cost = 5 per cent
Tax rate = 40 per cent
Find the cost of debt.

Solution:
By trial and error kd = 9.51%

(Shortcut for Debt)
Cost of Irredeemable Preference Share Capital
 The capital raised by a firm through issue of preference shares is

more like debt than equity.
 The treatment of irredeemable preference share can be done in the

same way as perpetual bond.
Where,
P0 = Issue price of preference share

Dp = Expected preference dividend
kp = Cost of preference share
Cost of Redeemable Preference Share Capital
 Redeemable preference shares are those shares which have finite

maturity.
Where,
P0 = Issue price of preference share
Dp = Expected preference dividend
n = Number of periods left till maturity
Pn = Redemption value or Maturity Value at the end of the period.
(Shortcut for Preference Share
PD = Expected preference dividend

n = Number of periods to redemption

RV= Redemption value or Maturity Value at the end of the
period.
P0 or NP= Issue price (Net Proceeds) of preference share
Cost of Equity
 The return the shareholders would have received from the best
alternative options (expected rate of return) is called the cost of
equity.
 In order to determine the cost of equity, the following methods
are generally used;
1. Dividend Capitalisation Approach (DCA)
2. EPS Approach
3. Capital Asset Pricing Model (CAPM)

 In the case of external equity, from the firm’s point of view, there
are three issues, which are as follows:
1. The flotation cost

2. Underutilization of external equity
3. Under pricing of the fresh capital
Dividend Capitalisation Approach (DCA)
If we assume that dividend is expected to grow by rate g each year,
then the present value equation can be written as
Example:
 Following information is given about a firm
 Current market price = Rs 200
 Recent dividend = Rs 20
 Historical annual growth in dividend= 10%
a)Find the cost of equity capital using dividend discount
method.
b)If dividend were to grow at 12%, what would be the cost of
equity capital?
Solution:
= 0.210 = 21%
Cost of equity if dividend is growing at 12% is equal to 23.2%

Limitations of Dividend Capitalisation Approach (DCA):
 It cannot be applied to firms that do not pay dividend.
 Normally dividend payout is only very small part of the growth
in earnings.
 It is assumed dividend will grow at constant rate (g) for all time
to come.
 The growth rate has to be estimated over long period, which
can be very subjective.
 It does not consider risk of project as a factor.
EPS Approach
 EPS Approach:
Ke = EPS/ MPS
 Ke is cost of equity
 EPS is Earnings per share
 MPS is Market Price Per share

EPS Approach
 If the future earnings per share will grow at a constant rate ‘g’
then cost of equity share capital (Ke) will be
 Ke = (EPS/ MPS) + g
Example
 The share capital of a company is represented by 10,000 Equity
Shares of Rs. 10 each, fully paid. The current market price of the
share is Rs. 40. Earnings available to the equity shareholders
amount to Rs. 60,000 at the end of a period.
 Calculate the cost of equity share capital using Earning/Price

ratio.
Solution
 EPS = 60000/10000 = Rs 6
 MPS = 40
 Ke = 6/40 = 0.15 = 15%

Concept of Beta ()
and
CAPITAL ASSET PRICING MODEL (CAPM)
 The CAPM model is based on the concept that return on
an asset (particularly stocks) is based on total reward
which includes reward for waiting and reward for risk
undertaken.
 Reward for waiting is the risk free rate of return and

reward for undertaking risk is the risk premium.
The formula can be expressed as
 RA = Rf + *(Rm – Rf)
 where,
 RA = Expected return on an asset (ke)
 Rf = Risk-free of return rate
 Rm = Expected return on market portfolio
  = A measure of systematic risk of an asset
Note: The systematic risk of an asset can be measured in terms of

beta ().
Diversification of Risk
The risk of a portfolio comprises of two parts viz.,
 Unsystematic (diversifiable) risk (Unique)
 Systematic (non-diversifiable) risk (Market Risk)
 Total risk = Unsystematic risk + systematic risk

Diversification of Risk
What is Beta ()????
 The beta (β) of an investment security (i.e., a stock) is a
measurement of its volatility of returns relative to the entire
market.
 It is used as a measure of systematic risk and is an integral

part of the Capital Asset Pricing Model (CAPM).
Example:
 Ashoka Fasteners Ltd. is a well established company. Current

market share price is Rs 50. Dividend payout has been
increasing at 15% per annum in recent years. Last dividend paid
was Rs 5. The beta of the firm is 1.25. Expected market return is
20% while the investment in government securities provides 8%.
 Find the cost of equity by DDM and CAPM methods.


Cost of equity (as per CAPM):
ke = rf + b(rm – rf)
= 8 + 1.25(20 – 8)
= 8 + 15
= 23%
i.e., Cost of equity by DDM method = 26.5%
Cost of equity by CAPM method = 23%

The flotation cost
The cost of fresh equity involves floatation cost comprising

advertisement cost, fee for merchant bankers etc.
Where,
 f = Floatation cost as percentage of equity
Example:
United Plastics Limited wants to expand to meet growing demand.

They plan to raise equity of Rs 1,000 crore. The details are given
below.
 Face value of shares = Rs 100
 Current market price = Rs 400
 Dividend record for last three years = 20%, 24%, and 30%
 Floatation cost = 4%
 What is the cost of equity?


 Underutilization of external equity

 Underpricing of the fresh capital
Cost of General Reserves
 Cost of general reserves is taken equal to cost of equity.
 Cost of General Reserve = Cost of Equity

Weighted Average Cost of Capital (WACC)
 Weighted Average Cost of Capital (WACC)

= we x ke + wd x kd + wp x kp
Where,
 we = Proportion of equity capital
 wd = Proportion of debt capital
 wp = Proportion of preference capital
 ke = Cost of equity capital
 kd = Cost of debt capital
 kp = Cost of preference capital
Example
Kd= 7%
Ke=12%
Weights 60% and 40% in debt and equity
respectively
WACC
= 0.6*7% +0.4*12% = 4.2% + 4.8% = 9%
 We can use one of the following three methods to determine

proportion of the capital from each source:
 Book Value Proportions: Book value proportions are based on

historical figures
 Market Value Proportions: In case, equity and debt both are

traded on stock exchange, then today’s value of these would be
known which will be more realistic to use for calculation of weights.
 In case only equity is traded, then values of only equity and
reserve will have to be modified.
 Marginal Proportions: It means that we use the proportion of

each source that has been used in raising additional capital.
Example
 Following data is available for XYZ firm:
 After tax cost of debt = 7%

 PAT = Rs 8,45,000
Total Assets Financed = Rs 76,00,000
Sources of funds to Finance Rs 76,00,000

 Equity Share Capital = Rs 45,00,000
 Debt = Rs 22,00,000
 Reserves = 9,00,000
 Issue price per equity share = Rs 100

 Current Share Price = Rs 120 per share
Compute WACC as per market value weights.

Solution
Steps to Solve:
 Step 1: Compute Cost of Individual Sources
 Step 2: Compute Weights (Based on whether book value

proportion is to be taken or market value proportion is to be
taken)
 Note: In case only equity is trading, then only market value of

equity and reserves will change.
 Step 3: Compute WACC

Example
Estimating Costs of various sources:
Post tax cost of debt = 7%
Cost of Equity = EPS/ Current MPS

 EPS = PAT/ Number of equity shares
 PAT = Rs 8,45,000 (given)
Number of equity shares = Rs 45,00,000/ 100 = Rs 45,000

EPS = 8,45,000/ 45,000 = 18.78
Cost of equity = EPS/ Current MPS = 18.78/ 120 = 0.157 = 15.7%
Cost of reserves = cost of equity = 15.7%

Example
Estimating Weights of various sources:
Note: For calculating weights based on market value weights, we

will have to first calculate the current market value of equity and
current market value of reserves
Steps to calculate current market value is given in next

slide
Example
Estimating Weights of equity and reserves:
First, we calculate:
Initially proportion of equity share to (total equity share + reserve)
=4500000/(4500000+900000)
= 45/54
Initially proportion of reserve to (total equity share + reserve)
=900000/(4500000+900000)
= 9/54
Example
Current Market Value of Equity = Number of shares * Current

Market Price
= 45000 * 120 = 5400000
This may be allocated between equity share capital and reserves in

the same proportion as initially.
i.e
 45/54 of 5400000 will be for equity capital and
 9 /54 of 5400000 will be for reserves
Example
Market Value of Equity Share Capital

= Current Market Value of Equity
* proportion of equity share to (total equity share + reserve)
= 5400000 * 45/54 = 4500000
Similarly,
Market Value of Reserves = 5400000 * 9/54 = 900000

Calculating WACC
Weighted Costof
Market
Cost of capital Capital (%)
Particulars Value Weights
(Post Tax) WACC
(Rs)
Calculation
Debt 2200000 0.289 7.0% 2.03%
Equity 4500000 0.592 15.7% 9.30%
Reserve 900000 0.118 15.7% 1.86%
7600000 13.18%
WACC = 13.18%
Note: Since equity and reserve has the same cost of capital
(15.7%), so it could have been considered together, hence in
market value weight method reserves could have been taken as a
part of equity.
Working Notes
 Weights of debt = 2400000/ 7600000 = 0.289
 Similarly other weights are calculated
Weighted cost of debt = Weight * Cost of debt (Post Tax)

= 0.289 * 7% = 2.03%
Similarly other costs are calculated
WACC = sum of all the weighted costs.

FACTORS AFFECTING COST OF CAPITAL
 The general condition of economy
 Debt market interest rates depend on the general principle of demand

and supply.
 If the tax rate is higher, the debt will be cheaper
 Bank term deposit interest rates.
 Investment policy, dividend policy and capital structure of the firm are
the factors which are specific to each firm.
 Risk profile of the new project is a major factor which affects cost of
capital.
Thank You

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Corporate Finance

 The required rate of return (cost of capital) as discount rate

 The examples of areas which require the cost of capital as a

➢ Evaluating Investment Decision

➢ Designing Capital Structure:

➢ Formulating Dividend Policy:

 The cost of capital of individual sources is called component or

 This overall cost is known as Weighted Average Cost of Capital

 Debt is generally raised at fixed rate of interest for specified period of

In this case the contracted rate of interest is the cost of debt.

The equation to determine before tax cost of debt in such cases is

A firm issues 7 year 12% bond at a discount of 5% i.e.

Determine the cost of debt.

i.e. 95 = 12 * PVIFA (7, kd) + 100 * PVIF(7, kd)

 If we take kd as 14%, we get right hand side as

The cost of debt in the case of 5% discount on issue is 13.14%

 P0 = Face Value (+ or –) for premium or discount respectively –

For redeemable debt:

Find the cost of debt.

By trial and error kd = 9.51%

 The capital raised by a firm through issue of preference shares is

 The treatment of irredeemable preference share can be done in the

P0 = Issue price of preference share

 Redeemable preference shares are those shares which have finite

PD = Expected preference dividend

kp = Cost of preference share

1. Dividend Capitalisation Approach (DCA)

3. Capital Asset Pricing Model (CAPM)

1. The flotation cost

Cost of equity if dividend is growing at 12% is equal to 23.2%

 EPS is Earnings per share

 MPS is Market Price Per share

 Calculate the cost of equity share capital using Earning/Price

 Ke = 6/40 = 0.15 = 15%

 Reward for waiting is the risk free rate of return and

Note: The systematic risk of an asset can be measured in terms of

 Total risk = Unsystematic risk + systematic risk

 It is used as a measure of systematic risk and is an integral

 Ashoka Fasteners Ltd. is a well established company. Current

 Find the cost of equity by DDM and CAPM methods.

i.e., Cost of equity by DDM method = 26.5%

Cost of equity by CAPM method = 23%

The cost of fresh equity involves floatation cost comprising

United Plastics Limited wants to expand to meet growing demand.

 Face value of shares = Rs 100

 Current market price = Rs 400

 What is the cost of equity?

 Underutilization of external equity

 Cost of General Reserve = Cost of Equity

 Weighted Average Cost of Capital (WACC)

 We can use one of the following three methods to determine

 Book Value Proportions: Book value proportions are based on

 Market Value Proportions: In case, equity and debt both are

 Marginal Proportions: It means that we use the proportion of

 After tax cost of debt = 7%

Total Assets Financed = Rs 76,00,000

Sources of funds to Finance Rs 76,00,000

 Issue price per equity share = Rs 100

Compute WACC as per market value weights.

 Step 1: Compute Cost of Individual Sources

 Step 2: Compute Weights (Based on whether book value

 Note: In case only equity is trading, then only market value of

 Step 3: Compute WACC

Cost of Equity = EPS/ Current MPS