Sem II | Financial Management | 2020-21

COST OF CAPITAL-FORMULAE
COST OF CAPITAL = 𝑊𝐴𝐶𝐶 = 𝑘 = 𝑊𝑑 ∗ 𝐾𝑑 + 𝑊𝑒 ∗ 𝐾𝑒 + 𝑊𝑃 ∗ 𝐾𝑃
𝐷 𝐸 𝑃
COST OF CAPITAL = 𝑊𝐴𝐶𝐶 = 𝑘 = ∗ 𝐾𝑑 + ∗ 𝐾𝑒 + ∗ 𝐾𝑃
𝐷+𝐸+𝑃 𝐷+𝐸+𝑃 𝐷+𝐸+𝑃
(𝐷 ∗ 𝐾𝑑 + 𝐸 ∗ 𝐾𝑒 + 𝑃 ∗ 𝐾𝑃 )
COST OF CAPITAL = 𝑊𝐴𝐶𝐶 = 𝑘 =
𝐷+𝐸+𝑃
E ∗ 𝑓𝑒 + D ∗ 𝑓𝑑
Floatation cost 𝑓𝑓 = Floatation cost needs to be adjusted to Issue Price or Po
E+D
Financial
Cost to Firms
Instruments
𝐾𝑖 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒
Bank Loan
𝐾𝑑 = 𝐾𝑖 ∗ (1 − 𝑡𝑎𝑥)
𝐼𝑛𝑡
𝐾𝑖 = … 𝑤ℎ𝑒𝑟𝑒 𝐾𝑖 = 𝑝𝑟𝑒 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
Debentures 𝑃𝑜
(Irredeemable) 𝐼𝑛𝑡(1 − 𝑡)
𝐾𝑑 = … 𝑤ℎ𝑒𝑟𝑒𝐾𝑑 = 𝑝𝑜𝑠𝑡 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
𝑃𝑜
𝑛 𝒏
𝐼𝑛𝑡 𝑀𝑉 𝑰𝒏𝒕(𝟏 − 𝒕) 𝑴𝑽
𝑃𝑜 = ∑ 𝑥
+ 𝑛
𝑜𝑟 𝑷𝒐 = ∑ 𝒙
+
(1 + 𝐾𝑖 ) (1 + 𝐾𝑖 ) (𝟏 + 𝑲𝒅 ) (𝟏 + 𝑲𝒅 )𝒏
𝑥=1 𝒙=𝟏
)𝑛
[(1 + 𝐾𝑖 − 1] 𝑀𝑉 [(𝟏 + 𝑲𝒅 )𝒏 − 𝟏] 𝑴𝑽
𝑃𝑜 = 𝐶 ∗ { 𝑛
}+ 𝑛
𝑜𝑟 𝑷𝒐 = 𝑪(𝟏 − 𝒕) ∗ { }+
𝐾𝑖 (1 + 𝐾𝑖 ) (1 + 𝐾𝑖 ) 𝑲𝒅 (𝟏 + 𝑲𝒅 )𝒏 (𝟏 + 𝑲𝒅 )𝒏
Debentures
(Redeemable) 𝐼𝑛𝑡 (1 − 𝑡) +
𝑀 − 𝑃𝑜
𝐾𝑑 = 𝑛 … by shortcut method
𝑀 + 𝑃𝑜
2
𝑁𝑃𝑉𝐿
𝐾𝑑 = 𝑟𝐿 + [( ) 𝑋 (𝑟𝐻 − 𝑟𝐿 )] … by interpolation
𝑃𝑉𝐶𝐼𝐿 − 𝑃𝑉𝐶𝐼𝐻
Preference shares 𝑃 𝑟𝑒𝑓. 𝐷𝑃𝑆1 𝑃 𝑟𝑒𝑓. 𝐷𝑃𝑆1
𝑃𝑜 = 𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒, 𝐾𝑝 =
(Irredeemable) 𝐾𝑝 𝑃𝑜
𝑛
𝑃𝑟𝑒𝑓 𝐷𝑃𝑆1 𝑀𝑉
𝑃𝑜 = ∑ 𝑥 + 𝑛 … 𝑤ℎ𝑒𝑟𝑒 𝐾𝑝 𝑖𝑠 𝑝𝑜𝑠𝑡 𝑡𝑎𝑥
𝑥=1
(1 + 𝐾𝑝 ) (1 + 𝐾𝑝 )
𝑛
[(1 + 𝐾𝑝 ) − 1] 𝑀𝑉
Preference shares 𝑃𝑜 = 𝑃𝑟𝑒𝑓. 𝐷𝑃𝑆 ∗ { 𝑛 } + 𝑛
(Redeemable) 𝐾𝑝 (1 + 𝐾𝑝 ) (1 + 𝐾𝑝 )
𝑀 − 𝑃𝑜
𝑃𝑟𝑒𝑓 𝐷𝑃𝑆1 +
𝐾𝑝 = 𝑛 … by shortcut method
𝑀 + 𝑃𝑜
2
𝐷𝑃𝑆1 𝐸𝑃𝑆1 ∗ (1 − 𝑏)
Equity 𝑃𝑜 = =
𝐾𝑒 − 𝑔 𝐾𝑒 − 𝑟𝑏
(Dividend Model)
𝐷𝑃𝑆1
(Constant Growth) 𝐾𝑒 = + 𝑔 . . 𝑤ℎ𝑒𝑟𝑒 𝐷𝑃𝑆1 = 𝐷𝑃𝑆0 (1 + 𝑔) & b = earnings retention rate
𝑃𝑜
Equity
(bond-yield-plus-
𝐾𝑒 = 𝐾𝑖 𝑜𝑓 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 ′ 𝑠 𝑏𝑜𝑛𝑑 + 𝐽𝑢𝑑𝑔𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
judgmental-risk-
premium method)
Equity (CAPM) 𝐾𝑒 = 𝑅𝑓𝑟 + 𝛽(𝑅𝑚 − 𝑅𝑓𝑟 )
𝐷𝑃𝑆1
Retained earnings 𝐾𝑟𝑒 = + 𝑔 ……(always ignore floatation cost)
𝑃𝑜

Compiled by Prof. Khushboo Vora

 Sem II | Financial Management | 2020-21

COST OF CAPITAL-CASELETS
1. Assume that ABC Corporation has the following capital structure: 30% percent debt, 10%
preferred stock and 60% equity. ABC Corporation wishes to maintain these proportions as
it raises new funds. Its cost of debt is 8%, its cost of preferred stock is 10%, and its cost of
equity is 15%. If the company’s tax rate is 40%, what is ABC’s weighted average cost of
capital? (11.44%)

2. A company has 10% perpetual debt of Rs 1,00,000. The tax rate is 35%. Determine the
cost of capital (before tax as well as after tax) assuming the debt is issued at (i) par (ii) 10%
discount (iii) 10% premium (Ki=10%, 11.11%, 9.09%; Kd=6.5%, 7.22%, 5.91%)

3. Calculate the explicit cost of debt for each of the following situations, assuming coupon
rate of debentures is 10%, face value of debentures is Rs 100, maturity period is 10 years
and tax rate is 35%.
(a) Debentures are sold at par and floatation cost is 5%. (7.219%, shortcut7.18%)
(b)Debentures are sold at a premium of 10% and floatation cost is 5% (5.89%)
(c) Debentures are sold at a discount of 5% & floatation cost is 5% of issue price (7.94%)

4. The Ess Refrigerator Company is deciding to issue 2,00,000 of Rs 1,000, 14%, 7 Year
debenture. The dentures will have to be sold at a discount rate of 3%. Further the firm will
pay underwriting fee of 3% of the face value. Assume a 35% tax rate. Calculate the after tax
cost of the issue. What would be the after tax cost of debenture, if it were sold at a premium
of Rs 30. (10.33%, 9.1%)

5. A company issues new debentures of Rs 2 million at par; the net proceeds being Rs 1.8
million. It has a 13.5% rate of interest and 7-year maturity. The company’s tax rate is 52%.
What is the cost of debenture issue? What will be the cost in 4 years if the market value of
debenture at that time is Rs 2.2 million? (8.43%, 2.95%)

6. Compute the after-tax cost of capital, a preference share sold at Rs 95 in market with an
11% dividend and a redemption at par, if the company redeems it in 5 years. (12.4%).

7. A company issues 11% irredeemable preference shares of face value Rs 100 each.
Floatation costs are estimated at 5% of the expected sale price.
(a) What is the Kp, if preference shares are issued at (i) par value, (ii) 10% premium and (iii)
5% discount? (11.6%, 10.5%, 12.2%)
(b) Also, compute Kp in above situations assuming 13.125% dividend tax. (13.1%, 11.9%,
13.8%)

8. Suppose that the current market price of a company’s share is Rs 90 and the expected
dividend per share next year is Rs 4.50. If the dividends are expected to grow at a constant
rate of 8%, find the shareholders’ required rate of return? (13%)

9. The share of a company is currently selling for Rs 100. It wants to finance its capital
expenditures of Rs 100 million either by retained earnings or selling new shares. If the
company sells new shares, the issue price will be Rs 95. The dividend per share next year, is
Rs 4.75 and it is expected to grow at 6%. Calculate a) The cost of internal equity (retained
earnings) (10.75%) b) The cost of external equity (new issue of shares). (11%)

Compiled by Prof. Khushboo Vora

 Sem II | Financial Management | 2020-21

10. Beta corporation is listed at a stock exchange and the current market price of its share is
Rs 200. The earnings and dividend has been growing at 10% and the last dividend was Rs
12. Through regression analysis, the beta of the firm is estimated at 1.20. The expected
market return is 16% while the return in government securities are prevailing at 6%. Find
out the cost of equity for Beta Corporation using DDM and CAPM. Why do you think that
there is difference in two figures? (16.60% and 18%)
(CAPM –based on systematic risk, estimates the rate of return, DDM – factors affecting the growth of specific firm.)

11. Assuming that a firm pays tax at a 50% rate, compute the after-tax cost of capital in the
following cases
a) An ordinary share selling at a current market price of Rs 120 and paying a current
dividend of Rs 9 per share, which is expected to grow at a rate of 8%. (16.1%)
b) An ordinary share of a company, which engages no external financing, is selling for Rs 50.
The earnings per share are Rs 7.50 of which 60% is paid in dividends. The company reinvests
retained earnings at a rate of 10%. (13.36%)
c) ABC ltd declared and paid annual dividend of Rs 4 per share. It is expected to grow @20%
for the next 2 years and at 10% thereafter. The shares are sold in the market at Rs 104.
Compute the cost of equity. (15%).

12. Megha Steel Limited has capital employed of Rs 100 crores whose market value is Rs
150 crores as shown below:
Book Values Rs Crores Market values Rs Crores
Equity shares 30 130
Retained Earnings 45 -
Preference shares 7 6
Debentures 18 14
Total 100 150
The firm paid dividend of Rs 20 for current year which have been growing at 8%. It also pays income tax at
35%.
Following further information is available in respect of various sources of capital:
 Equity shares: Fresh shares can be issued at a price of Rs 220 & floatation cost being 4% of issue
price.
 Debentures: Fresh debentures can be issued with following features:
Coupon Rate 12%
Periodicity Annual
Face Value Rs 100.00
Redemption value Rs 100.00
Coupon payment Rs 12.00
Time to maturity 15 years
Floatation cost 1.50% of face value
Issue Price Rs 95.00
 Preference Shares: New preference shares can be issued as follows:
Dividend 15%
Floatation Cost 2.00% of issue price
Face Value Rs 100.00
Issue Price Rs 110.00
Find cost of specific sources of capital (ke=18.23%, Kre=17.82%, kp=13.91%, kd=8.58%)
Find WACC based on a) book values and b) market values. (16%, 17.16%)

Compiled by Prof. Khushboo Vora

 Sem II | Financial Management | 2020-21

13. Suppose that a firm is considering an investment project, which involves a net cash outlay
of Rs 450,000, and is expected to generate an annual cash inflow of Rs 150,000 for 7 years.
The company’s target debt ratio is 50%. The floatation cost of debt and shares are estimated
to be 10% of the amount raised. To finance the project, the firm will issue 7 year 15%
debenture of Rs 250,000 at par (Fv Rs 100) and new shares of Rs 250,000. The issue price
of a share is Rs 20 and the expected dividend per share next year is Rs 1.80. Dividends are
expected to grow at a compounded rate of 7% forever. Assume that corporate tax rate is
50%.
 Calculate Cost of Capital of the firm? (WACC=k=13.26%)
 What is the NPV of the project? (NPV 190,025 using WACC =11.75%)

14. Ramesh engineering is currently at its target debt-equity ratio 4:5. It is evaluating
proposal to expand capacity which is expected to cost Rs 4.5 million and generate after tax
cash flow of Rs 1 million per year for the next 10 years. The tax rate for the company is 25%.
The following two financing options are finalized:
 Issue of equity stock. The required return on the company’s new equity is 18%. The
issuance cost will be 10%
 Issue of debentures carrying a yield of 12%. The issuance cost will be 2%.
What is the NPV of the expansion project? (DF=14%, Ff=6.44%, NPV=4,06,367.87)

15. Amit Electronics is evaluating an expansion project that is expected to cost Rs 20 million
and generate an annual after tax cash flow of Rs 4 million for the next 10 years. The tax rate
for the company is 35%. Amit Electronics has a target debt-equity ratio of 1:1. Its cost of
equity is 16.9% whereas its pre-tax cost of debt is 14%. The floatation cost of equity is 12%
whereas the floatation cost of debt is 2%. What is the NPV of the expansion project? (DF =
13%, Ff= 7%, PVCO=21505376, NPV is 1,99,597)

Compiled by Prof. Khushboo Vora

 Sem II | Financial Management | 2020-21

COST OF CAPITAL -HOME ASSIGNMENT

A. Anand Industries has three sources of capital - the equity shares, preference shares and
straight debt, costing 18%, 15% and 7% respectively. The proportions of different kinds of
capital as reflected in the balance sheet and as per the market values are as under:
Proportions
Capital Book value Market value
Equity 50% 70%
Preference 20% 15%
Debt 30% 15%
Find out the WACC based on a) book values b) market values.
Anand Industries wishes to raise the capital for an expansion programme with equity,
preference and debt at 15%, 35% and 50%. What would be the cost of capital for the
expansion programme? (14.10%, 15.90%, 11.45%)

B. Calculate the explicit cost of debt for each of the following situations
(a) Debentures are sold at par (6.5%)
(b)Debentures are sold at a premium of 10%. (5.19%)
(c) Debentures are sold at a discount of 5%. (7.21%)
Assume: coupon rate of debentures is 10%, face value of debentures is Rs 100, maturity
period is 10 years and tax rate is 35%.

C. A company decides to sell a new debenture issue of 7 years 15% bonds of Rs 100 each at
Rs 94 and redeemable at a premium of 5%. What will be the cost of debenture pretax and
after tax if tax rate is 50%. (15%, 7.5%)

D. A 7 year, Rs 100 debenture of a firm can be sold for a net price of Rs 97.75. The rate of
interest is 15% per year, and bond will be redeemed at 5% premium on maturity. The firm’s
tax rate is 35%. Compute after tax cost of debenture. (10.73%)

E. A company has 100,000 shares of Rs 100 at par, of preference shares, outstanding at

9.75% dividend rate. The current market price of the preference share is Rs 80. What is the
cost. (12.18%)

F. Raj Plastic has been in operation for the last 15 years and its shares in the stock market
are currently trading at Rs 120. The most recent dividend by the firm was Rs 10 per share.
Historically, the dividend of Raj Plastic has been growing at 10% but a majority of financial
analyst are of the opinion that the firm would grow at 12% per annum and so would be the
dividend. Find out the cost of equity from the perspective of
(a) Management of Raj Plastics (b) financial analyst. (19.17%, 21.33%)

G. Assuming that a firm pays tax at a 50% rate, compute the after-tax cost of capital in the
following cases
a) A perpetual bond sold at par, coupon rate of interest being (3.5%).
b) A perpetual Preference Share sold at par, coupon rate of interest being (7%).
c) A ten year, 8% Rs 1000 par bond sold at Rs 950 less 4% underwriting commission.

Compiled by Prof. Khushboo Vora

 Sem II | Financial Management | 2020-21

d) A ten year, 8% Rs 1000 par Preference Share sold at Rs 950 less 4% underwriting
commission.
e) A 8.5% preference share sold at par. (8.5%)
f) A preference share sold at Rs 100 with a 9% dividend and a redemption price of Rs 110 if
the company redeems it in 5 years. (10.61%).

H. Multiplex Ltd has a debenture with face value Rs 1000, coupon interest rate 12% and
remaining maturity period is 4 years. The debenture is currently selling at Rs 1040 in the
market. Find the cost of debenture. Also find the cost of debenture post tax if tax is assumed
to be 35%. (Ki=10.718%, Kd=6.628%)

L. The next expected dividend on equity shares per share is Rs 3.60; the dividend per share
is expected to grow at the rate of 7%. The market price per share is Rs40. Preference stock,
redeemable after 10 years, is currently selling at Rs 75 per share. Debentures, redeemable
after 6 years, are selling at Rs 80 per debenture. The income tax rate for the company is 40%.
You are required to calculate WACC a) book values b) market values.
Equity capital (in shares of Rs 10 each, fully paid up at par) 15,00,00,000
12% preference capital (in shares of Rs 100 each, fully paid up at par) 1,00,00,000
Retained Earnings 20,00,00,000
11% debentures (of 100 each) 10,00,00,000
11% term loan 12,50,00,000
(Ke=16%, kp=16.57%, kd=11.37%, Kre=16%, WACC (Bv) = 13.21%, WACC (MV)=14.09%)

Assumptions of Gordon Model / Dividend Model of Equity.

1) The firm finances all investment through retained earnings; that is debt or new equity is
not issued; You are an all equity firm
2) The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3) All earnings are either distributed as dividend or reinvested internally immediately.
4) Beginning earnings and dividends never change. The values of the earnings per share
(EPS), and the divided per share (DPS) are assumed to remain constant forever.
5) The firm has a very long or infinite life.
6) The corporate taxes do not exist.
7) The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8) K > br i.e. K > g if this condition is not fulfilled, we cannot get a meaningful value for the
share.

Compiled by Prof. Khushboo Vora

 Sem II | Financial Management | 2020-21

CASE STUDY ON COST OF CAPITAL –HOME ASSIGNMENT

HARRY DAVIS INDUSTRIES

During the last few years, Harry Davis Industries has been too constrained by the high cost
of capital to make many capital investments. Recently, though, capital costs have been
declining, and the company has decided to look seriously at a major expansion program that
has been proposed by the marketing department. Assume that you are an assistant to Leigh
Jones, the financial vice-president. Your first task is to estimate Harry Davis’s cost of capital.
Jones has provided you with the following data, which she believes may be relevant to your
task:
 The firm's tax rate is 40%.
 The current price of Harry Davis’s 12% coupon, semi-annual payment, non-callable
bonds with 15 years remaining to maturity is Rs 1,153.72. Harry Davis does not use
short-term interest-bearing debt on a permanent basis. New bonds would be
privately placed with no flotation cost. Assume Face Value as Rs1000
 The current price of the firm’s 10%, Rs 100 par value, quarterly dividend, perpetual
preferred stock is Rs 116.95. Harry Davis would incur flotation costs equal to 5% of
the proceeds on a new issue.
 Harry Davis’s common stock is currently selling at Rs 50 per share. Its last dividend
was Rs 3.12, and dividends are expected to grow at a constant rate of 5.8% in the
foreseeable future. Harry Davis’s beta is 1.2; the yield on T-bonds is 5.6%; and the
market risk premium is estimated to be 6%. For the over-own-bond-yield-plus-
judgmental-risk-premium approach, the firm uses a 3.2% judgmental risk premium.
 Harry Davis’s target capital structure is 30% long-term debt, 10% preferred stock,
and 60% common equity.

To help you structure the task, Leigh Jones has asked you to answer the following questions.
a. (1) What sources of capital should be included when you estimate Harry Davis’s
weighted average cost of capital (WACC)?
(2) Should the component costs be figured on a before-tax or an after-tax basis?
(3) Should the costs be historical (embedded) costs or new (marginal) costs?
b. (1) What is the market interest rate on Harry Davis’s debt, and what is the component
cost of this debt for WACC purposes? (Hint pre & post tax) (10%, 5.66%)
(2) Should flotation costs be included in the estimate?
c. (1) What is the firm's cost of preferred stock? (9%)
d. (1) What are the two primary ways companies raise common equity?
(2) Why is there a cost associated with reinvested earnings?
(3) Harry Davis doesn’t plan to issue new shares of common stock. Using the CAPM
approach, what is Harry Davis's estimated cost of equity? (12.8%)
e. (1) What is the estimated cost of equity using the discounted cash flow (DCF) approach?
(12.4%)
(2) Could the DCF method be applied if the growth rate was not constant? How?
f. What is the cost of equity based on the bond-yield-plus-judgmental-risk-premium
method? (13.2%)
Compiled by Prof. Khushboo Vora
 Sem II | Financial Management | 2020-21

g. What is your final estimate for the cost of equity? (12.8%)

h. What is Harry Davis’s weighted average cost of capital (WACC)? (10.278%)
i. What factors influence a company’s WACC?
j. Should the company use the overall, or composite, WACC as the hurdle rate for each of
its divisions?
k. Harry Davis is interested in establishing a new division that will focus primarily on
developing new Internet-based projects. In trying to determine the cost of capital for
this new division, you discover that specialized firms involved in similar projects have
on average the following characteristics: (i) Their capital structure is 10% debt and 90%
common equity. (ii) Their cost of debt is typically 12%. (iii) The beta is 1.7. Given this
information, what would your estimate be for the division’s cost of capital? (14.94%)
l. What are three types of project risk? How can each type of risk be considered when
thinking about the new division’s cost of capital?
m. Explain in words why new common stock that is raised externally has a higher
percentage cost than equity that is raised internally as retained earnings.
n. (1) Harry Davis estimates that if it issues new common stock, the flotation cost will be
15%. Harry Davis incorporates the flotation costs into the DCF approach. What is the
estimated cost of newly issued common stock, taking into account the flotation cost?
(13.567%)
(2) Suppose Harry Davis issues 30-year debt with a par value of Rs 1,000 and a coupon
rate of 10%, paid annually. If flotation costs are 2%, what is the after-tax cost of debt for the
new bond? (6.147%)
o. What four common mistakes in estimating the WACC should Harry Davis avoid?

Compiled by Prof. Khushboo Vora