Class Notes Cost of Capital

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Programme Paper 8
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Financial and Strategic Management Class Notes
Chapter 4
Sources of Raising Long-Term Finance and Cost of Capital
 The cost of capital concept is very important for financial decision purpose by a finance manager.
(Ex- A girl purchasing bags from two different shops.)
 In this chapter, we shall deal with the long-term approach.
 Cost of capital means the cost of arranging/raising the capital. For ex: When we take loan from
a bank, the bank charges interest. Hence, we pay money to get money. In this case, the interest
is an income for the bank and expense for me.
 The cost of capital concept helps to take investment decision. For ex- Suppose, a business gives
a return of 10% and you have got an offer to invest in that business. The investment amount is
₹10 lakhs. You can get this 10 lakh rupees finance from a bank at 12% interest rate will you
invest? The answer is no.
Different names of Cost of Capital

 Cut off rate
 Target rate
 Hurdle rate
 Requirement rate of return
 Minimum rate of return.
Important Note: The topic of cost of capital shall be used in case of present value concept.
 Cost of capital is closely associated with the value of the firm and the earning capacity of
the firm.
Purpose of long-term finance
Finance Finance the Permanent Finance Growth and

Fixed Assets Part of Working Capital Expansion of Business
Factors Determining Long-Term Finance Requirements
Nature of Business Nature of Goods Produced Use of Technology
A manufacturing company needs huge amount of fixed capital in

comparison to a trading concern
1
Sources of Long-Term Finance
Ownership Capital Borrowed Capital

(Internal) (External)
Equity share Retained earnings Debenture Other

capital (savings)
Bonds, bank
loans, etc
Preference share capital
(Owners of the Company) Term loans
(Creditors of the Company)
 Cost of capital is the rate of return that a firm must earn on its project investments to maintain
its market value and attract funds.
Assumptions of Cost of Capital

Three basic Concepts
Hurdle Rate Minimum Rate of Return  Business Risk

 Financial Risk
 Zero Risk level

 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
 The more the risk, the more is the profit.
2
Importance of Cost of Capital
Importance to Importance to Importance to Importance to

Capital Budgeting Capital Structure Evolution of Other Financial
Decision Decision Financial Decisions
Performance
Cash Inflow = Cash Outflow
Measurement of Cost of Capital

 Cost of Debt refers to the cost of long - term debentures and bonds.
 It generally represents the interest components of the cost of capital.
 Cost of debt is calculated after tax because interest payments are tax deductible for the
firm.
 Formula – Kd after tax = (Kd before tax) (1 – tax rate)
Super Note:
Students must note that in the exam while calculating the final answer should be Kd after tax and
not Kd before tax, that means you have to multiply the same with (1 – tax rate).
Tax Deductible Expenses:

Company – A (Tax – 30%)
Profit & loss A/c
Particulars Amt (Rs) Particulars Amt (Rs)
Expenses 50 Sales 100
Interest 0
Net Profit 50
Total 100 100
Tax liability – Rs 15 (50*30%)

Company – B (Tax – 30%)
Profit & loss A/c
Particulars Amt (Rs) Particulars Amt (Rs)
Expenses 50 Sales 100
Interest 20
Net Profit 30
Total 100 100
Tax liability - Rs 9 (30*30%)
3
Illustration 1:
If the cost of debt for cowboy energy service is 10%. Kd before tax (effective rate) and its tax
rate is 40%. Find the Cost of Debt.
Solution:
Kd = 10%
40
Tax rate = 40% = = 0.4
100
Kd after tax = Kd (1 - tax rate)
= 10 (1 – 0.4)
= 6%
= 10 × 0.6
Illustration 2:
Mohit ltd. takes a loan of Rs 100 crore. The Kd after tax is 10% and the tax bracket is 50%.
Find the cost of debt.
Solution:
Cost of debt = 10% [Because in this sum Kd after tax is already given so we don’t need to do
(1-t)]
Nani’s Concept
In this chapter of cost of capital, we are concerned with the actual cost. (Exactly kitna laga)
Illustration 3:
Find the effective interest rate.
Solution:
1. Interest Rate = 6%
2. Face Value (FV) = Rs.100
3. No of debentures = 50
Total FV = 100 × 50 = Rs. 5000
Interest Amount = 6% of 5000 = Rs. 300.
Note:
The interest amount in case of debentures/bonds is always calculated on face value and
not on market value.
4
Question: What if the FV is not given in the question?

Answer: If the FV is not given in the sum then we have to assume that the FV is 100.
Types of Debentures
There are generally two types of debentures:

 Redeemable – Which is repayable after a certain period of time (n is known)
 Irredeemable – Where the time period is not fixed.
Redeemable Debentures
Question:
1000, 10% Debentures of Face Value Rs.100 per share issued at –
i. Par
ii. Discount
iii. Premium
Answer:
Situation 1: (At Par)
Jitna Value tha utna hi mila (Rs.1,00,000 ka maal, 1,00,000 hi mila)
Situation 2: (At Discount)
Jitna tha usse kam mila (Rs.1,00,000 ka maal, 90,000 mila)
Situation 3: (At Premium)
Jitna Value tha usse jyada mila (Rs. 1,00,000 ka maal, 1,10,000 mila)
Question: (Important)
How to approach the sum till the point of Kd before tax in case of par, discount and
premium case of debentures?
Answer: First of all, we need to calculate the interest amount (in any situation)
The interest amount is to be calculated on the Face Value (strictly)
Then we need to recalculate the effective rate with the actual amount received this
shall be the Kd before tax.
5
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Illustration 4:
6% debentures of 1000 (in number) sold at par. Find Cost of Debt.
Solution:
In the given case, the total FV is 1000 × Rs.100 = 1,00,000 (Assume FV is Rs. 100)
Now the given interest rate is 6%
So, the interest amount = 6% of 1,00,000 = Rs 6000
As per the given question the selling has been done at par that means FV = Actual amount
received from the investors. So, if we recalculate the original cost of capital (debt).
The formula shall be:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑚𝑜𝑢𝑛𝑡
× 100
𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑
6,000
= × 100 = 6%
1,00,000
Now we have got finalized Kd before tax & we have to multiply it with
(1 – tax rate) to get Kd after tax.
Illustration 5:
(At Discount)
6% debenture of 1000 (in numbers) sold at discount of 10%. Find Cost of Debt.
Solution:
Total FV = 1000 × 100 = Rs. 1,00,000
10
Discount = 10% = × 100000 = 𝑅𝑠. 10000
100
Interest Amount = 6% of 1,00,000 = Rs 6000

Actual amount received = 100000 – 10000 = Rs.90000
 × 100
6000
 × 100 = 6.66%
90,000
6
Illustration 6:
(At Premium)
6% debentures of 100 (in numbers) sold at the premium of 10%. Find Cost of Debt.
Solution:
Total FV = 1000 × 100 = Rs. 1,00,000
10
Premium = 10% = × 100000 = 𝑅𝑠. 10000
100
Interest Amount = 6% of 1,00,000 = Rs 6000

Actual amount received = 100000 + 10000 = Rs.110000
 × 100
6,000
 × 100 = 5.45%
1,10,000
Cost of Redeemable Debt
 Redeemable debt means where the principal amount (capital) is repaid

 In this type of sum based on redeemable debt, we shall be provided with the number of
years (n).
𝑅𝑉 −𝑆𝑉
(𝐼+ )
 Formula – 𝑛
𝑅𝑉+𝑆𝑉
2
Where:
1. I = Annual Fixed Interest
2. RV = Redeemable Value of debenture net of commission and flotation cost, if any
3. SV = Sale value of debentures net of discount or premium
4. n = Term of debt till maturity
Illustration 7:
A firm issues debenture worth 1,00,000 and realizes 98000 after allowing 2% commission to
brokers. They carry on interest rate of 10% and are due for maturity at the end of 10 th year.
The Company has 40% tax bracket.
7
Solution:
(𝐼+ )
𝑛
Cost of debt = 𝑅𝑉+𝑆𝑉
2
10
I = 10% = × 100000 = 𝑅𝑠. 10000
100
RV = 100000
SV = 98000
n = 10
40
Tax rate = 40% = = 0.40
100
Where:
4. n = Term of debt till maturity.
1,00,000−98,000
10,000+
 10
1,00,000+98,000
2
10200
 × 100
99000
 10.30% (kd before tax)

Kd (after tax) = 10.30% (1-0.40)
= 10.30% × 0.6 = 6.18%
Illustration 8:
X limited issues its bond at par @ Rs 1000 per bond. These bonds will mature after 20 years
at par and bears coupon rate of 10%. Coupons are annual. The bond will sell for par but
flotation costs amount to Rs 50 per bond. What is the pre – tax and after tax of debts for X
limited?
8
Solution:
I = 100
RV = 1000
SV = 1000 – 50 = 950
n = 20
34
Tax rate = 34% = = 0.34
100
Where:
4. n = Term of debt till maturity.
(𝐼+ )
𝑛
Cost of Debt = 𝑅𝑉+𝑆𝑉
2
(1000−950)
(100+ 20
)
= 950+1000
2
50
100+
20
= 1950
2
102.5
Kd before tax = = 10.5%
975
Assuming tax rate = 34%
 10.5 (1 – 0.34)
= 6.93%
 10.5 × 0.66 (kd after tax)
Cost of Preference Share Capital
 Preference Shareholders are the privileged class of shareholders

 They are treated on a priority basis in relation to dividend payment (fixed dividend
subject to availability of profit for distribution) and repayment of capital
 Here there is no treatment of tax rate that is (1 - tax rate)
 Cost of preference share capital is denoted by Kp.
9
Super Note:
Students must note that payment of dividend whether to preference or equity shareholder is not
allowed as on expense for the purpose of taxation.
Question:
Why there is no tax treatment of (1-tax rate) for Kp, Ke, Kr?
Answer:
Dividend is paid on the basis of net profit after reducing all expenses, interests on loan/ debentures,
tax liability etc. that is it is a free profit from any charge. So, the moment tax is also reduced to arrive
at this free profit it means the tax treatment is already done before making the dividend payment.
Hence to avoid double taxation effect, (1 – tax rate) is not involved in the formulae of Kp, Ke and
Kr.
Types of Preference Shares
There are two types of Preference Shares –

 Redeemable preference shares
 Irredeemable preference shares.
Cost of Irredeemable Preference Shares
The company has no obligation to pay back the principal amount of the shares during its
lifetime.
Formula:
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒𝑠
𝐾𝑝 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆ℎ𝑎𝑟𝑒𝑠) =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆𝑡𝑜𝑐𝑘
Illustration 9:
Calculate the cost of 10% preference capital of 10,000 preference shares whose face value is
Rs 100. The market price of the shares is currently Rs 115.
Solution:
Dividend = Rs 10(10% of 100)
Market price = Rs.115
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒𝑠
𝐾𝑝 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆ℎ𝑎𝑟𝑒𝑠) =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆𝑡𝑜𝑐𝑘
10
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𝟏𝟎
= = 8.7%
𝟏𝟏𝟓
Cumulative Preference Shares
Cumulative preference shares are those shares whose dividends will get accumulated if they
are not paid periodically. All the arrears of cumulative preference shares must be paid before
paying anything to the equity shareholders. In case of cumulative preference shares, the
market price of the preference stock, will be increased by such amount of dividend in arrears.
Note:
Always reduce the issue price / market price by the flotation cost or other related cost.
Formula:
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐾𝑝 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑎𝑓𝑡𝑒𝑟 𝑓𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡, 𝑖𝑓 𝑎𝑛𝑦
Illustration 10:
A limited company issues 8% preference shares which are irredeemable. The face value of
share is Rs 100 but they are issued at Rs 105. The flotation cost is Rs 3 per share. Calculate
Cost of Capital.
Solution:
Net proceed = 105 – 3 = 102
Annual Dividend = Rs.8
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐾𝑝 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑎𝑓𝑡𝑒𝑟 𝑓𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡, 𝑖𝑓 𝑎𝑛𝑦
8
= × 100 = 7.84%
102
11
Cost of Redeemable Preference Shares
Formula:
𝑅𝑉 − 𝑆𝑉
𝐷+
𝐾𝑝 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑅𝑒𝑑𝑒𝑒𝑚𝑎𝑏𝑙𝑒 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒𝑠) = 𝑛
(𝑅𝑉 + 𝑆𝑉)
2
Where:
1. Kp = Cost of Preference Shares
2. RV = Redemption Value
3. SV = Sale Value
4. n = Number of years to maturity
5. D = Annual Dividend
Illustration 11:
A company issues 10,000, 8 % preference shares of Rs 100 each redeemable after 20 years
at face value. The flotation costs are Rs 3 per share. Find the cost of capital.
Solution:
RV = Rs. 100
SV = 100 – 3 = Rs. 97
n = 20
Annual Dividend = Rs.8
𝑅𝑉 − 𝑆𝑉
𝐷+
𝐾𝑝 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑅𝑒𝑑𝑒𝑒𝑚𝑎𝑏𝑙𝑒 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒𝑠) = 𝑛
(𝑅𝑉 + 𝑆𝑉)
2
Where:
1. Kp = Cost of Preference Shares
2. RV = Redemption Value
3. SV = Sale Value
4. n = Number of years to maturity
5. D = Annual Dividend
100−97
8+
 20
100+97
2
12
3
8+
 20
197
2
8+0.15
 98.5
× 100 = 8.27%
Cost of Equity
 It is denoted by 𝐾𝑒
 Returns expectation by the equity share holder
Explicit Returns Implicit Returns

(Dividends) (Capital Appreciation)
The cost of equity capital is the minimum rate of return that a company must earn on the
equity financed portion of its investments in order to maintain the market price of the equity
share at the current level.
Capital Asset Pricing Model (CAPM) (Most Popular)

Formula:
Ke = Rf + (Rm - Rf) β
Where:
1. Ke =Cost of equity
2. Rf = Risk – free rate
3. Rm=Equity market required return (expected return on market portfolio)
4. β = Beta is systematic Risk coefficient
Note:
Several times it has been observed that instead of mentioning Rf in the question, the examiner
mentions treasury bills or government securities.
13
Illustrations 12:
1. Rf = 6%
2. Rm= 8%
3. β =0.4
Where:
4. β = Beta is systematic Risk coefficient
Solution:
Ke =Rf + (Rm-Rf) β
= 6% +(8-6) % 0.4
= 6% + (2×0.4)%
= 6% + 0.8% = 6.8%
What do you mean by Rf?
Rf means risk free rate of return. It is the return which an investor gets without taking risk
in the market on his her/her investment. For example- treasury bills, government securities.
Illustration 13:
The treasury bills provide a return of 5% and the market risk premium is 3%. β is 0.3. Find
cost of equity.
Solution:
Where:
β = Beta is systematic Risk coefficient
Ke = Rf + (Rm – Rf) β = 5% + 3× 0.3

= 5% + (8-5) ×0.3 = 5 + 0.9 = 5.9%
14
Beta (β)
The degree to which a company’s equity returns vary with the return of the overall market .
Beta is a function of both the business risk as well as the financial risk.
Risk premium
Return%
Between 3%
and 9%
Market Return
Risk free rate
Risk free rate is normally taken as the

yield on a longer-term government bond
in the county where the project/ company
is based
Beta of the Risk (market)

market β=1
Illustration 14:
Calculate the cost of equity capital for a company whose risk free return = 10% equity market
required return = 18% with a beta of 0.5.
Solution:
Ke = Rf + (Rm-Rf) β
Where:
a) Ke = cost of equity
b) Rf = risk – free rate
c) Rm = equity market required return (expected return on market portfolio)
d) β = Beta is the systematic risk coefficient
Ke = 0.10 + (0.18 – 0.10) ×0.5

Ke = 0.10 + (0.08×0.5)
= 0.10+0.04 = 0.14 or 14%
=
15

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Illustration15:
A&S corporation common stock has beta (β) of 1.2. the risk-free rate is 6% and the market
return is 11%. Determine the risk premium on A&S’s cost of common stock equity using the
CAPM.
Solution:
Risk premium = Rm – Rf
= 11% - 6% =5%
Re = Rf + (Rm – Rf) β
Where:
1. Ke = cost of equity
2. Rf = risk- free rate
3. Rm = equity market required return
4. Β = beta is the systematic risk coefficient.
= 6% + (11%- 6%) ×1.2

= 6% + (5×1.2)%
= 6% + 6% = 12%
Bond Yield Plus Risk Premium Approach

Formula:
Cost of equity = Field on long term bonds + Risk Premium.
Illustration 16:
Given, the yield of debt is 10% and the risk premium as 5%. Calculate cost of equity.
Solution:
Cost of equity = yield on long term bonds + risk premium
=10% +5% = 15%
Note:
 Firms that have risky and consequently high cost of debt will also have consequently high cost
of equity. (Refer Class discussion)
 There is no objective way to determine the risk premium and hence many financial analysts look
at the operating and financial risks of the business and arrive at a subjectively determined risk
premium that ranges between 2 percent and 6 percent.
16
Illustration 17:
Janak limited has its shares quoted in the market price for last several years. Its beta is been
estimated to be 1.30. The yield on T-Bills is 5% and market return is expected to be 15%. Find the
cost of equity of Janak ltd.
Solution:
Ke = Rf + (Rm - Rf) β
= 5% + (15%-5%) 1.30
= 5% + (10 × 1.30) %
= 5% + 13% = 18%
Dividend Growth Model Approach
 This concept typically represents time value of money and capital budgeting concepts
Formula:
𝐷1
𝐾𝑒 𝑜𝑟 𝑟 = +𝑔
𝑃0
Illustration 18:
A company has issued 5000 equity shares of 100 each. Its current market price is ₹ 95per share
and the current dividend is ₹ 4.5 per share. There dividends are expected to grow at the rate of
6%. Compute the cost of equity capital.
Solution:
𝑃𝑜 =95
𝐷𝑜 =4.5
g = 6%
𝑃1= 𝐷𝑜 + 𝑔
6
= 4.5 + ( × 4.5)
100
= 4.5 + 0.27
= 4.77
𝐷1
Ke = +𝑔
𝑝0
4.77
= + 6% = 0.11 or 11%
95
17
Earning Price Ratio Approach
𝐸1
𝐾𝑒 =
𝑝0
Where:
1. 𝐸0= Expected earnings per share for the next year.
2. 𝑃0= Current Market Price per share
3. 𝐸1= (Current EPS) × (1+ Growth rate of EPS)
Illustration 19:
A company has currently 10,000 equity shares of Rs. 100 each and its earnings are Rs.
1,50,000. Its current market price is Rs. 112 and growth rate of EPS is expected to be 5%.
Calculated the cost of equity.
1,50,000
𝐸0 /share =
10,000
= Rs. 15
E1= 𝐸0 + 𝑔
= 15+(0.05 of 15)
= Rs. 15.75
E1
Ke =
𝑃0
15.75
= = 0.14 or 14%
112
Cost of Retained Earning
 It is denoted by 𝐾𝑟
 Usually in maximum cases, 𝐾𝑟 is separately not given. In simple word, 𝐾𝑒 =𝐾𝑟
 Here the concept of operating cost operates.
Question:
Why the retained earnings are not tax adjusted for cost of capital purpose?
Answer:
The retained earnings are derived from the free profit (refer class discussion) and this free profit is
already tax adjusted. So, if we adjust tax again, then there will be double taxation effect.
18
Question:
Why there is no education of floatation cost, brokerage, commission or any other related cost like
under 𝐾𝑃 , 𝐾𝑑 , 𝐾𝑒 ?
Answer:
In case of retained earning there is no new issue or further issue of securities, hence there is no
floatation cost, brokerage, commission, etc.
Retained earnings means savings of the company, hence there is no such cost which is to be reduced
for the ‘nani effect’ (refer to class discussion)
Illustration 20:
ABC ltd. Has expected earnings at ₹ 30/share which is growing at 8% annually. company follows
fixed pay-out ratio of 50%. The market price of its share is ₹ 300.
Find the following:

a) Current cost of equity.
b) Cost of new equity if the firm issues fresh shares at current market price but with floating cost
of 5%
Solution:
a) E1= ₹30/share
b) g = 8%
c) D1 = 15(30×50%)
d) P0= 300
D1
Ke = +𝑔
P0
15
= +0.08
300
= 0.05+0.08 = 0.13 or 13%

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔
Growth (g) = ×100
𝑃𝑟𝑖𝑐𝑒
Ke
b)K ex =
1−f
19
Where:
1. F = floating cost
2. 𝐾𝑒 = cost of internal equity
0.13
𝐾𝑒𝑥 =
1−0.05
0.13
= = 0.1368 or 13.68%
𝟎.𝟗𝟓
Illustration 21:
Asteck ltd. Is expected to earn ₹30/ share. Company follows fixed pay-out ratio of 40%. The
market price of its share is ₹ 200. Find the following -
i. Cost of existing equity if dividend tax of 15% is imposed on the distributed earnings when
a) Current level of dividend amount is maintained
b) When dividend to shareholders is reduced by extent of dividend tax.
ii. How do you interpret the role of dividend distribution tax on cost of equity?
Solution:
1. E 1= ₹30/share
2. D 1= ₹12
3. P0 = ₹200
16.2
4. G = ×100
200
𝐷1
𝐾𝑒 = +𝑔
𝑃0
12
= +0.081
200
= 0.06+0.081 = 14.1%
a) D1 = 12-1.8
= Rs. 10.2
(If the company will recover the tax from the shareholders then the amount of tax will be
deducted from the dividend amount and the 𝐷1 will change).
20
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18
g= ×100
200
= 9%
D1
Ke = +g
P0
10.2
= + 0.09
200
= 0.051+ 0.09 = 14.1%
ii)The cost of equity remains indifferent to the policy of distribution confirming the principal
that cost of equity depends upon the earning levels only and the way how are they
appropriated
Capsule Concept
Weighted Average cost of Capital
Example: Ratio and Proportion
A:B:C = 2:2:1
Value Weights
2
A 50 2 50× = 20
5
2
B 100 2 100× = 40
5
1
C 50 1 50× = 10
5
Illustration 22:
Oxford company has compiled the information shown in the following table -
Source of capital Book value Market value After tax cost

Equity 10,80,000 30,00,000 17%
Preference stock 50,000 60,000 13%
Long term 45,00,000 38,40,000 6%
Total 56,30,000 69,00,000
a) Calculate the weighted average cost of capital using book value weights
b) Calculate the weighted average cost of capital using market value weights
c) Calculate the answers obtained in parts a & b. Explain the differences.
21
Solution:
a)
Source of capital Book value Weight Cost (%) WACC=𝑲𝒆𝒙 we+𝒌𝒑
0.19
Equity 10,80,000 1080000 17 3.23
[ ]
5630000
0.01
Preference stock 50,000 50000 13 0.13
[ ]
5630000
0.80
Long term debt 45,00,000 4500000 6 4.80
[ ]
5630000
Total 56,30,000 1 8.16
b)
Source of capital Market value Weights Cost (%) WACC
0.43
Equity 30,00,000 3000000 17 7.31
[ ]
6900000
0.01
Preference shares 60,000 60000 13 0.13
[ ]
6900000
0.56
Long term debts 38,40,000 3840000 6 3.36
[ ]
6900000
Total 69,00,000 1 10.8
c)The difference lies in the two different value bases. The market value approach yields
the better value because the cost of the components of the capital structure are calculated
using the prevailing market prices. Since the common stock is selling at a higher value than
its book value, the cost of capital is much higher when using the market value weights.
Notice that the book value weights give the firm a much greater leverage position than
when the market value weights are used.
22
Question:
When are we required to calculate the weighted average cost of capital (WACC)?
Answer: When there is more than one source of capital. Say, equity debt, preference debt,
equity preference debt, etc. In these cases, weighted average cost of capital is required.
Illustration 23:
Particulars Existing Additional Cost (%) Existing (WACC)
Value value
Debt 4000 2000 14 5.6
Preference capital 1000 1000 9 0.90
Equity capital 1000 2000 15 1.5
Retain earnings 4000 6000 18 7.2
Total 10,000 11000 1 15.2
4000
1. Debt = ×14 = 5.6
10,000
1000
2. Preference capital = × 9 = 0.9
10,000
1000
3. Equity capital = × 15 = 1.5
10,000
4000
4. Retained earnings = × 18 = 7.2 = 15.2%
10,000
New WACC –
Particulars Weight Cost New WACC
Debt 28.57 14.6 14.6×0.29 = 4.23
Preference capital 9.52 10.5 10.5×0.0952 = 1
Equity 14.28 18.34 18.34×0.1428 = 2.62
Retained earning 47.62 18 18×0.4762 = 8.57
Total 100 N.A 16.42
6000
1. Debt = × 100 = 28.57
21,000
2000
2. Preference = × 100 = 9.52
21,000
3000
3. Equity capital = × 100 = 14.28
21,000
10,000
4. Retained earnings = × 100 = 47.62 = 16.42%
21,000
23
Marginal Cost of Addition
New WACC – Existing WACC

= 16.42 – 15.2
= 1.22%
Illustration 24:
ABC Ltd. Has the following capital structure –
Sl no. Particulars Amount (E)
1. Equity (Expected Dividend 12%) 10,00,000
2. 10% Preference 5,00,000
3. 8% Loan 15,00,000
Solution:
Source of fund Amount (₹) After tax cost of capital Weights Cost
Equity (Exp. Dividend) 10,00,000 12% 33.33 3.99
10% Preference 5,00,000 10% 16.66 1.67
8% Loan 15,00,000 4% 50 2
Total 30,00,000 100 7.66
Illustration 25:
Optimum Ltd. Company uses only debt and internal equity to finance its capital budget and
uses CAPM to compute its cost of equity. Company estimates that its WACC its 12%. The
capital structure is 75% debt and 25%. internal equity. Before the cost of debt is 12.5% and
tax rate is 20%. Risk free rate is 6% and market risk premium is 8%. What is the beta of the
company?
Solution:
WACC= 𝑾𝒅 𝑲𝒅 = 𝑲𝒆 𝑲𝒅
0.12 = 0.75(0.125) (1-t) +0.25𝐾𝑒
0.12 = 0.75 × 10% + 0.25𝐾𝑒
0.12 = 0.075 +0.25𝐾𝑒
0.12 – 0.075 = 0.25𝐾𝑒
0.045 = 0.25𝐾𝑒
0.045
= 𝐾𝑒 = 0.18 or 18%
0.25
24
Now as per CAPM,

Ke = Rf + β(Rm-Rf) 12% = β × 8%
18% = 6% + β (14% - 6%) 12%
=β = 1.5
18% = 6% + β (8%) 8%
Illustration 26:
ABC Ltd. has expected earning at ₹ 30/ share which is growing at 8% annually. Company
follows fixed payout ratio of 50%. The market price if its share is ₹ 300.
Find the following:
Solution:
1. 𝐸1 = ₹ 30/share
2. g = 8%
3. 𝐷1= 15
4. 𝑃0= 300
𝐷1
a) Cost of Equity = +g
𝑃0
15
= + 0.08
300
= 0.05 + 0.08 = 0.13 or 13%
𝐾𝑒
b) 𝐾𝑒𝑥 = . Where, F= Floatation cost
1−𝑓
𝐾𝑒 = Cost of Internal policy
0.13
=
(1−0.05)
0.13
= = 13.68%
0.95
Illustration 27:
A company 10% irredeemable debentures of ₹ 10,000. The company is in 50% tax bracket.
Calculate cost of debt capital at par, at 10% discount and at 10% premium.
25
Solution:
F.V = 10,000
Situation 1: At par
10
Effective Interest = 10,000 × = 1000
100
𝐼𝑛𝑡𝑟𝑒𝑠𝑡
× 100
𝐴𝑐𝑡𝑢𝑎𝑙 𝑖𝑛𝑡𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑
1000
= × 100 = 10% (Kd before tax)
10,000
Kd after tax = 10(1-t)

= 10 (1-0.05)
= 10 × 0.5 = 5%
Situation 2: At Discount (10%)

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
× 100
𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑝𝑎𝑖𝑑
1000
Kd before tax = × 100 = 11.11
9000
Kd after tax = 11.11(1-0.50)

= 11.11×0.5 = 5.55%
Situation 3: At Premium (10%)

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
× 100
𝐴𝑐𝑡𝑢𝑎𝑙 𝑖𝑛𝑡𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑
1000
Kd before tax = ×100 = 9.09
11,000
Kd after tax = 9.09 (1-0.50)

= 4.55%
= 9.09 × 0.5
26

76850-94940

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CS Executive Module 2

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Different names of Cost of Capital

Finance Finance the Permanent Finance Growth and

Factors Determining Long-Term Finance Requirements

Nature of Business Nature of Goods Produced Use of Technology

A manufacturing company needs huge amount of fixed capital in

Sources of Long-Term Finance

Ownership Capital Borrowed Capital

Equity share Retained earnings Debenture Other

Assumptions of Cost of Capital

Hurdle Rate Minimum Rate of Return  Business Risk

 The more the risk, the more is the profit.

Importance of Cost of Capital

Importance to Importance to Importance to Importance to

Cash Inflow = Cash Outflow

Measurement of Cost of Capital

Tax Deductible Expenses:

Tax liability – Rs 15 (50*30%)

Question: What if the FV is not given in the question?

There are generally two types of debentures:

The interest amount is to be calculated on the Face Value (strictly)

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Interest Amount = 6% of 1,00,000 = Rs 6000

Interest Amount = 6% of 1,00,000 = Rs 6000

Cost of Redeemable Debt

 Redeemable debt means where the principal amount (capital) is repaid

 10.30% (kd before tax)

Cost of Preference Share Capital

 Preference Shareholders are the privileged class of shareholders

Types of Preference Shares

There are two types of Preference Shares –

Cost of Irredeemable Preference Shares

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Explicit Returns Implicit Returns

Capital Asset Pricing Model (CAPM) (Most Popular)

What do you mean by Rf?

Ke = Rf + (Rm – Rf) β = 5% + 3× 0.3

Risk free rate

Risk free rate is normally taken as the

Beta of the Risk (market)

Ke = 0.10 + (0.18 – 0.10) ×0.5

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= 6% + (11%- 6%) ×1.2

Bond Yield Plus Risk Premium Approach

Dividend Growth Model Approach