Cost of capital

The rate of return that an organization

must earn on its project investment to
maintain its market value.
Also known as - Cut-off rate
- Target Rate
- Required rate of return

Cost of capital - Explicit or Implicit

Explicit Cost
The explicit cost is the discount rate that equates present value of
inflows with the present value of outflows (similar to IRR).

Implicit Cost
Opportunity costs are technically referred to as implicit cost of
capital.
The rate of return associated with the best investment opportunity
that would be forgone is implicit cost.

Significance of the cost of capital

1)) Evaluating investment decisions and allocating the firms funds
2)) Designing a firms debt policy
3)) Appraising the financial performance of top management

Sources of funds
Equity Shares
Preference Shares
Term Loans, Debentures and Long term debt
Reserves
Each carries a cost denoted by K

Cost of Equity Capital (Ke):The cost of equity may be defined as the

minimum rate of return that a company that a company must earn on
equity shares capital.
Following Methods are used:
A) Dividend yield method
Ke = D1

Po
Where,
Ke = cost of Equity Capital
D1 = annual dividend per share on equity capital in period 1 (expected dividend)
Po = current market price of equity share
When the Equity shares are newly issued, the Cost of Capital can be calculated as follows:
Ke = D1

NP
Where NP = Net proceeds of issue (after deducting floating expenses and discount from
Inflows)
D1 = total expected dividend

Sums: Dividend Yield method

Q1) Rihanna ltd is expected to disburse a dividend of Rs.30 on each equity shares of
Rs.10 each. The current market price of shares is Rs.80. Calculate the cost of Equity
capital as per dividend yield method.
Solution : D1/Po = 30/80*100 = 37.5%

Q2) Beyonce ltd issued 10,000 shares of Rs.10 each at a premium of Rs 2 each. The
company has incurred issue expenses of Rs.5000. The equity shareholders expects
the rate of dividend to 18% p.a. Calculate the cost of equity share capital.
Solution: D1/NP = 18000/(115000) *100 = 15.65%

Q2) Beyonce ltd issued 40,000 shares of

Rs.10 each at a premium of Rs 12 each.
The company has incurred issue
expenses of Rs.15000. The equity
shareholders expects the rate of dividend
to 12% p.a. Calculate the cost of equity
share capital.
Solution: D1/NP = ?

B) Dividend Growth Model

Ke = D1 + g
Po
Where,
Ke = cost of Equity Capital
D1 = expected dividend per share Po = CMP of equity share
g = growth rate at which dividends are expected to grow per year
When Equity shares are newly issued:
Ke = D1 + g
NP
Where, NP = net proceeds
Example: R Ltd is expected to disburse a dividend of Rs.3 on each equity shares of Rs.10 each. The
current market price of shares is Rs.8. Calculate the cost of Equity capital if g = 5%
Note: Sometimes the dividend growth model formula for calculation of cost of equity share capital
is also written as follows, if the last declared dividend is known:
Ke = Do*(1+g) + g
Po
Where,
Ke = cost of Equity Capital
Do = Recent/Last dividend paid per equity share
g = constant annual growth rate of dividends
Po = Current market price per share

 Q3) Whitney ltd has its equity shares of Rs.10 each quoted in a stock exchange has market
price of Rs.56. A constant expected annual growth rate of 6% and a dividend of Rs.3.60 per
Share was paid for the current year. Calculate cost of capital.
Solution: 3.60*(1+0.06) +0.06 = 12.81%

56
Q4) Shakira Ltd has its shares of Rs 10 each quoted on the stock exchange, the current market
price per share is Rs.24. The gross dividend per share over the last four years have been
Rs.1.20, Rs.1.32, Rs.1.45 and Rs.1.60. calculate Ke
Solution: First lets find g
G = 1.32-1.20/1.20, 1.45-1.32/1.32. etc. Approx 10%
Ke = 1.60*(1+0.10) + 0.1

24

= 17.33%

Example:
Tuntun Ltd is expected to disburse a dividend of Rs.6 on each equity
shares of Rs.10 each. The current market price of shares is Rs.10.
Calculate the cost of Equity capital if g = 8%
Ke = ??

 Q5) Amy Lee ltd is an all equity financed company. The CMP of the share is Rs. 180.
It has paid a dividend of Rs. 15 per share and expected future growth in dividend is
12%.

Solution:

[ 15*(1+0.12) ] + 0.12
180

Capital Asset Pricing Model

Ke = Rf + i (Rm Rf)
Where,
Rf = risk free rate of return
Rm= average market return
i = beta of investment or firm

 Q7) Janet Jackson ltd is planning to raise money from the capital
markets which are expected to give a return (Rm) of 14%. The t-bill
going rate is 8%. The beta of the firm is 0.9. Calculate the cost of
equity based on CAPM model
Solution:
Ke = Rf + i (Rm Rf)

= 0.08 + 0.9*(0.14-0.08)

= 13.4%

Micheal-bhai Jackson ltd is planning to raise money from the

capital markets. Sensex is expected to give a 10% return in the last
one year. The 10 year government yield going rate is 8%. The
Covariance of the Rm and IPOs is 0.12 and their market variance is
0.9. Calculate the cost of equity based on CAPM model
Solution:
Beta = Cov (Rp, Rm) / VARm. = 0.12 / 0.9 = 0.133
Ke (capm) = 0.08 + 0.133*(0.10-0.08) = 0.0826 = 8.26%

Cost of Preference Capital: Cost of Irredeemable Preference Shares

(Perpetual Security)
Kp = Dp
NP
Where,
Kp = Cost of preference share
Dp = Expected preference dividend
NP = Net proceeds received Issue price of Preference Share

Q8) Kylie Minogue ltd, issues 11% irredeemable preference shares of the face value of Rs. 100
each. Floatation costs are estimated at 5% of the expected sale price. What is the Kp, if
preference shares are issued at (i) par value, (ii) 10% premium and (iii) 5% discount.
Solution:
(i) Issued at par: 11 / 100*(1-0.05) * 100 = 11.6 percent
(ii) Issued at premium: 11/ {110*(1-0.05)} *100 = 10.5 percent
(iii) Issued at discount: 11 /{95*(1-0.05)}*100 = 12.2 percent

Cost of Redeemable Preference shares

Kp =

Dp + (RV SV) / n
{(RV+SV) / 2}

* 100

Where,
Kp = cost of preference share
Dp = expected dividend at time t
RV= Redemption value or Maturity value of preference share (when shares are
redeemed/repaid)
SV = Sales value or Net proceeds (at time of issue)
n = Maturity period
Q9) Avril Lavigne ltd has Rs. 100 preference share redeemable at a premium of 10% with
15 years maturity. The coupon rate is 12%. Floatation cost is 5%. Sale price is Rs. 95
(net). calculate the cost of preference shares.
Solution:
Kp = 12 + (110-95)/15
(110+95)/2
Kp = ?

Cost of Debt (Irredeemable / Redeemable)

Cost of Irredeemable debt
Before tax cost of debt:
Kd = I / SV
Where,
Kd = Before tax cost of debt
I = Annual interest payment
SV = Sales proceeds of
bonds / debentures (Net proceeds, amount received at time of issue)
Tax adjusted cost of debt
Kd = {I / SV} * ( 1- t )
Where,
Kd = Tax adjusted cost of debt
I = Annual Interest payment
SV = Sale proceeds of bonds
/ debentures
Q10 ) Madonna ltd has 10% perpetual debt of Rs.100,000. 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, and
(iii) 10% premium
Solution:
(i) Debt issued at par: Before tax = 10,000/100,000*100 = 10%, After tax= 10% (1-0.35) = 6.5%
(ii) Debt issued at discount: Before tax = 10,000/90,000*100 = 11.11%, After tax= 11.11% (1-0.35)
= 7.22%
(iii) Debt issued at premium: Before tax = 10,000/110,000*100 = 9.09%, After tax= 9.09% (1-0.35)
= 5.91%

Cost of Redeemable debt

Before tax
Kd = I + {(RV SV) / n}
(RV + SV) / 2
Where,
I = Annual interest payment
RV = Redemption value of debentures (amount payable on maturity of debentures)
SV = Sale proceeds of debentures (amount received at time of issue)
n = Number of years to maturity
After tax
Kd = I + {(RV SV) / n} x (1-t)
(RV + SV) / 2
t = tax rate

Q11) Calculate the explicit cost of debt (after tax) for Annie Lenox limited in
each of the following situations:

(a)
(b)
(c)
(d)

Debentures are sold at par and floatation costs are 5%

Debentures are sold at premium of 10% and floatation costs are 5% of issue price
Debentures are sold at discount of 5% and floatation costs are 5% of issue price.
Assume Interest rate on debentures is 10%, face value is Rs. 100 maturity period is
10 years and tax rate is 35%

Solution:
(a) Kd = [10 + {(100-95)/10} ] / {(100+95)/2} * (1-t) = ?
(b) Kd = [10 + {(100-104.5#)/10} ] / {(100+104.5)/2} * (1-t) = ?

[# 100+10%-5%of 110]
(c) Kd = [10 + {(100-90.25#)/10} ] / {(100+90.25)/2} * (1-t) = ?

[#100-5% - 5%of 95]

Cost of Retained Earnings

Opportunity cost approach
Kr = Kr = Ke (normally used)
Where,
Kr = cost of retained earning

D = rate of dividend

t = tax rate of dividend

Weighted Average Cost of Capital

CIMA defines WACC as the average cost of the company's finance (equity, preference and
debt) weighted according to the proportion each element bears to the total pool of capital
WACC = (Cost of equity x % of Equity) + (Cost of debt x % of debt)
Where,
Ko = Weighted average cost of capital
Kd (1-T) = After tax cost of debt
Ke = Cost of Equity
D = amount of debt
E = amount of equity

Ko = Kd (1-T) Wd + KeWe
OR

Ko = Kd (1-T)* D + Ke* E

D+E
D+E

Two approaches: Book Value based and Market value based

Q14) Stefani ltd has a capital gearing ratio of 40%. Its cost of equity is 21% and cost of debt is
15%. Compute WACC
Solution: WACC = (0.21 * 0.60) + (0.15 * 0.40)

Q15) Sheena Cements ltd has given you the following capital structure, Calculate WACC based on book
values and market values. Cost of capital is net of tax.

WACC based on Market

values
Sources Market

Values

0.53333
Equity
80
3
Preference
30
0.2
0.26666
Debentures
40
7

Total

150

WACC based on BOOK values

Cost WACC
(%)
18
15
14

47

9.6
3
3.73333
3
WACC
=16.33
3

Sources

Book

Cost

WACC

Values

(%)

Equity

120

0.666667

18

12

Preference

20

0.111111

15

1.666667

Debentures

40

0.222222

14

Total

180

47

3.111111
16.7777
8

WACC = 16.78%

 Q16) Britney Spears limited is considering raising of funds of about Rs. 100 lakhs by one
of the two alternative methods viz., 14% institutional term loan and 13% non-convertible
debentures. The term loan option would attract no major incidental cost. The debentures
would have to be issued at a discount of 2.5% and would involve a cost of issue of Rs. 1
lakh. You are to advise the company as to the better option based on the effective cost of
capital in each case. Assume a tax rate of 50%.
(CA Final 1991)

Solution: Evaluation of Raising Rs. 100 lakhs based on Effective cost of capital (Amount in Lakhs)

Recommendation:
the
cost of capital is lower i.e.
6.74%, if company raises
13%
non-convertible
debentures (NCDs) and
hence it is suggested to
issue NCDs and raise
funds.

See hand out for more sums..

 Caselet: Aries limited wishes to raise additional finance of Rs. 10 lakhs for meeting its investment
plans. It has Rs. 210,000 in the form of retained earnings available for investment purposes. The
following are the further details: (1) debt-equity mix 30:70 (2) cost of debt up to 180,000, 10
percent (before tax); beyond 180,000. 12 percent (before tax) 3. EPS = Rs. 4 per share (paid)
4. Dividend payout, 50 percent of earnings 5. Expected growth rate in dividend, 10 per cent
6.
CMP = Rs. 44 (on BSE). 7. Tax rate = 35% YOU are required to (a) determine the pattern for
raising the additional finance, assuming the firm intends to maintain existing debt-equity mix
(b) to determine post tax average cost of additional debt (c) to determine cost of retained
earnings and cost of equity (d) compute overall cost of capital after tax of additional finance

Solution: (a) Pattern for raising additional finance:

Debt = 0.3*10L = Rs. 3 Lakh;
Equity: 0.7*10 L = Rs. 7 Lakh
Break up of Source of Funds:
Retained Earnings 210,000 + Equity (b.f.) 490,000 = Total Equity Funds = Rs. 700,000
Debt funds (Rs 300,000): 10% debt = 180,000 + 12% debt 120,000 = Total = Rs. 300,000
(b) Kd = I / NP x (1-t) : (18000+14400)/300,000 (1-0.35) = 7.02%
(c) Ke = Rs 4(50%) (1+0.10) + 0.10 = 15%
Kr = Ke = 15%
Rs. 44
(d) Overall cost (WACC)

Practice Questions

Ques 1 A company issues 11% debentures of Rs.100 for an amount aggregating

Rs.1,00,000 at 10% discount, redeemable at par after 5 years. The companys tax
rate is 35%. Determine the cost of debt.

Ques 2 Calculate the explicit cost of debt for each of the following situation:
a) Debentures are sold at par and floatation costs are 5% of issue price.
b) Debentures are sold at premium of 10% and floatation costs are 5% of issue price.
c) Debentures are sold at discount of 5% and floatation costs are 5% of issue price.
Note: Coupon rate of interest on debentures is 10%
Face Value of debentures is Rs.100, Maturity period is 10 years

Tax rate is 35% , Redemption at Par

Ques 3 Compute the cost of Preference shares sold at Rs.100 with 9% dividend and
a redemption price of Rs.110 if the company redeems it in 5 years.

Ques 4 Calculate the cost of an ordinary share selling at a current market price of
Rs.120 and paying dividend of Rs.9 per share which is expected to grow at a rate of
8%.

Ques 5 From the following information, determine the cost of equity capital using the CAPM approach:
a) Required rate of return on risk-free security is 8%
b) Required rate of return on market portfolio of investment is 13%
c) The firms beta is 1.6
Ques 6 Investors require a 12% rate of return on equity shares of company Y. What would be the market price of
the shares if the dividend for the previous year was Rs.2 and investors expect dividends to grow at a constant rate
of
i) 4% , (ii) 0% (iii) -4%
(iv) 11%
Ques 7 A mining companys iron ore reserves are being depleted and its cost of recovering a declining quantity of
iron ore are rising each year. As a consequence, the companys earnings and dividends are declining at a rate of
8% per year. If the previous years dividend was Rs.10 and the required rate of return is 15%, what would be the
current price of the equity share of the company?
Ques 8 A company has on its books the following amounts and specific costs of each type of capital:
Capital
Book Value
Market Value
Specific Cost (%)
Debt
Rs.4,00,000
Rs.3,80,000
5
Preference
1,00,000
1,10,000
8
Equity
6,00,000
12,00,000
15
Retained Earnings
2,00,000
13
13,00,000
16,90,000
Determine the weighted average cost of capital using
(i) Book value weights (ii) Market value weights
Note: Market value is for Equity and Retained Earnings together.

Cost of Capital Practices in India

The most frequently used (67% cases) discount rate to evaluate capital budgeting
decision is based on the overall cost (WACC) of the corporate.
Depending upon the risk characteristics of the project, multiple risk-adjusted discount
rates are used by about 1/5th of corporate enterprises in India
The CAPM model is most popular method of estimating the cost of equity (54% cos.)
The Gordon`s dividend model is equally popular method to compute the cost of equity
(52% cos.)
As regards debt, the cost of debt, the most widely used method is the interest tax
shield method