COST OF CAPITAL

SEEMA CHAKRABARTI
 MEANING
COST OF CAPITAL:
It is the return paid to an investor or the
lender of funds on the money borrowed from
him by the company.It may be in the form of
dividends or interest or the opportunity cost
of funds in case of retained earnings.
 SIGNIFICANCE OF THE COST OF
CAPITAL
 Evaluating investment decisions,

 Designing a firm’s debt policy, and

 Appraising the financial performance of

top management
 SOURCES OF CAPITAL
The capital required for a firm can be funded
through any one or more of the following
sources:

EQUITY SHARES forming equity capital.

PREFERENCE SHARES forming preference capital.

DEBT INSTRUMENTS forming debt capital.

 Cost Of Equity
MEANING:
It is the minimum rate of return that a firm must
offer to its shareholders to compensate for waiting
for their returns and bearing some risk.

There are two sources of equity finance:

 Retained Earnings or Internal Equity

 Issue of New Shares to public or Right Shares Known

as External Equity.
 Cost Of Equity
In case of retained earnings, the cost comes in the
form of opportunity cost and is delivered in the form
of capital appreciation (i.e. increase in share prices)
whereas in case of new issue of shares to public or
right shares issued to existing shareholders ,it is paid
in form of dividends.

In case of issue of additional shares, the company

has to incur additional cost in the form of floatation
costs. The floatation cost generally ranges between
2-10%.
 Cost Of Equity
The returns to be considered are expected future
returns, not the historical returns, hence it should be
expressed as the anticipated dividends on the shares
every year in perpetuity.

It involves a certain degree of risk as the RETURNS

ARE NOT FIXED.

The risks associated with equity can be broadly

divided into two categories:
 Unsystematic Risk or Unique risk
 Systematic Risk or Market Risk
 UNSYSTEMATIC RISK
The unsystematic risk is specific to a security.

It generally stems from firm specific factors.

It is measured in terms of STANDARD DEVIATION,

which is a measure of the dispersion of a set of data
from its mean.The higher the value, the riskier the
stock. A volatile stock will always have a high
standard deviation.

It may be considerably eliminated by an efficient

portfolio diversification.
 SYSTEMATIC RISK
The systematic risk affects the market as a whole.

Also known as "un -diversifiable risk" as it cannot be

eliminated.

It is measured in terms of BETA, which reflects the

sensitivity of a stock to the movements of the market
as a whole.

Interest rates, recession and wars all

represent sources of systematic risk because they
affect the entire market and cannot be avoided
through diversification.
Cost Of Equity
( Dividend Growth Model)
I ) Internal Equity or Retained Earnings;
A) Normal Growth:
DIV1 P0 denotes price of
ke   g
P0 new shares or
market price in case
B) Supernormal Growth: of existing shares
t
n
DIV0 (1  g s ) DIVn  1 1
P0   t
 
t= 1 (1  ke ) ke  g n (1  ke ) n
Cost Of Equity
( Dividend Growth Model)
c) Zero Growth: In case of zero growth( i.e
g=0), a firm will not retain any earnings &
hence distribute all profits as dividends.
Therefore,

DIV1 EPS1
ke   (since g  0)
P0 P0
Cost Of Equity
( Dividend Growth Model)
II ) External Equity:

DIV1 P0 denotes price of

ke   g
P0 new shares or
market price in case
Where, of existing shares
P0 = Issue Price of Shares
g = Growth rate of Dividends
DIV1 = Dividend paid in next year
Cost Of Equity
( Dividend Growth Model)
LIMITATIONS:
It cannot be applied to companies which do not pay
dividends or which are not listed on stock exchange.

The assumption that dividends will grow at a

constant rate is not valid.

There is no explicit consideration of risk.Only an

implicit consideration in the form of stock prices is
done.
Cost of Equity & Earnings Price
Ratio

EPS1 (1  b)
ke   br (g  br )
P0
EPS1
 (b  0)
P0
Cost Of Equity
( Capital Asset Pricing Model )
CAPM :
It refers to a model that helps in calculating the
returns that are required by an investor by investing
in a particular security, given a particular level of risk.

The returns required by an investor are for

compensating two things:

 Time value of money

 Market risk associated with a security

Cost Of Equity
( Capital Asset Pricing Model )
TIME VALUE OF MONEY : It represented by the
risk-free rate, which is generally taken to be equal to
the yield given by a long term government bond of
maturity period of more than 10 years.It
compensates the investors for placing money in any
risk-free investment avenue over a period of time.
Cost Of Equity
( Capital Asset Pricing Model )
MARKET RISK ASSOCIATED WITH A SECURITY:

It refers to additional compensation in the form of

risk premium that an investor would ask for taking
additional risk.

Market risk or the risk premium is given by the

difference between the average returns given a
market portfolio and the average risk free rate over
the past 10 years or more multiplied by the beta of a
security i.e ßs ( E (RM) – Rf ).
Cost Of Equity
( Capital Asset Pricing Model )
Thus,

According to CAPM,the returns required from a

security or a portfolio of securities equals the risk-
free rate plus a risk premium.

Or

Mathematically speaking:
Cost Of Equity
( Capital Asset Pricing Model )
REQUIRED RETURNS ON A SECURITY S:
E(R)S= Rf + ßs ( E (RM) – Rf )

where,
E(R)S = Required returns on a security S
Rf = Risk free return
ßs = Beta of Security S
E(RM)= Expected return on market portfolio
Cost Of Equity
( Capital Asset Pricing Model )
If the expected return does not meet or beat the
required return, then the investment should not be
undertaken.
Cost Of Equity
( Capital Asset Pricing Model )
ASSUMPTIONS OF CAPM:
Only systematic risk is taken into account assuming
that investors are able to eliminate unsystematic risk
themselves by portfolio diversification.

Investors are risk averse.

Investors can borrow and lend freely at the risk free

rate of interest.

The market is perfect – there are no taxes, no

transaction costs, securities are perfectly divisible and
the market is competitive.
Cost Of Equity
( Capital Asset Pricing Model )
LIMITATION OF CAPM:
Beta of a securities keep changing,thus using
a historical beta value for cost calculation
becomes questionable.
Debt As A Source Of Finance
Debt instruments are contracts in which one party
lends money to another on predetermined terms with
regard to rate of interest to be paid by the borrower to
the lender, the periodicity of such interest payments,
and the repayment of the principal amount borrowed
(either in installments or in bullet).

In the Indian securities markets, we generally use the

term ‘bond’ for debt instruments issued by the central
and state governments and public sector
organizations, and the term ‘debentures’ for the debt
instruments issued by the private corporate sector.
 Debt As A Source Of Finance
The three principal features of bonds are:
 Principal – refers to the amount that has been
borrowed and is also called the par value or the face
value of the bond.
 Coupon – refers to the rate at which the interest is
paid, and is usually paid as a percentage of the par
value or the face value of the bond.
 Maturity – refers to the date on which the bond
matures or the date on which the borrower has
agreed to repay (redeem) the principal amount to
the lender.
 Cost Of Debt
It refers to the the effective rate that a company
pays on its current debt.It can be measured in terms
of either before or after-tax returns.

Debt can be in the form of debentures or bonds,

bank loans,commercial papers etc.

In case of a bank loan or a commercial paper, the

cost will be the rate of interest that is to be paid back
to the bank or the corporate issuing such commercial
paper.
 Cost Of Debt

In case of any other debt instrument it

is calculated as it’s “yield to maturity” .

Since interest expense is deductible, the

after-tax cost is used most.
 Cost Of Debt V/S Cost Of Equity

Cost of debt is always less than equity because:

 The rate of interest required to be paid on

debt is always less as compared to equity

because the risk involved with debt is always
less than equity.
 The interest paid on debt can be setoff

against pre-tax profits, thus reducing the tax

liability of a company.Hence, a profitable
company effectively pays all the more less for
debt capital than equity.
 Cost Of Debt V/S Cost Of Equity
 Floatation costs associated with raising debt is
generally less as compared to equity shares.
 Cost Of Debt
Debt Issued at Par
INT
kd  i 
B0
Debt Issued at Discount or Premium
n INTt Bn
B0   
t 1 (1  k ) 
t n
d (1 k d )
Tax adjustment  
After-tax cost of debt  kd (1  T )
Cost Of Debt
( Approximate Method)
The “BEFORE TAX” cost of debt is equal to it’s Yield to
Maturity and is given by:

kDBT = I + ( F – PO ) / n
1 / (P + F)
2 O

Where,
kDBT = Cost of debt
I = Annual Interest Payment
PO = Current market price or issue price
n = numbers of years left to maturity
F = Maturity value or redemption price
Cost Of Debt
( Approximate Method)
The “AFTER TAX” cost of debt is given
by:
kDAT = kDBT (1 – T)

where,
kDAT = After tax cost of debt
kDBT = Before tax cost of debt
T = Marginal tax rate of a firm
Cost Of Preference Capital
The preference capital carries a fixed rate of
dividend.

They are redeemable in nature.

It does not produce any tax savings as it is not a tax

deductible expenditure.

The formula for calculating cost of preference capital

is same as the formula for cost of debt before tax.
Cost Of Preference Capital
Irredeemable Preference Share  

PDIV
kp 
P0
Redeemable Preference Share  
n PDIVt Pn
P0 =  +
t 1 (1  k ) 
t n
p (1 k p )
COST OF CAPITAL OF A FIRM
AVERAGE COST OF CAPITAL (WACC)OF
A FIRM IS GIVEN BY:

The weighted average cost of various

sources of finances used by the company in
the form of equity, preference or debt capital.
 WEIGHTED AVERAGE COST
OF CAPITAL
WACC = wEkE + wPkP + wDkD (1- tc)
Where,
wE = Proportion of equity
kE = cost of equity
wP = proportion of preference
kP = cost of preference
wD = proportion of debt
kD = cost of debt
tc = corporate tax rate
 WEIGHTED AVERAGE COST
OF CAPITAL
Ex:The cost of specific sources of capital for BHEL is:
rE = 16%, wE =0.60
rP = 14%, wP =0.05
rD = 12%, wD =0.35
The tax rate is 30%
WACC :-
16* 0.60 + 14*0.05 + 12*0.35(1-0.3)
=9.60 + 0.70 + 2.94
=13.24%
WEIGHTED MARGINAL COST OF
CAPITAL
CONCEPT:
Given the capital structure of the firm,the
weighted average cost of capital tend to
increase as firms seek more and more capital.

This is because as suppliers provide more

funds they start expecting higher returns.
WEIGHTED MARGINAL COST OF
CAPITAL
BREAKING POINT: The level at which the cost of
new components would change given the capital
structure of the company is known as Breaking
Point.It is calculated as:
BPs = TFs / Ws

where,
BPs = Breaking Point of source (s)
TFs = Total new financing from source (s) at the
breaking point
Ws = Proportion of source (s) in the capital structure
WEIGHTED MARGINAL COST OF
CAPITAL
PROBLEM:
The following is the set of data relating to the capital
structure & the cost associated with the various sources of
finance for different ranges (Rs in million):

SOURCE/RATIO RANGE (Rs) COST(%)

0 – 30 18
EQUITY (40%)
More than 30 20
DEBT 0 - 50 10
(60%) More than 50 11
 CALCULATE:
 The Breaking point at which the cost of new
components would increase?
 WACC for various ranges of total financing
between breaking points?
 Prepare the marginal cost of capital schedule
which reflects the WACC for each level of total
new financing?
CALCULATION FOR BREAKING POINT AND NEW RANGE
OF FINANCE

NEW
SOURCE COST (%) RANGE BP
RANGE

18 0-30 30/0.4=75 0-75

Equity
20 Above 30 -- Above 75

10 0-50 50/0.6=83.3 0-83.3

Debt
11 Above 50 -- Above 83.3
RANGE OF SOURCE OF PROP. IN COST (%) WEIGHTED
NEW CAPITAL TOTAL (3) COST (%)
FINANCE (1) CAPITAL [(2)*(3)]
(2)
Equity 0.4 0.18 .072
0-75 Debt 0.6 0.10 .060
WACC .132
Equity 0.4 0.20 .080

75-83.3 Debt 0.6 0.10 .060

WACC .140

Equity 0.4 0.20 .080

Above Debt 0.6 0.11 .066

83.3
WACC .146
RANGE OF TOTAL WEIGHTED MARGINAL
FINANCING COST OF CAPITAL (%)

0-75 13.2

75-83.3 14.0

Above 83.3 14.6