COST OF CAPITAL

Capital Budgeting decisions depend upon 2 basic factors –

• Cash flows of the projects
• The discount rate
The discount rate is the cut-off rate, the minimum required
rate of return. It is also called the target rate or the
hurdle rate.
This rate is called the Cost of Capital.
It is used in Capital budgeting decisions.
It is also used to optimise the capital structure or the financial
plan of the firm.
What is the minimum required rate of return?
It is the cost of raising funds for the investment proposals of the
firm.
So, the cost of capital is the minimum rate of return a firm must
earn so that it can source the necessary funds.
If the actual rate of return exceeds the cost of capital, then it
makes a net contribution to the wealth of the shareholders,
given that there is no increase in risk.
The cost of capital when used as the discounting rate in capital
budgeting, helps the firm to choose only those investments
which increase the value of the firm.
So, to increase the value of the firm, the cost of capital must be
minimised.
Cost of capital is also known as the opportunity cost of capital.
In an all equity financed company, the equity capital is the
only source of finance.
So the company’s cost of capital is equal to the opportunity
cost of equity capital which depends upon the business risk
of the firm.
Factors affecting the cost of capital of a firm –
• Risk free interest rate – It
• Business risk – b
• Financial risk – f
• Other considerations

So, cost of capital k = It + b + f

Risk and return –
Investors must be compensated for undertaking any additional
risk or else they will not supply the required funds.
Government securities do not have any risk and so they have
the lowest return to the investor.
This rate is called the risk free rate of return .
The rate of return on bonds issued by Government
departments is higher than the risk free rate.
The rate of return on private sector bonds is even higher, since
the risk is higher.
The rate of dividend on preference shares will be higher than
bonds since they are riskier than debts.
The rate of return expected on equity shares will be highest,
since they bear the highest risk.
The cost of capital of a firm can also be analysed as explicit
or implicit cost of capital.
Interest on capital, dividend at fixed rate on preference
shares, expected dividend on equity shares are all explicit
cost of capital.
Retained earnings are profits earned by the firm but not
distributed to the shareholders.
Retained earnings are a substantial source of funds for the
firm.
The firm has an implicit cost of retained earnings and this
implicit cost is the opportunity cost of the investors.
Except for retained earnings, all other sources of funds have
explicit cost of capital.
Measurement of cost of capital –
The cost of capital is measured at a given point of time but it
must reflect the cost of funds over the long run since it is
used in capital budgeting decisions which provide benefits
in the long run.
Assumptions – the measurement of the cost of capital is
based on the following assumptions.
• Business risk is unaffected by the proposal being evaluated
• Financial risk remains unchanged
• Tax implications
• Omission of short term sources of credit
The overall cost of capital is the combined cost of different
sources of capital like
• Long term debt and loans
• Preference shares
• Equity shares
• Retained earnings.
The firm has a specific cost of capital for each of these
sources and on the basis of the specific cost, the overall
cost of capital of the firm can be determined.
Cost of bonds and debentures –
It depends upon
• The current level of interest rates
• Default risk of the firm
• Tax saving in debt
Cost of perpetual debt –
kd = I (1-t)
D
Where kd = after tax cost of debt
I = Annual interest payment
t = tax rate
D = net proceeds of debt issue
Cost of redeemable debt –
It is the discount rate which equates the net proceeds from the
debt to the expected cash outflows in the form of interest
and principal repayments
kd = I (1-t) + F – P
n
F+P
2
Where F = redemption value of debt
P = net amount realised
n = maturity period
1. S Ltd issued non-convertible debentures for Rs.5 lakhs.
Each debenture has a face value of Rs.100 and has a
coupon rate of 10%. The interest is payable annually
and the debenture is redeemable at a premium of 5%
after 5 years. If the debenture was issued for Rs.97 and
tax rate is 40%, what is the cost of the debt.

kd = 10(1-0.4) + (105 – 97)/5

(105 + 97)/2
= 7.52%
If the firm decides to write off the difference between the
redemption price and the net amount realised in equal
amounts over the life of the debt, the amount so written off
is a tax deductible expense.
The cost of debt then gets modified
kd = I (1 – t) + (F – P) (1 – t)
_________n_______
(F + P)/2
2. X Ltd issued 12% debentures of face value Rs.100. The
debentures were issued for Rs.96 and were redeemable
at a premium of 2% after 6 years. The loss on issue and
redemption is to be written off over the life of the
debentures and is tax deductible. Tax rate is 40%. What
is the cost of debt.

6.67%
Cost of Preference share capital –
kp = D + (F – P)/n
(F + P)/2
Where D = Preference dividend per share
3. If a company pay tax @ 50%, compute the after tax cost
of capital in the following cases:
i) A 12% preference share sold at par
ii) A perpetual bond sold at par, coupon rate of interest
15%.
iii) A 10 year, 8% Rs.1,000 par bond sold at Rs.950 less 4%
underwriting commission.
iv) A preference share sold at Rs.100 with a 9% dividend
and a redemption price of Rs.110 after 5 years.
v) A 12 year 16% Rs.1000 bond sold at Rs.960 less 5%
flotation costs, redeemable @ 110%.