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Introduction

Important input in the capital budgeting It helps in determining present value Called weighted average of the cost Major long term sources of funds are 1) Debt , 2) preference shares,

3)retained earnings, and 4) equity capital Each source of fund has its cost called the specific cost of capital

SPECIFIC COST OF CAPITAL

SPECIFIC COSTS OF CAPITAL COST OF DEBT 1) Perpetual debt Ki= I/SV Kd= I/SV (1-t) where Ki= before tax cost of debt Kd= after tax cost of debt I= annual interest payment SV= amount of debt t= tax rate

COST OF PREFERENCE SHARES

IRREDEEMABLE SHARES

REDEEMABLE SHARES

**IRREDEEMABLE SHARE CAPITAL
**

CALCULATION:Kp = Cost of preference share capital D p = Annual dividend Po = Sale price f = Flotation cost

FORMULAE: K p = D p / P o (1-f)

**REDEEMABLE SHARE CAPITAL
**

Po (1-f) =

N t=1

Dt/ (1+Kp)+ Pn/(1+Kn)n

Pn =repayment of principal

EQUITY CAPITAL

**COST OF EQUITY CAPITAL
**

DIVIDEND APPROACH METHOD:Ke = cost of equity capital D1 = expected dividend per share at the end of the year Po = current market price f = flotation cost g = growth in expected dividends

FORMULAE-: Ke = [D1/Po (1-f)]+g

**CAPITAL ASSET PRCING MODEL (CAPM) APPROACH
**

Rf = required rate of return on risk free investment b = beta coefficient Km = required rate of return on market portfolio, i.e , the avg. rate of return on all assets. FORMULA:-

Ke = Rf + b(Km Rf )

**WEIGHTED AVERAGE COST OF CAPITAL
**

Ko = overall cost of capital Wd = percentage of debt to the total capital Wp = percentage of preference shares to the total capital We = percentage of external equity to total capital Wr = percentage of retained earnings to total capital

Formula

Ko = KdWd +KeWe+KrWr

Problem

A financial consultant of HPCL recommends that the firm should estimate its cost of equity capital by applying the capital asset pricing model rather than the dividend yield plus growth model. He has assembled the following facts: (i) Systematic risk of the firm is 1.4 (ii) 182 days Government treasury bills currently yields 8% (iii) Expected yield on the market portfolio of assets is 13%

Determine the Cost of Equity Capital based on the above data

Formula

Cost of equity capital

where Rf = Required rate of return on risk free investment b = Beta coefficient Km =Required rate of return on market portfolio, ie., the average rate of return on all assets

**Solution To the Problem
**

Cost of Equity Capital Ke =R f +b(Km-Rf) = 8% + 1.4(13%- 8%) = 15%

Note: Yield on treasury bills is considered a good proxy for risk free required rate of return

Indian oil corporation sold Rs 1,000 16%debentures

carrying no maturity date to the public 5 years ago. Interest rate since have risen so that the debentures of the quality represented by this company are selling at 14% yield basis.

i.

ii.

Determine the current indicated market price of debentures would you buy the debentures for Rs 12,00? Assuming that the debentures of the company are selling at Rs 1,040 and if the debentures have 8 years to run to maturity, compute the approximate effective yield an investor would earn on his investment .

SOLUTION

i.

**Vd= Interest on debentures(I) =Rs 160 =Rs 1,143
**

Current interest rate (Kd) 14% (No,the debenture is not worth purchasing for Rs 12,000)

ii.

Rs 825 =

Rs 120 + Rs 1000 (1 + Kd)t (1 +Kd)8 Let us try the discount rates of 15% and 16% as coupon rate is 15%.

PV Year 1-8 8 Cashflow Rs 160 1000 15% 4.487 0.327 16% 4.344 0.305 TOTAL PV 15% Rs717.92 327.00 1,044.92 16% Rs 695.04 305.00 1,000.04

Effective yield=15%

Essar Global Limited is a diversified business corporation with a balanced portfolio of assets in the manufacturing and services sectors of Steel, Energy, Power, Communications, Shipping Ports & Logistics, and Construction. Essar Global employs over 40,000 people across offices in Asia, Africa, Europe and the Americas. With a firm foothold in India, Essar Global has been focusing on global expansion with projects/investments in Canada, USA, Africa, the Middle East, the Caribbean and South East Asia. Privately owned and professionally managed, Essar is judiciously invested in the commodity, annuity and services businesses. Forward and backward integration, state-of-the-art technologies, in-house research and innovation have made Essar Global a leading player in each of its businesses. Essar s abiding philosophy is to be a low cost, high quality, technology driven group with innovative customer offerings.

Work Problems

1. Essar Global has issued 15% preference shares of the face value of Rs 100 each to be redeemed after 10 years. Floatation cost is expected to be 4%. We have to determine the cost of preference shares of the company. Formula : -- Cost of preference shares: Redeemable: - P0 (1 - f) = n

t=n

D (1+KP )t

+

Pn ( 1+KP )

KP = Cost of preference share capital DP = Annual dividend P0 = Sale Price f = Floatation cost

Solution

Cost of preference shares (K p ) P0 (1 - f) = 10

t=1

Rs. 15 + ( 1+KP ) t

Rs.100 (1+KP )10

**Kp is likely to lie between 15 and 16% as rate of dividend is 15%.
**

Year 1-10 10 Cash 15% PV Flow(Rs) 15 100 5.019 0.247 16% PV 4.833 0.227 15%PV 16%PV Total(Rs) Total(Rs) 75.28 24.70 99.80 72.50 22.50 95.20

Therefore Kp = 15% + 0.8 = 15.2% 4.78

WORK PROBLEM 2

2. Equity Shares of Essar Global are currently selling for Rs. 125 per share. The company expects to pay Rs. 15 per share as dividend at the end of the coming year and the estimated growth rate is 6%. It is expected that new equity shares can be sold at Rs 123; the company expects to incur Rs 3 per share as floatation cost. What is the cost of equity capital? SOL: Ke = D1 Po (1-f)

+

g = 15/120 + 0.06 = 18.5 %

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