Cost of Capital

Cost of Capital Definition

• Minimum rate of return that a firm must earn on to
investment for the market value of the firm to remain
unchanged.
• Explicit cost: Rate that the firm pays to procure financing.
• Implicit cost: It is the rate of return associated with best
investment opportunity forgone.
 Problem
• Ordinary Shares (2,00,000 Shares) 40,00,000
• 10% Preference Shares (100) 10,00,000
• 14% debenture (100) 30,00,000
• 80,00,000
• Market Price= 20 Dividend = 2 Per Share
growth rate=7% tax rate=50%

• Find out cost of capital of the firm

 Cost of Debt
• Ki = *100
• I is interest NP is Net Proceeds
• K stands for cost of capital
• Interest 14% Face Value 100
• So Rs.14 per debenture
• *100 =14%
• *100 =14%
• Simply we can say 14%
• Interest is paid before tax
• This is before tax cost of capital
 After Tax
• For comparison we require common cost of capital
• What we require is after tax cost of capital
• Kd = *100
• = *100
• *100
• =7%
• Simply 14(1-.5) = 7%
 Cost of Preference Share
• Kp = *100
• D is Preference Dividend NP is Net Proceeds
• *100 =10%
• Preference dd is 10% so we can simply say 10%
• Dividend is paid after tax
• So it is after tax only
 Cost of Equity
• Ke = +g
• D1 = Future Dividend, Expected Dividend or D1= D0(1+g)
• P is the Market Price
• G is a growth rate
• Whatever divided given let us presume that, that is future
dividend
• D1=2, P=20, g=7% or 0.07
• Ke = +.07 = .1+.07 = 0.17 = 17%
• Dividend is paid is after tax – Calculated is only after tax
 Overall
• For the entire firm
• Capital budgeting
Source Capital Cost Payment/cost
Equity 40,00,000 17 6,80,000
Preference 10,00,000 10 1,00,000
Debenture 30,00,000 7 2,10,000
80,00,000 9,90,000

• Ko = *100
• = = .12375
• =12.38%
 Another Method
Source Capital Cost Proportion Cost
Equity 40,00,000 17 0.5 8.5
Preference 10,00,000 10 0.125 1.25
Debenture 30,00,000 7 0.375 2.625
80,00,000 1 12.375

• Proportion of that capital in overall capital =

• 12.375 = 12.38%
 Additional Capital
• Additional 20,00,000 debt 15%
• DD -> 3 Price = 15 per share
• For additional debt
• I(1-t)
• 15(1-t) = 15(1-.5) = 7.5
• Ke = +.07 =.2+.07 =.27=27%
• Ke =27, Kp=10, Kd1=7, Kd2=7.5
 Overall
Source Capital Cost (%) Payment (Cost in Rs)
Equity 40,00,000 27 10,80,000
Preference 10,00,000 10 1,00,000
14% Debenture 30,00,000 7 2,10, 000
15% Debenture 20,00,000 7.5 1,50,000
100,00,000 15,40, 000

• = = .154 = 15.4%

Source Capital Cost Proportion Cost (in%)

Equity 40,00,000 27 .4 10.8
Preference 10,00,000 10 .1 1.0
14% Debenture 30,00,000 7 .3 2.1
15% Debenture 20,00,000 7.5 .2 1.5
100,00,000 1 15.4
 WACC –Ex 2
• Capital Structure
Equity (2,00,000 Shares) 40,00,000
6% Preference shares 10,00,000
8% Debenture 30,00,000
80,00,000

• MP = 20 D = 2 per share g=7% t=50%

a)Weighted average cost of capital
• Ke= 2/20 + 0.07 =17%
40,00,000 0.17 0.5 0.0850
• 10,00,000 0.06 0.125 0.0075
10.75
30,00,000 0.04 0.375 0.0150
0.1075
b)New weighted average if 10% debenture 20,00,000 expected
DD 3 g= no change
P falls->15
40,00,000 0.4 27 10.8
10,00,000 0.1 6 0.6
30,00,000 0.3 4 1.2
20,00,000 0.2 5 1.0
13.6

30 0.4 12.00
6 0.1 0.6
Ke= (3/15) + 0.07 4 0.3 1.2
= 0.2+0.07 = 27% 5 0.2 1.0
c) If growth is 10% 14.8
(3/15) +0.1 = 30%
 WACC –Ex 3
• Weighted Average cost of capital
• Book value weights
• Kd= 8
• KP= 14
• Ke=17
• 16% Deb 300000 14% Pre 2,00,000 Equity 5,00,000
FV Amount Prop Cost Weighted cost
100 3,00,000 0.3 8 2.4
100 2,00,000 0.2 14 2.8
100 5,00,000 0.5 17 8.5
10,00,000 1 13.7
 WACC
3,00,000 8 24000
2,00,000 14 28000
5,00,000 17 85000
1,37,000
• 1,37,000 / 10,00,000) * 100 = 13.7
• Market value weights
• Market Value Deb =Rs.90 PS =115, EQ Sh =150

2,70,000 8 21,600
2,30,000 14 32,200
7,50,000 17 1,27,500

• (1,81,300
12,50,000/ 12,50,000 ) * 100 = 14.5%
1,81,300
Marginal Weight
Wishes to rise 5,00,000

debt 3,00,000 0.5 8 4.8

PS 1,00,000 0.2 14 2.8
RE 1,00,000 0.2 17 3.4
5,00,000 11.00

No FV MV Cost after Tax

Eq 50,000 10 15 17
PS 2,000 100 115 14
Deb 3,000 100 90 8
 WACC –Ex 3 -Same
• A Firm after tax cost
a) Cost of Debt 8%
b) Cost of Preference 14%
c) Cost of equity 17%
• Following is the capital structure

Amount Proportion Cost Weighted Cost

Debt 3,00,000 0.3 8 2.4
Preference Capital 2,00,000 0.2 14 2.8
• Equity 5,00,000 0.5 17 8.5
10,00,000 1 13.7
Alternate method
Amount Cost Total Cost
3,00,000 8 24000
2,00,000 14 28000
5,00,000 17 85000
10,00,000 137000

Weighted Average = (1,37,000 / 10,00,000 ) * 100 =13.7%

Marginal Value
The firm wishes to raise Rs 5,00,000 for expansion. It estimates
that Rs 1,00,000 will be available for retained earnings balance
will be raised as Long term debt 3,00,000 PS 1,00,000.

Debt 3,00,000 8 24000

PS 1,00,000 14 14000
Ret 1,00,000 17 17000
55000

55000/500000 * 100 =11%

 Cost of Equity
• Expected Dividend Rs .1 per share
• Market price 20
• Investor expects a growth rate of 5% per year
Company’s Cost of Capital
Ke= +g
• +.05
• 0.05+0.05= 0.10 = 10%
• (ii) If the growth rate is 6% -> Find out Market Price
• P=
• =
• =.1/0.04
• =25
 Cost of Equity
• MP = 125, , f= 3% of current selling price
• DD 94: 10.70% 95: 11.45% 96: 12.25% 97: 13.11%
98: 14.03%
• i) What is dividend growth rate
• P1=Po(1+0.07)4
• =(1+0.07)4
• = ( 1+0.07)4
• 1.3112= (1+0.07)^4
2)Cost of fund if the growth rate continues
Ke= + g
D1=D0(1+g) =14.03(1.07) =15.01
= (15.01 / 125) +0.07 = 19.01%
(14.03+14.03*0.07)=15.01
3) Cost of new equity
(D/ NP) + g
15.01 / (125-3.75)+0.07=19.38 Floating= (3/100*125=375)
NP = issue – floating expenses
• Ke = Rf + b(Km- Rf)
• Km= Required return on the market portfolio.
 Cost of Debt
• 10% debt 10,00,000 EBIT 3,00,000 Tax 40%
• Before tax cost of capital is 10%
• After tax 10(1-t)
• 10(1-.4) = 10(.6) =6=6%
 Cost of Debt
• 10% debt 10,00,000, EBIT 3,00,000, Tax Rate 40%
With Debenture Without Debt
EBIT 3,00,000 3,00,000
Interest 1,00,000 -
EBT 2,00,000 3,00,000
Tax 80,000 1,20,000
Gain in tax 40,000
Interest 1,00,000
Gain 40,000
Net Payment 60,000

• 10(1-.t) = 10(1-.4)= 10(.6) =6%

• 6% on 10,00,000 = 60,000
 Cost of Debt
• 10,00,000 term loan with 8% interest, Company is having tax
rate of 30%
• Interest Rs. 80,000
• *100 = =.08*100 =8%
• After Tax =8(1-.3) = 8(.7) = 5.6
• *100 = = =.056*100 =5.6%
• Same is the case for Public Deposit
• No issue expense is involved
• No question of issuing at discount
 Debenture
• The company has 15% perpetual debt of Rs 1,00,000
• The Tax rate is 35% assuming issued
(i) At par
(ii) 10% discount
(iii)10% premium
 Issued at par
• Before tax = *100 = =.15 *100 =15%
• Kd= Ki (1-t) = 15 (1- 0.35) = 9.75%
• (ii) Issued at discount
• Interest is paid on face value(Capital)
• 15% on 1,00,00 =15,000
• NP=FV(1-d) =1,00,000(1-.1) =1,00,000(.9) = 90,000
• *100 = =.1667*100= 16.67%
• After Tax
16.67 (1-0.35) = 10.83%
= =.1083*100=10.83%
 Issued at Premium
– (iii) Issued at premium
= *100
Interest on Face value =15% on 1,00,000 = 15,000
NP or SV = FV(1+P) = 1,00,000(1.1) =1,00,000*1.1 =1,10,000
*100 = .13636=13.636
After Tax
– 13.636 (1-0.35) = 8.86
 Floating Cost
• 10% Debenture 1000, sold 5% discount floating cost 5% , 35 Tax.
• Discount 5%, and floating cost 5%
• Interest = 10% on 1000 =100
• NP or SV= FV(1-(d+f+rp-ip)) =FV(1-(.05+.05)) =FV(1-.1) =FV*.9 = 1000*.9
=900
• *100 =.1111*100=11.11%
• After Tax
• 11.11(1-.35) =7.22%
• 10% Debenture 1000, sold 5% discount and floating cost 5% on issue price ,
35 Tax.
• Discount = 100*.05 =5, Issue Price = 100-5 =95
• NP = 95(1-f) = 95(1-.05) = 90.25
 Redemption
• 10% Debenture 1000 redeemed after 10 years, sold 5%
discount, floating cost 5% , 35 Tax.

• I = Interest = 10% of 1000 =100

• F=Floating expenses =Rs.50, Discount =Rs.50
• Cost of capital = Cost per year
• 100/10=10
• RV=Redemption value= Redeemed at par =1000
• SV=NP= 1000-50-50 =900
• Beginning 900 end 1000 =Average = (900+1000)/2
• *100 =.07894=7.89
 Another Method-Discounting
• 10% Debenture 1000 redeemed after 10 years, sold 5%
discount floating cost 5% , 35 Tax
• 0 +900
• 1-10 -100
• 10 1000
• Though we pay interest 100 but net payment is
• 100(1-t) =100(1-.35) = 65
• R0= + +.....
• 900= + ++++++
• Find out by using trial and error method
 PV factor
• Compound Interest
• A=P(1+i)n
• P1=P0(1+i)n
• =P0
• P0=
• P0= P1()
• P0 = 1000()
• =1000*.909= 909
• PV = FV *PV factor ()
 Discounting Method
• 900= + ++++++
• Take 7%
• =65*.935+65*.873 +65*.816…..+1000*.508
• 65*(.935+.873+.816…) =65*Annuity
• =65*7.024 +1000*.508 (Annuity value for 7% for 10 years
• 456.56 +508 = 964.56
• 900 ≠964.56
• Increase the discount to 8%
• 65*6.710 +1000*.463
• 436.15 +463=899.15
• 900≈899.15
• So 8%
• So cost of capital is 8%
0 +900
1-10 -100
10 1000

100(1-t) = 65

PV Total
7% 8% 7% 8%

1-10 65 7.024 6.710 456.56 436.15

11 1000 0.508 0.463 508.00 463
964.56 899.15

Kd = 8%
 Redemption on continuous Basis
• 10% debenture 1,00,000 floating cost =4%, redeemed in
• 5 Equal installments and tax rate is= 35%
• Floating expenses is 4%, 4% on 1,00,000 =4000
• NP (Sv) =1,00,000 -4000 =96000
• Interest rate after tax 10(1-t) = 10*.65 =6.5%
• Payment table =20,000+6.5% of 1,00,000 II year 20,000+6.5% of 80,000

Year Redemption Interest Total Payment Remaining

Capital
I 20,000 65,000 26500 80,000
II 20,000 52,000 25200 60,000
III 20,000 39,000 23900 40,000
IV 20,000 26,000 22600 20,000
V 20,000 13,000 21300 0
As the initial cash flow is higher. 7% or 8%

PV Amount
7% 8% 7% 8%
26500 0.935 0.926 24,777 24,539
25200 0.873 0.857 22,000 21,596
23900 0.816 0.794 19,502 18,977
22600 0.763 0.735 17,244 16,611
21300 0.713 0.681 15,187 14,505
98,710 96,228

96,000≈96,228
So cost of capital is 8%
14% institutional loan 13% non convertible debenture
Loan no major incidental cost
The Debenture issued at discount of 2.5 % and would involve Rs 1 Lakh
as cost of issue.
Assume Tax rate is 50%
(i) 14% 14/ 100 (1-0.35) =9.1
13/ 96.5 (1-0.35) =8.76
100 -2.5-1 = 96.35
Ki= I / SV
The company has 15% perpetual debt of Rs 1,00,000
The Tax rate is 35% assuming issued
(ii) At par
(iii)10% discount
(iv)10% premium
(i)Issued at par
Before tax = (15,000 / 1,00,000) =15
Kd= Ki (1-t) = 15 (1- 0.35) = 9.75%
(ii) Issued at discount
15,000 / 90,000 = 16.7%
16.7 (1-0.35) = 10.85
(iii) Issued at premium
15,000 / 1,10,000 = 13.36
13.36 (1-0.35) = 8.84
A Company issues a new 15% debentures of Rs 1000 face value to be redeemed
after 10 years. The debenture is expected to be sold at 5% discount. It will also
involve floatation costs of 2.5. The company tax rate is 35%. What would be the
cost of debt be.?
Kd= I (1-t) +(f+d+Pr-Pi) / Nm
----------------------------------
(RV + SV)/ 2
Rv – Redeemable Value SV- Net Sale Proceeds
f= Floatation d= discount on issue
Pi= Premium on issue
Pr= Premium on redemption
150(1-0.35) + (50 +25) / 10
------------------------------------
(925+1000)/ 2
 Cost of Preference Share
• Kp=*100
• 10% PSC 1,00,00,000
• Kp=10%
• Before Tax = ===15.38%
• Kp=
• Issues 14% irredeemable Preference shares of the face value
100 each. Floatation cost are estimated at 5% of expected
Sale price.
a) Par ii) 10% Premium iii) 5% discount b) Dividend
Distribution tax10%
 Cost of Preference Share
• Kp =
• Kp =
• f= floating
• Dt = Tax
• D= Constant annual discount
• 14% fv = 100 fl= 5%
• i)10 Premium ii) 5% dis 10% dividend distribution tax
• At Par
• *100 =14.736
• = *100=16.2
 Premium
• 10% Premium, so issue price is 110
• ==.13397*100 =13.4%
• Dt=10%
• = =.147368=14.7%
• Issued at 5% discount, So issue price is 95
• ==.15512=15.5%
= =.17063=17.06%
Redeemable P Share
14% FV 100 10 years Flo = 5%
Inflow 100 - 5% = 95
Outflow 14 every years last years +100
14 15 14 15
14 5.216 5.019 73 70.30
100 0.270 0.247 27 24.70
100 95
 Market Value -Ex
• ESC (150 m * 10) 1500 million
• R&S 2.250 m
• 10.5 % PSC (1 m * 100) 100 million
• 9.5% Debenture (1.5 m * 1000) 1500 m
• 8.5% term loan from FI Rs 500 m
• ->Debentures redeemable after 3 years and are quoted at 981.05 per
debenture IT 35%
• MP 60 Rf 5.5% risk premium 8%
• The Beta 1.1875
• ->Preferred stock redeemable after 5 years and is currently selling at Rs
98.15 per share
• -> WACC using market value weights
1) Debenture
Kd =
Kd = =6.5%
2) Cost of long term loans
8.5% (1-t) = 0.05525 or 5.525%
3) Preference shares
Kp =
Kp = =0.11 =11%
4) Equity
Ke=Rf+β(Rm-Rf) Rm-Rf = Risk premium
5.5 + 1.185 * 8 = 14.98 = 0.15 = 15%
Weights

Market Value
ESC 150 m * 60 9000 0.813
10.5% PSC 1m * 98.15 98.15 0.0089
9.5% deb 1.5 * 981.05 1471.575 0.1329
8.5% term loan 500 0.04517
11,069.725 1.0000

WACC
ESC 0.813 15% 0.1219
10.0% PSC 0.0089 11% 0.0009
9.5% Deb 0.1329 6.5% 0.0086
8.5% Term loan 0.04517 5.25% 0.0023
0.1337

=13.37%
 WACC -Market Value-Ex
Book Value Market Value
Equity Capital (25,000*10) 2,50,000 4,50,000
13% PSC (500 Shares 100) 50,000 45,000
R&S 1,50,000 -
12% Debt (1500 Deb of Rs 100) 1,50,000 1,45,000
6,00,000 6,40,000

• Expected Dividend per share is Rs 1.40

• Expected to grow at 8%
• PS redeemable after 5 years at par,
• Debenture redeemable after 6 years at par
• Tax rate 40%
Ke= D / Po + g ---P0 or Market Price?
P0 =
Po= 4,50,000/25,000 = 18 per share
Ke = 1.4 / 18 + 0.08 = .15777=15.77%
Kp =
Sold at Market value =Sale V=NP=MV
Redeemed at Face value or Book Value
MP or MV= 45000/500=90
= =15/95=.15789 =15.79%
= Market price of debt = 1,45,000/1500 = 96.67
 Debt
• Kd =
• Kd =
• Kd = =.078863=7.89
WACC
MV Wo K
ESC 4,50,000 0.703 0.1577 0.1108
PSC 45,000 0.071 0.1579 0.0112
R&S
Deb 1,45,000 0.226 0.0789 0.0179
6,40,000 1 13.99

Say 14%