Cost of Capital

Understanding: Cost of Capital

 Definition of Cost of Capital
According to Mittal and Agarwal “the cost of capital is the
minimum rate of return which a company is expected to
earn from a proposed project so as to make no reduction in
the earning per share to equity shareholders and its
market price”.
Importance of Cost of Capital
 Cost of Debt
A company may raise debt in variety of ways. It may borrow funds
from financial institutions or public either in the form of public
deposits or debentures (bonds) for a specified period of time at a
certain rate of interest.

A debenture or bond may be issued at par or at a discount or

premium as compared to its face value.
Debt Issued at Par
 
 Illustration
A company has issued 8% debentures and the tax rate is
50%, the after tax cost of debt will be?
A. 6%
B. 5%
C. 4%
D. 4.5%
Debt Issued at Premium or at Discount

 
 Illustration
A company issues 10% Debentures to Rs. 2,00,000 Rate of tax is
55%. Calculate the cost of debt (after tax) if the debentures are
issued

(i) at par
(ii) at a discount of 10% and
(iii) at a premium of 10%.
 Solution
(i) Issued at Par
= Rs. 20,000/Rs. 2,00,000 (1 – .55)
=1/10 x .45
= 4.5%
(ii) Issued at a Discount of 10%
Rs. 20,000/Rs. 1,80,000 (1 – .55)
= 1/9 x .45
= 5 % 
(iii) Issued at Premium of 10%
Rs. 20,000/Rs. 2,20,000 (1 – .55)
= 1/11 x .45
= 4.1 %
Formula for WACC
 
 Contd….
In a general form, the formula for calculating WAC can be
written as follows:

where k1, k2, … are component costs and w1, w2, … weights of various
types of capital, employed by the company.
 MCQ
The weighted average cost of capital for a firm is the:
a. Discount rate which the firm should apply to all of the projects it undertakes.
b. Rate of return a firm must earn on its existing assets to maintain the current
value of its stock.

c. Coupon rate the firm should expect to pay on its next bond issue.
d. Maximum rate which the firm should require on any projects it undertakes.
B. Rate of return a firm must earn on its existing
assets to maintain the current value of its stock.
 Illustration

The following information is available from the balance sheet of the

company:
Equity share capital (2,00,000 shares) ₹ 40,00,000
11.5% Preference share ₹ 10,00,000
10% Debenture ₹ 30,00,000
The equity share of the company sells for ₹ 20. It is expected that the
company will pay next year a dividend of ₹ 2 per equity share, which is
expected to grow at 5% p.a. forever. Assume a 35% corporate tax rate.
Compute weighted average cost of capital (WACC) of the company
based on the existing capital structure.
Solution
Contd……
Contd…..
 Illustration
Find the weighted average cost of capital from information given
below
 Contd…..
Suppose Lohia Chemicals LTD has 45,000,000 equity shares outstanding and the
current market price per share is ₹ 20. Assume that the market values and the book
values of debt and preference share capital are the same. If the component costs
were the same as before, the market value weighted average cost of capital would
be? Computation of WACC (Market value weights)?
Why do managers prefer the book value weights for
calculating WACC?
1) Firms in practice set their target capital structure in terms of book values.
2) The book value information can be easily derived from the published
sources.
3) The book value debt equity ratios are analyzed by investors to evaluate
the risk of the firms in the practice.
 Contd…..
Market value weights are theoretically superior to book value
weights.
They reflect economic values and are not influenced by accounting
policies.
They are also consistent with market determined component
costs.
Cost of Equity & The CAPM (Capital Asset Pricing
Model)

 
 MCQ
If the CAPM is used to estimate the cost of equity capital,
the expected excess market return is equal to the:
a. Return on the stock minus the risk-free rate.
b. Difference between the return on the market and the risk-free rate.
c. Beta times the market risk premium.
d. Beta times the risk-free rate.
b. Difference between the return on
the market and the risk-free rate.
 Illustration

The risk-free rate of return of the Purple Widget

Company is 5%, the return on the Dow Jones
Industrials is 12%, and the company’s beta is 1.5.
The cost of equity is?