Cost of Capital

Prof. Himanshu Jain,

DMS, PIET
1
Cost of Capital
The term cost refers the expenditure which has been
incurred or to be incurred.

Form this definition of cost we can say that the cost of

capital means that expenditure which has been
incurred or to be incurred for acquiring that particular
capital. Or

The cost of capital is the rate of return a company

must earn on an investment to maintain the value of
the company.

2
Importance of the concept of cost of capital
Designing the optimal capital structure
Assisting in investment decisions
Helpful in evaluation of expansion projects
Rational allocation of national resources
Evaluation of financial performance of top management
Basis of other financial decisions

3
Computation of Cost of Capital

Cost of Debt.
 Irredeemable
 Redeemable
Cost of Preference Share
 Irredeemable
 Redeemable
Cost of Equity Share
 Dividend Yield Method
 Earning Yield Method
 Dividend yield + growth in dividend method

Cost of Retained Earnings

4
Computation of Cost of Capital
Cost of Debt.
 Perpetual or irredeemable Debt

Cd = i / NP x 100
Where
i= Amount of annual interest
NP= Net Proceeds

Illustration
A company issues 10% debentures of Rs. 1000/- at par and expenses
of issue are 4%.

Redeemable Debt…

5
Computation of Cost of Capital
Cost of Debt.
 Redeemable Debt

Cd = I + (MV – NP)
n
Where, (MV + NP)
i = 2
annual interest payment
MV = Maturity value
NP = Net proceeds
n = number of years to maturity
Illustration
A company issues 10% debentures of Rs. 1000/- at par and expenses
of issue are 4%. Debenture will be redeem after 10 years

6
Cost of Preference Share

Cost of Preference Share.

 Perpetual or irredeemable Preference Share

Cp = PD / NP x 100
Where
PD = Preference Dividend Per Share
NP = Net Proceeds

Illustration
A company issues 10% debenture of Rs. 1000/- at par and expenses
of issue are 4%.

Redeemable Preference …
7
Cost of Preference Share

Cost of Preference Share.

 Redeemable Preference Share

Cp = PD(MV
+ – NP)
n
(MV + NP) / 2
Where
PD = Preference Dividend Per Share
NP = Net Proceeds
MV = Maturity Value
n = No. of Years to Maturity

Illustration
A company issues 10% debenture of Rs. 1000/- at par and expenses
of issue are 4%. With a maturity of 10 Years.
8
Cost of Equity Share
Dividend Yield Method
Ce = (DPS / MP) x 100
where
DPS = Dividend Per Share
MP = Market Price

Illustration
ABC Ltd. has paid a dividend of Rs. 20 on each share of Rs. 10. the
current market price of the share is Rs. 80. Compute the cost of
Equity share.
Earning Yield Method…

9
Cost of Equity Share
Earning Yield Method
Ce = (EPS / MP) x 100
where
EPS = Earning Per Share
MP = Market Price

Illustration
ABC ltd. has 80000 equity share of Rs. 10 each and this current
market value is Rs. 160 each. the profit of the company for the
year is Rs. 160000. calculate the cost of equity share.
Dividend yield + growth in dividend method…

10
Cost of Equity Share
Dividend yield + growth in dividend method

where
DPS = Dividend Per Share
MP = Market Price
G = Growth Rate in Dividend
Illustration
The equity shares of a company are traded in the market at Rs.
135 each. The expected dividend per share is Rs. 18 and expected
to grow at 6% per year. Determine the cost of equity capital.

11
Cost of Retained Earnings
Many people feel that such retained earnings are absolutely cost
free. This is not the correct approach because the amount retained
by company, if it had been distributed among the shareholders by
way of dividend, would have given them some earning.

This can be understood in the following manner. Suppose the

earnings are not retained by the company and passed on to the
shareholders, are invested by the shareholders in the new equity
shares of the same company, the expectation of the shareholders
from the new equity shares would be taken as the opportunity cost
of the retained earnings.

12
Cost of Retained Earnings…
Adjustment Required
 Income Tax Adjustment
 Brokerage Cost Adjustment.
The cost of retained earnings after making adjustment for income
tax and brokerage cost payable cost payable by the shareholders
can be determined according to the following formula:
Cr = Ce (1-T) (1- B)
Where,
Cr = cost of retained earnings
Ce = cost of equity
T = Tax rate
B = Brokerage cost

13
Cost of Retained Earnings…
Illustration
A firm’s cost of equity is 15%, the average tax rate of shareholders
is 40% and its expected that 2% is brokerage cost that
shareholders will have to pay while investing their dividends in
alternative securities. What is the cost of retained earnings.

14
Before Tax & After Tax Adjustment
Cost of Debenture
Cd (after tax) = Before tax cost (1- Tax rate)

Cost of Preference Share

Cp (before tax) = after tax cost / (1- tax rate)

Cost of Equity Share

Ce (before tax) = after tax cost / (1- tax rate)

Cost of Retained Earnings

Cr (before tax) = after tax cost / (1- tax rate)

15
Weighted Average Cost of Capital
The capital structure of a company and its specific costs are given
below.

Source of Funds Amount After-tax Cost

Debt 1500000 5
Preference Share 1200000 10
Equity Share 1800000 12
Retained Earnings 1500000 11
Total 6000000

You are required to calculate the average cost of capital on the basis
of (i) Book Value (ii) Market value if firm has 18000 equity shares of
Rs. 100 each with market price is Rs. 300.

16
Weighted Average Cost of Capital
Solution: Book value
Source of Amount Proportion After- Weighted
Funds (%) tax Cost Cost %
Debt 1500000 25 5 1.25
Preference 1200000 20 10 2.00
Share
Equity 1800000 30 12 3.60
Share
Retained 1500000 25 11 2.75
Earnings
Weighted 9.60
Average
Cost of
Capital
17
Weighted Average Cost of Capital
Solution: Market Value
Source of Amount Proportion After- Weighted
Funds (%) tax Cost Cost %
Debt 1500000 18.52 5 0.93
Preference 1200000 14.81 10 1.48
Share
Equity 5400000 66.67 12 8.00
Share
Weighted 10.41
Average
Cost of
Capital

18