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# The cost of capital is an integral part of

## investment decisions as it is used to

measure the worth of investment
proposal.
It is used as a discount rate in
determining the present value of future
cash flows associated with capital
projects.

Conceptually, it is the minimum rate of return
that a firm must earn on its investments so as
to leave market price of its shares unchanged.
It is also referred to as cut-off rate, target rate,
hurdle rate, required rate of return and so on.

In operational terms, it is defined as the
weighted average cost of capital (k
0
) of
all long-term sources of finance. The
major long-term sources of funds are
1) Debt,
2) Preference shares,
3) Equity capital, and
4) Retained earnings.

The theory of cost of capital is based
on certain assumptions. A basic
assumption of traditional cost of capital
analysis is that the firms business and
financial risks are unaffected by the
acceptance and financing of projects

Business risk is the risk to the firm of being
unable to cover fixed operating costs.
Business risk measures the variability in
operating profits [earnings before interest
and taxes (EBIT)] due to change in sales
Financial risk is the risk of being unable to
cover required financial obligations such as
interest and preference dividends.
Capital budgeting decision determines the
business risk complexion of the firm. The
financing decision determines its financial
risk.

The explicit cost of capital is
associated with the raising of funds
(from debt, preference shares and
equity).
The explicit cost of any source of
capital (C) is the discount rate that
equates the present value of the cash
inflows (CI
o
) that are incremental to the
taking of financing opportunity with the
present value of its incremental cash
outflows (CO
t
).

where CI
0
= initial cash inflow, that is,
net cash proceeds received by the firm
from the capital source at time O, CO
1
+
CO
2
... + CO
n
= cash outflows at times 1,
2 ... n, that is, cash payment from the
firm to the capital source.

( )

=
+
=
n
t
t
t
C
CO
CI
1
0
1
If CI
0
is received in instalments, then,
CI
0

It is evident from the above
mathematical formulation that the
explicit cost of capital is the rate of
return of the cash flows of the financing
opportunity

( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
n
n
n
n
C
CO
C
CO
C
CO
C
CO
C
CI
C
CI
C
CI
C
CI
CI
+
+
+
+
+
+
+
=
+
+
+
+
+
+
+
+
1
...
1 1 1
1
...
1 1 1
3
3
2
2
1
1
3
3
2
2
1
1
0
Retained earnings involve no future
cash flows to, or from, the firm.
Therefore, the retained earnings do not
have explicit cost.
However, they carry implicit cost in
terms of the opportunity cost of the
foregone alternative (s) in terms of the
rate of return at which the shareholders
could have invested these funds had
they been distributed to them/or not
retained by the firm
There are four types of specific costs
Cost of Debt
Cost of Preference Shares
Cost of Equity Capital
Cost of Retained Earnings

Cost of debt is the after tax cost of long-
term funds through borrowing. The debt
carries a certain rate of interest. Interest
qualifies for tax deduction in determining
tax liability.
Therefore, the effective cost of debt is less
than the actual interest payment made by
the firm by the amount of tax shield it
provides. The debt can be either
Perpetual/ irredeemable Debt
Redeemable Debt

In the case of perpetual debt, it is
computed dividing effective interest
payment, i.e., I (1 t) by the amount of
debt/sale proceeds of debentures or bonds
(SV). Symbolically

k
i
= Before-tax cost of debt
k
d
= Tax-adjusted cost of debt
I = Annual interest payment
SV = Sale proceeds of the bond/debenture
t = Tax rate

( )
SV
t I
k
SV
k
d
t

=
=
1
) 3 (
1
Example 1
A company has 10 per cent perpetual debt
of Rs 1,00,000. The tax rate is 35 per cent.
Determine the cost of capital (before tax as
well as after tax) assuming the debt is
issued at (i) par, (ii) 10 per cent discount,
and (iii) 10 per cent premium.

In the case of redeemable debt, the
repayment of debt principal (COP)
either in instalments or in lump sum
(besides interest, COI) is also taken into
account. k
d
is computed based on the
following equations:

( ) ( )
( )
( )
( )
( )

=
+
+
+
=
+
+
=
n
1 t
t
d
t
t
d
t
0
d
k 1
COP
t 1
k 1
COI
CI s, instalment in paid is debt When
/2 SV RV
SV/N - RV value, Redeemable t 1 I
K ely, Alternativ
( )
( )
( )

=
+
+
+
=
n
1 t
t
d
t
t
d
t
0
k 1
COP
t 1
k 1
COI
CI s, instalment in paid is debt When
where CI
0
= Net cash proceeds from
issue of debentures or from raising debt
COI
1
+ COI
2
+ ... + COI
n
= Cash outflow on
interest payments in time period 1,2 and
so on up to the year of maturity after
adjusting tax savings on interest payment.
COP
n
= Principal repayment in the year of
maturity k
d
= Cost of debt.
The cost of debt is generally the lowest
among all sources partly because the risk
involved is low but mainly because interest
paid on debt is tax deductible.

Example 2
A company issues a new 10 per cent
debentures of Rs 1,000 face value to be
redeemed after 10 years The debenture is
expected to be sold at 5 per cent discount.
It will also involve floatation costs of 5 per
cent of face value. The companys tax rate
is 35 per cent. What would the cost of debt
be? Illustrate the computations using (1)
trial and error approach and (2) shortcut
method.

Example 3 A company has issued 10
per cent debentures aggregating Rs
1,00,000. The flotation cost is 4 per
cent. The company has agreed to repay
the debentures at par in 5 equal annual
instalments starting at the end of year
1. The companys rate of tax is 35 per
cent. Find the cost of debt.a

The cost of preference share (k
p
) is akin to
k
d
. However, unlike interest payment on
debt, dividend payable on preference
shares is not tax deductible from the point
of view assessing tax liability. On the
contrary, tax (D
t
) may be required to be
paid on the payment of preference
dividend.
Irredeemable Preference Shares
Redeemable Preference Shares

The cost of preference shares in the
case of irredeemable preference shares
is based on dividends payable on them
and the sale proceeds obtained by
issuing such preference shares, P
0
(1
f ). In terms of equation:
( )
( )
( ) f P
D D
k
f P
D
K
t p
p
p
p

+
=

=
1
1
) 8 (
1
0
0
where k
p
= Cost of preference
capital
D
p
= Constant annual dividend payment
P
0
= Expected sales price of preference
shares
f = Flotation costs as a percentage of
sales price
D
t
= Tax on preference dividend

A company issues 11 per cent
irredeemable preference shares of the
face value of Rs 100 each. Flotation
costs are estimated at 5 per cent of the
expected sale price. (a) What is the k
p
, if
preference shares are issued at (i) par
value, (ii) 10 per cent premium, and (iii)
5 per cent discount? (b) Also, compute
k
p
in these situations assuming 13.125
per cent dividend tax

The cost of redeemable preference
shares requiring lump sum repayment
(P) is determined on the basis of the
following equation:

( )
( )
( ) ( )
( )
( )
( ) ( )

=
=
+
+
+
+
=
+
+
+
+
=
n
1 t
t
p
t
t
p
t p
0
n
1 t
n
p
n
t
p
t p
0
k 1
P
k 1
1 D
f 1 P
: s instalment in required repayment of case the In
k 1
P
k 1
1 D
f 1 P
D
D
where P
0
= Expected sale price of
preference shares
f = Floatation cost as
percentage of P
0

D
p
= Dividends paid on
preference shares
P
n
= Repayment of preference
capital amount

ABC Ltd has issued 11 per cent
preference shares of the face value of
Rs 100 each to be redeemed after 10
years. Flotation cost is expected to be 5
per cent. Determine the cost of
preference shares (k
p
).

The computation of cost of equity
capital (k
e
) is conceptually more
difficult as the return to the equity-
holders solely depends upon the
discretion of the company
management.
It is defined as the minimum rate of
return that a corporate must earn on
the equity-financed portion of an
investment project in order to leave
unchanged the market price of the
shares.

One simple basis suggested to
determine cost of equity is to add a
judgmental risk premium of 3 to 5
percentage points to the interest rate
paid by the firm on its own long-term
debt. Such a method may be referred to
as debt-yield plus risk premium
approach
There are two approaches to measure
Ke:
Dividend Valuation Model Approach
Capital Asset Pricing Model (CAPM)
Approach.

As per the dividend approach, cost of equity capital is
defined as the discount rate that equates the present
value of all expected future dividends per share with the
net proceeds of the sale (or the current market price) of a
share.
The cost of equity capital can be measured with the
following equations:
When dividends are expected to grow at a uniform rate
perpetually:

( )
( )
( )
( )
( )
( )
( )
( )
( )
(1 g
P
D
k (11)
g k
D
P
get we 10, Eq. g Simplifyin equation. the of
sides two the equates which rate) (discount return of rate the is 10 Eq. in k
(10)
k 1
g 1 D
k 1
g 1 D
...
k 1
g 1 D
k 1
g 1 D
f 1 P
0
1
e
e
1
0
e
n
1 t
t
e
1 t
1
n
e
n
0
2
e
2
0
1
e
1
0
0
+ =

=
+
+
=
+
+
+ +
+
+
+
+
+
=

=

where D
1
= Expected dividend per share
P
0
= Net proceeds per share/current market price
g = Growth in expected dividends

The calculation of k
e
on the basis of Eq. 12 is based on certain
assumptions with respect to the behaviour of investors and
their ability to forecast future values:
the market value of shares depends upon the expected
dividends;
investors can formulate subjective probability distribution of
dividends per share expected to be paid in various future
periods;
the initial dividend, D
0
, is greater than zero (D
0
> 0);
the dividend pay-out ratio is constant;
investors can accurately measure the riskiness of the firm so
as to agree on the rate at which to discount the dividends.
Note: Under the provisions of Section 115(O), of the Income
Tax Act, 1961, a domestic company is liable to pay tax at a flat
rate of 11.5 per cent (plus surcharge) on dividends
declared/distributed/paid on/after April 1, 2003. The payment
of the dividend tax will reduce the growth (g) in dividends:

B) Under different growth assumptions
of dividends over the years:

( ) ( )
( ) | | ( )
hig be would Dt without g Obviously,
A) (12
P
D 1 DPS EPS
EPS
Dt 1 DPS EPS
P
EPS
b.r g
EPS/P r
tax Dividend Dt where
EPS
Dt 1 DPS EPS
EPS
Dt 1 DPS
1 b
return. of rate r rate, retention b where b.r, g
0
t
0
0

+
=
+
= =
=
=
(

+
=
(

+
=
= = =
( )
( )
( )
( )
yea later in growth Constant g
years earlier in growth of Rate whereg
(13)
k 1
g 1 D
k 1
g 1 D
P
c
h
n
1 t 1 n t
t
e
1 t
c n
t
e
1 t
b 0
0
=
=
+
+
+
+
+
=

=

+ =

Example 6
Suppose that dividend per share of a firm
is expected to be Re 1 per share next year
and is expected to grow at 6 per cent per
year perpetually. Determine the cost of
equity capital, assuming the market price
per share is Rs 25.

In case companys past growth rate has been abnormally
high or low, either due to its own unique situation or due
to general economic fluctuations, historic growth rates (g)
may not be reliable. In such situations, dividend growth
forecasts should be based on factors such as projected
sales, profit margins and competitive factors.
Accordingly, ke would be as follows:

D
1
k
e
= ------ + (Growth rate as projected)
(11.13-A)
P
0

Another method for estimating g can be conceived in
terms of the companys projected retention rate and its
expected future rate of return on equity. More profitable
firms retain a large proportion of their earnings for
reinvestment and will, therefore, tend to have higher
growth rate compared to less profitable firms which
distribute a large proportion of their earnings as
dividends.

However, the dividend growth model
approach is beset with a number of
practical problems and drawbacks. The
major ones are:
(1) It is applicable only to those
corporates which pay dividends. Its
results are really applicable to cases
where a reasonably steady growth is likely
to occur;
(2) Cost of equity is very sensitive to the
estimated growth. As explained earlier, it
is not easy to estimate its value;
(3) The approach does not explicitly
reckon risk factor. There is no allowance
for the degree of risk associated with the
estimated growth rate for dividends.

Example 7
From the undermentioned facts determine the cost of
equity shares of company X:
(i) Current market price of a share = Rs 150.
(ii) Cost of floatation per share on new shares, Rs 3.
(iii) Dividend paid on the outstanding shares over the
past five years:
Year Dividend per share
1 10.50
2 11.02
3 11.58
4 12.16
5 12.76
6 13.40

(iv) Assume a fixed dividend pay out ratio.
(v) Expected dividend on the new shares at the end of
the current year is Rs 14.10 per share.

The CAPM describes the relationship between the required rate of return or
the cost of equity capital and the non-diversifiable or relevant risk of the
firm as reflected in its index of non-diversifiable risk, that is, beta.
Symbolically,
K
e
= R
f
+ b (K
m
R
f
) (14)
R
f
= Required rate of return on risk-free investment
b = Beta coefficient**, and
K
m
= Required rate of return on market portfolio, that is, the average rate or
return on all assets
M = Excess in market return over risk-free rate,
J = Excess in security returns over risk-free rate,
MJ = Cross product of M and J and
N = Number of years
( )

=
2
2
* *
M N M
J M N MJ
Example 8
The Hypothetical Ltd wishes to calculate its cost of equity
capital using the capital asset pricing model approach. From
the information provided to the firm by its investment advisors
along with the firms own analysis, it is found that the risk-free
rate of return equals 10 per cent; the firms beta equals 1.50
and the return on the market portfolio equals 12.5 per cent.
Compute the cost of equity capital.
Solution
K
e
= 10% + [1.5 (12.5% 10%)] = 13.75 per cent
Example 9: As an investment manager you are given the following
information
Investment in equity
shares of
Initial
price
Dividends Year-end
market price
Beta risk
factor
A Cement Ltd
Steel Ltd
Liquor Ltd
B Government of India
Bonds
Risk-free return, 8 per cent
Rs 25
35
45
1,000
Rs 2
2
2
140
Rs 50
60
135
1,005
0.80
0.70
0.50
0.99
You are required to calculate (i) expected rate of returns of market portfolio,
and (ii) expected return in each security, using capital asset pricing model
Solution
(i) Expected Returns on Market Portfolio
Security Return Investment
Dividends Capital
Appreciation
Total
A Cement Ltd
Steel Ltd
Liquor Ltd
B Government
of India Bonds
Rs 2
2
2
140
146
Rs 25
25
90
5
145
Rs 27
27
92
145
291
Rs 25
35
45
1,000
1,105
Rate of return (expected) on market portfolio = Rs 291/Rs 1,105 = 26.33 per
cent
(ii) Expected Returns on Individual Security (in percent)
k
e
= R
f
+ b(k
m
R
f
)
Cement Ltd = 8% + 0.8 (26.33% 8%) 22.66
Steel Ltd = 8% + 0.7 (26.33% 8%) 20.83
Liquor Ltd = 8% + 0.5 (26.33% 8%) 17.16
Government of India Bonds = 8% + 0.99 (26.33% 8%) 26.15
The capital assets pricing model (CAPM) approach to calculate the
cost of equity capital is different from the dividend valuation
approach in some respects. In the first place, the CAPM approach
directly considers the risk as reflected in beta in order to determine
the K
e
. The valuation model does not consider the risk; it rather uses
the market price as a reflection of the expected risk-return preference
of investors in the market.
Secondly, the dividend model can be adjusted for flotation cost to
estimate the cost of the new equity shares. The CAPM approach is
incapable of such adjustment as the model does not include the
market price which has to be adjusted.
Both the dividend and CAPM approaches are theoretically sound. But
major problems are encountered in the practical application of the
CAPM approach in collecting datawhich may not be readily
available or in a country like India may be altogether absent
regarding expected future returns, the most appropriate estimate of
the risk-free rate and the best estimates of the securitys beta.
In brief, various methods of estimating Ke are most likely to provide
different amounts because each method relies on different
assumptions. There are two ways to deal with the situation: (1) Each
estimate of Ke should be looked at to ascertain that its value is
neither too high nor too low. It should intuitively appear to be
reasonable; (2) Average the various estimates of Ke.
Cost of Retained Earnings
The cost of retained earning (k
r
) is equally difficult to
calculate in theoretical terms. Since retained earnings
essentially involves use of funds, it is associated with an
opportunity/implicit cost. The alternative to retained earnings
is the investment of the funds by the firm itself in a
homogeneous outside investment. Therefore, k
r
is equal to
k
e
. However, it might be slightly lower than k
e
in the case of
new equity issue due to flotation costs.
Weighted Average Cost of Capital
Weighted average cost of capital is the expected average
future cost of funds over the long run found by weighting the
cost of each specific type of capital by its proportion in the
firm;s capital structure.
Assignment of Weights
The aspects relevant to the selection of appropriate weights
are:
1) Historical weights
a) Book value weights or
b) Market value weights
2) Marginal Weights
Historical Weights Historic weights either book or market
value weights are based on actual capital structure
proportion to calculate weights.
Market Value Weights Market value weights use market
values to measure the proportion of each type of capital to
calculate weighted average cost of capital.
Book Value Weights Book value weights use accounting
(book) values to measure the proportion of each type of
capital to calculate the weighted average cost of capital
Marginal Weights Marginal weights use proportion of each
type of capital to the total capital to be raised.
Mechanics of Computation
Example 10: Book Value Weights
(a) A firms after-tax cost of capital of the specific sources is as
follows:
Cost of debt
Cost of preference shares (including dividend tax)
Cost of equity funds
8%
14
17
(b) The following is the capital structure
Source Amount
Debt
Preference capital
Equity capital
Rs 3,00,000
2,00,000
5,00,000
10,00,000
(c) Calculate the weighted average cost of capital, k
0
using
book value weights.
Table 1: Solution Computation of weighted average cost of capital (Book
Value Methods)
Source of funds
(1)
Amount
(2)
Proportion
(3)
Cost (%)
(4)
Weighted cost
(3 x 4)
(5)
Debt
Preference capital
Equity capital
Rs 3,00,000
2,00,000
5,00,000
10,00,000
0.3 (30)
0.2 (20)
0.5 (50)
1.00 (100)
0.08
0.14
0.17
0.024
0.028
0.085
0.137
Weighted average cost of capital 13.7%
An alternative method of determining the k0 is to compute, as shown in Table 2, the total
cost of capital and then divide this figure by the total capital. This procedure obviously
avoids fractional calculations.
TABLE 2 Computation of Weighted Average Cost of Capital (Alternative Method)
Sources Amount Cost (%) Total cost (2 3)
(1) (2) (3) (4)
Debt
Preference capital
Equity capital
Total
Rs 3,00,000
2,00,000
5,00,000
10,00,000
8
14
17
Rs 24,000
28,000
85,000
1,37,000
Weighted average cost of capital = [(Rs 1,37,000 / Rs 10,00,000) x 100] = 13.7 per cent
Example 11 (Market Value Weights)
From the information contained in Example 10, calculate the weighted average
cost of capital, assuming that the market values of different sources of funds
are as follows:
Source Market value
Debt Rs 2,70,000
Preference shares 2,30,000
Equity and retained earnings 7,50,000
Total 12,50,000
Solution
(1) The determination of the market value of retained earnings presents
operational difficulties. The market value of retained earnings can be indirectly
estimated. A possible criterion has been suggested by Gitman,19 according to
which, since retained earnings are treated as equity capital for purpose of
calculation of cost of specific source of funds, the market value of the ordinary
shares may be taken to represent the combined market value of equity shares
and retained earnings. The separate market values of retained earnings and
ordinary shares may be found by allocating to each of these a percentage of
the total market value equal to their percentage share of the total based on
book values.
On the basis of the foregoing criterion, the sum of Rs 7,50,000 in Example 11 is
allocated between equity capital and retained earnings as follows:
Source of funds Book value Per cent of book value Market value
(1) (2) (3) (4)
Equity shares Rs 4,00,000 80 Rs 6,00,000*
Retained earnings 1,00,000 20 1,50,000**
*(0.8 Rs 7,50,000) **(0.20 Rs 7,50,000)
(2) After the determination of market value, k
0
is calculated as shown in Table 3.
TABLE 3 Computation of Weighted Average Cost of Capital (Market Value Weights)
Sources Market value Cost (per cent) Total cost (3 2)
(1) (2) (3) (4)
Debt Rs 2,70,000 8 Rs 21,600
Preference shares 2,30,000 14 32,200
Equity capital 6,00,000 17 1,02,000
Retained earnings 1,50,000 17 25,500
Total 12,50,000 1,81,300
k
0
= (Rs 1,81,300/Rs 12,50,000) 100 = 14.5 per cent
Solution The computation is illustrated in Table 4.
TABLE 4 Weighted Average Cost of Capital (Marginal Weights)
Sources of funds Amount Proportion Cost (%) (2 4) Total cost
(1) (2) (3) (4) (5)
Debt Rs 3,00,000 0.60 (60) 8 Rs 24,000
Preference
shares
1,00,000 0.20 (20) 14 14,000
Retained earnings 1,00,000 0.20 (20) 17 17,000
5,00,000 1.00 (100) 55,000
Weighted average cost of capital = (Rs 55,000/Rs 5,00,000) 100 = 11 per cent
Example 12 The firm of Example 10 wishes to raise Rs 5,00,000 for expansion of its
plant. It estimates that Rs 1,00,000 will be available as retained earnings and the
balance of the additional funds will be raised as follows:
Long-term debt Rs 3,00,000
Preference shares 1,00,000
Using marginal weights, compute the weighted average cost of capital.
COST OF CAPITAL PRACTICES IN INDIA
The main features of the cost of capital practices followed by the corporates in India
are as follows:
The most frequently used (67 per cent of cases) discount rate (i.e., minimum
acceptable/required rate of return) to evaluate capital budgeting decision is
based on the overall cost (WACC) of the corporate.
Depending on the risk characteristics of the project, multiple risk-adjusted
discount rates are used by about one-fifth of the corporate enterprises.
The specific cost of capital used to finance the project (i.e. if the discount rate for
a project that will be financed entirely with retained earnings is the cost of
retained funds) is used by one-fourth of the sample corporates.
The CAPM is the most popular method of estimating the cost of equity capital (54
per cent). The Gordons dividend model is equally popular method to compute
the cost of equity capital (52 per cent). The earnings yield approach is used by
one-third of the sample corporates to estimate the cost of equity capital. The use
of the multi-factor model is used by very few corporates (7 per cent).
A significant feature of the methods used to estimate the cost of equity capital is
that while the CAPM is significantly used by the large corporates, the Gordons
discount model is more popular with small firms. Moreover, the highly profitable
corporate (based on ROCE and EAV) give significantly low importance to
dividend yield and earnings yield to compute the cost of equity capital than the
less profitable corporates.
The Government of India (GOI) 10-year bonds are the most widely used risk-free
rate to compute the cost of capital using the CAPM approach. The industry
average beta is the most popular measure of the systematic risk used by the
corporates. Each of the published sources of beta and the self-calculated beta
are also used by about one-fifth of the corporates respectively.
The self-calculated beta is more popularly used by the large and/highly profitable
corporates. The small and low profitable corporates rely more on the published
sources of beta.
The majority of corporates (two-thirds) considers the last 5-year monthly share
price data to estimate the equity beta. The highly profitable firms use weekly
share price data for the purpose.
The average market risk premium (9-10 per cent) is the most widely used
measure by the corporates. The average of historical return and the implied
return on the market portfolio are also fairly popular as an input while using the
CAPM.
As regards the cost of debt, the most widely used method is the interest tax
shield (i.e., tax advantage of interest on debt).
While the majority of the corporates revise their estimates of cost of capital
annually, some of the sample corporates continuously revise it with every
investment.
Apart from project choice criterion, the cost of capital is also used widely for (a)
divisional performance measurement , (b) EVA computation and (c) CVA
computations.
CONTD.
Majority of the sample companies adopt theoretically sound and
conceptually correct basis of determining the cost of capital, namely, the
weighted average cost of long-term sources of finance. However, there is no
systematic procedure followed to compute it. It is more likely to be subjective
in nature. The Indian corporates use of mix of the WACC, marginal cost of
capital of additional funds and management judgment in this regard.
There is wide divergence in the corporate practices as regards the
computation of the cost of equity capital. About one-tenth of the corporates
do not attach any cost to equity capital. Another one-tenth treat the cost of
equity capital as equivalent to primary rate of return available on securities of
balanced mutual funds and debentures issued by blue chip companies.
However, the vast majority of companies (two-thirds of the sample) follow the
conceptually sound methods (i.e. primary rate of return plus risk premium,
dividend valuation model and CAPM) of determining the cost of equity
capital.
About one-fifth of the sample corporates consider retained earnings as a
cost-free source of finance. However, a sizeable proportion of the sample
companies (75 per cent) regard cost of retained earnings either as equivalent
to opportunity cost of using these funds by the corporate/equity-holders or
equal to the cost of equity capital.