COST OF CAPITAL

Presented by: Kamlesh Sudeep A Praveen ML Yerra subbarayudu

Cost of Capital
The cost of capital determines how a company can raise money through a stock issue, borrowing, or a mix of the two. This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk.

Computation of Cost of Capital

It includes: Computation of cost of specific source of finance. Cost of Debt Cost of Preference share capital Cost of Equity share capital Cost of Retained Earnings Computation of weighted average cost of capital

Cost of Debt (Kd)

The effective rate that a company pays on its current debt Debt fund can be in the form of debentures or loans from financial institution. Debt can be of 2 types: Irredeemable Debt Redeemable Debt

Irredeemable Debt (Debentures)

A debenture with no maturity period Debenture holder can not demand the company to pay back the debt

Irredeemable debentures can not be issued in India

Cost of Irredeemable Debt

Before tax:Kdb = Int / sv

where.,
Kdb = Cost of Debt before tax Int = Interest SV = sale value of debt

Cost of Irredeemable Debt

After tax:Kda = Int *(1- t) * 100
sv
where.,
Kdb = Cost of Debt before tax Int = Interest SV = sale value of debt

Example
X Ltd has 10% perpetual debt of Rs 1 Lakh. The tax applicable to the company is 35%. Determine the cost of debt after tax assuming the debt is issued (a) at par, (b) at 10% discount, and at 10% premium

Kda =

Int *(1- t) * 100

sv

Where., Int => 10% of 1,00,000 = 10,000 t => 35% = 0.35 sv => 1,00,000

Continued..
At par value (kda) [10000*(1-0.35)/100000]*100 = 6.5% At 10% premium (kda) [10000*(1-0.35)/110000]*100 = 5.91% At 10% discount (kda) [10000*(1-0.35)/90000]*100 = 7.22%

Redeemable Debt (Debenture)

A debenture with maturity period Debenture holder can demand the company to pay back the debt

Redeemable debentures are widely issued in India

Cost of Redeemable Debt

# CIo = [ I * (1-t)] * PVIFA(r{kd},n)+ M* PVIF(r{kd},n) Where.,
Cio I t M n = Cash inflows at year 0 = Interest = Tax rate = Maturity value = Maturity period

Example
A company issues 10% debenture of rs 1000 to be paid after 10 years. It will be sold at a discount of 5% with a flotation cost of 5%, tax 35% calculate cost of debt? CIo = [ I * (1-t)] * PVIFA(r{kd},n)+ M* PVIF(r{kd},n) where., CIo => 1000-50-50 = 900 I => 10% on 1000 = 100

Continued..
t => 35% = 0.35 n => 10 years r kd

# 900 = 100 (1-0.35) * PVIFA(kd,10) + 1000 * PVIF(kd,10)

Do trail & error method So with 7% L.H.S R.H.S 900 964.56

So with 8% L.H.S R.H.S 900 899.15

Continued..
VLRCV K = + VLRVHR 964.56900 => Kd = 7 + 87 964.56899.15 => Kd = 7.897%

Cost of Preference Share Capital (Kp)

Cost of preference share capital is that part of cost of capital in which we calculate the amount which is payable to preference shareholders in the form of dividend with fixed rate. They are 2 types of Preference share capital: Irredeemable Preference share Redeemable Preference share

Irredeemable Preference share

Formula:Kp = Dp /Po - f where.,
Kp Dp f Po = cost of preference share = Preference Dividend = Floatation Cost = Current price of preference

Redeemable Preference Share

Formula:Po f= Dp x PVIFA(kp,n) + M X PVIF(kp,n) Where:Po = Current Price of Preference F = Floatation cost Dp = Preference Dividend

Example of preference share

A company issues 10% preference share of Rs 100 each. With a Floatation Cost of 2%. Calculate cost of preference capital if these are issued at par, at a premium of 10 % , at a discount of 5%.

Cost of Equity share capital (Ke)

The cost is difficult to measure, as the rate of return fluctuates every year Its not legally bound to pay dividend to equity share holder. As the future earning and dividend are expected to grow overtime.

Cost of Equity
The cost of equity can be computed with the following methods:Dividend yield method Earning yield method CAPM Approach

Dividend Yield Method

It is also known as Dividend/ Price method. This method is based on the assumption that when an investor invests in the equity shares of a company he expect to get a payment at least equal to the rate of return prevailing in the market. This method is suitable only when the company has stable earnings and stable dividend policy.

Cost of Equity Share Capital

Formula of computing Cost of Equity:(Dividend yield method) Ke = DPS/ MP * 100 where:ke = cost of equity DPS= Dividend Per share MP = Market Price

Earning Yield Method

Earning yield is the quotient of earning per share divided by the share price.

Earnings yield is quoted in percentage, allowing an easy

comparison.

The comparison can help in selecting the best investment

option at that point in time. Formula:Ke = EPS/ MP * 100

Capital Assets Pricing Model or CAPM Approach

This model describes the relationship between risk and
expected return and that is used in the pricing of securities. The time value of money is represented by risk free rate in the formula. The other half of formula represents risk and calculates the amount of compensation the investor needs for taking on the additional risk.

Ke = Rf + b (Km Rf)
where:Rf= risk free return b= beta co-efficient Km= req return on market return

Example
If the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return (3%+2(10%-3%)) = 17%

Weighted Average Cost of Capital (WACC)

The WACC is the rate that a company is expected to pay on average to all its security holders to finance its assets.
Formula:-

WACC wd k d w p k p we ke

WACC wd k d w p k p w

Example
A company capital structure as follows. Preference capital = 2,00,000 Debt = 3,00,000 Equity Capital = 5,00,000 The cost details are cost of debt - 8% cost of equity - 17% cost of preference - 14% Calculate WACC ?

THANK YOU