COST OF CAPITAL

The cost of capital to a company is the minimum required rate of return that it must
Earn on its investments in order to satisfy the various categories of investors, who
Have made investments in the form of shares, debentures & term loans.

SOURCE OF FINANCE:

1. Equity share capital; Preference share capital; Debt amount if it is new

organization.
2. In case of existing organization in addition to above Reserve & Surplus also the
one source.
COMPUTATION OF COST OF DEBT
{Kd}

DEBT

IRREDEMA
BLE DEBT

REEDEMA
BLE DEBT
 IRREDEMABLE DEBT
IRREDEMABLE DEBT
FORMULA
FORMULA
1. Kd, before tax = I
------------
NP/Mpo
2. Kd, after tax = I [ 1- T ]
------------
NP
Were: Kd = Cost of debt, I = Interest Amount, T = Tax Rate,

Rv = Redemption value, Np = Net Proceedings [ issue price-flotation cost ]

N = No of years, Mpo = Current Market Price.
Example:
Example: 1. A 10% debentures, face value of Rs 100 each issued at
1.[a]A 100;
10% [b]
debentures,
90; [c] 110face value of Rs 100 each issued at
compute cost [a] of
100; [b] before
debt, 90; [c] 110
tax @ 50%
compute
(1) With tax rate cost of
(2) with out taxtax
debt, before @?50%
rate
(1) With tax rate (2) with out tax rate ?

Solution: With tax rate With out tax rate

Solution: With tax rate With out tax rate
Formula Kd = I Kd = I (1-T)
Formula Kd = I Kd = I (1-T)
--------
------------ --------
------------ NP NP
1. Kd = 10/100 = 10%NP Kd = 10 (1-0.5)/100 = 5% NP
2.1.Kd
Kd= =10/90
10/100= =11.11%
10% KdKd==1010 (1-0.5)/100
(1-0.5)/90 = 5%
= 5.5%
3.2.Kd
Kd= =10/110
10/90 = =9.09%
11.11% KdKd = 10
= 10 (1-0.5)/90==4.54%
(1-0.5)/110 5.5%
3. Kd = 10/110 = 9.09% Kd = 10 (1-0.5)/110 = 4.54%
Note:- Tax shield on interest = Interest Tax Rate

Net interest = Interest – Tax shield on interest

Example:- 2 10% debentures, face value of Rs 100 each issued at 100 but repayable
After 5 years with Rs 10 assume tax rate 40%. Compute cost of debt ?

REEDEMABLE PREFERENCE SHARE

REEDEMABLE PREFERENCE SHARE
Formula
Formula

Solution: Kd = I (1-T) + Rv-NP/n I = Interest amount = 10

Solution: Kd =-----------------------------
I (1-T) + Rv-NP/n T I==Tax
Interest
rate =amount
40% = 10
----------------------------- RvT= = Redemption
Tax rate = 40%
value = 110
Rv + Np/2
Rv + Np/2 Np = Net proceeds =value
Rv = Redemption 100 = 110
Kd = 10 (1-40%) + (110-100)/5 n Np = Net
= No proceeds
of years = 5 = 100
n = No of years = 5
----------------------------------- = 7.6%
110+100/2

If FV, IP, RV = 100 Were:- FV = Face Value

Then Kd = CR(1-T) IP = Issue Price
RV = Redemption Value
CR = Coupon Rate
Kd = Cost of Debt
[ OR ]
 By using Internal Rate of Return [ IRR ] method
YEAR CASH DISFAC DIS DIS DIS
FLOW @ 8% CASH 9% CASH 12% CASH
FLOW FLOW FLOW

0 (100) 1 (100) 1 (100) 1 (100)

1-5 10 3.99 39.9 3.88 38.8 3.60 36

5 110 0.68 74.8 0.649 71.39 0.567 62.37

NPV 14.7 10.19 (1.63)

Internal Rate of Return [ IRR ], Formula

= 8 + 14.7
IRR = Li + NPVLi -------------- 4
--------------------------- Di 16.33
NPVLi - NPVHi
= 8 + 3.6 = 11.60

Were:- IRR = INTERNAL RATE OF RETURN

Were:-LiIRR = INTERNAL
= LOWER INDEXRATE OF RETURN
Li = LOWER
NPVLi INDEX
= NET PRESENT VALUE OF LOWER INDEX
NPVLi = NET PRESENT
NPVHi = NET PRESENT VALUE VALUEOF
OFHIGHER
LOWERINDEX
INDEX
DiNPVHi = NET PRESENT
= DIFFERENCE VALUERATE
IN INTEREST OF HIGHER INDEX
Di = DIFFERENCE IN INTEREST RATE
 PREFERENCE SHARE CAPITAL [ Kp ]

IRREDEMABLE PREFERENCE SHARE

REEDEMABLE PREFERENCE SHARE

 IRREDEMABLE PREFERENCE SHARE

FORMULA
Kp = Pd
Kp = Pd
-------------
-------------
NP/MPo
NP/MPo
REEDEMABLE PREFERENCE SHARE
REEDEMABLE PREFERENCE SHARE
FORMULA
FORMULA
Kp = Pd + [ Rv – Np ]
Kp = Pd + [ Rv – Np ]
------------
------------
n
n
Were:
---------------------------
---------------------------
Rv+Np/2
Rv+Np/2
Kp = Cost of preference share
Pd = Preference Dividend
Rv = Redemption value Mpo = Current market value
Np = Net proceedings [ issue price – floatation cost ] n = No of years
 Example:
Example:1. 10% preference share face value of Rs 100 each issued at 100,
1. 90
10% preference
& 110 ? share face value of Rs 100 each issued at 100,
90 & 110 ?
Solution: Kp = Pd/NP

1. Kp = 10/100 = 10%
2. Kp = 10/90 = 11.11%
3. Kp = 10/110 = 9.09%

2. 10% preference share of Rs 100 each issued at 100 but redeemable

after 5 years @ 120 Rs ? Compute KP ?
Solution:
KP = Pd + [ Rv – Np ] = 10 + [ 120-100 ]
-------------- ---------------
n 5
------------------------------ --------------------------
Rv + Np/2 120 + 100/2

= 10 + 4
----------- = Kp = 12.72% ; This formula gives only approximate answer.
110
 By Using IRR Method

YEAR CASH DIS DCF DIS DCF

FLOW FAC FAC
13% 14%
0 (100) 1 (100) 1 (100)
1–5 10 3.517 35.17 3.433 34.33
5 120 0.542 65.04 0.519 62.28
NPV 0.12 (3.39)
Internal Rate of Return [ IRR ], Formula = 13 + 0.21
---------------- 1
IRR = Li + NPVLi 0.21 + 3.39
--------------------------- Di
NPVLi - NPVHi = 13 + 0.058 = 13.058%

Note: 1. At IRR = NET PRESENT VALUE OF = TOTAL PRESENT VALUE OF

CASH IN FLOW OUT FLOW

2. At IRR ------- NET PRESENT VALUE { NPV } = 0

 COST OF EQUITY [ Ke ]
Formula’s

1. Dividend Yield Model = Ke = D/MPo

Ke = Cost of Equity; D = Dividend Per Share; MPo = Current Market Value

2. Dividend Yield + Growth Model = Ke = d1

------- + g Were: E = EARNINGS
MPo
D = DIVIDENDS
= d0 ( 1+g )
-------------- + g CE = CAPITAL
MPo EMPLOYED

d1 = Dividend at the end of current year; MPo = Current Market Value;

g = Growth Rate in Dividend; b = Retention Rate = E – D/D
r = Required Rate of Return = E/CE
3. Dividend Net Worth Model = Ke = D
-------------------------
Average Net Worth

D = Dividend Per Share

Avg Net Worth = Opening + Closing Net Worth/2

4. Price Earning Approach [ PEA ], Ke = 1 1 EPS

------------- = --------------- ---------
PER MPS/EPS MPS
PER = Price Earning Ratio
EPS = Earning Per Share PER = MPS/EPS
MPS = Market Price Per Share

5 . Price Earning + Growth Model, Ke = EPS

---------- + g
MPS
g = Growth in Earning Per Share
 6 . CAPITAL ASSET PRICING MODEL [ CAPM ]

1. Ke = Rf + β [ Rm – Rf ]

2. Rp = Rm - Rf

Were: Rf = Risk free rate of return

Rm = Return on market Portfolio
β = Beta Factor
Rp = Risk Premium

Note: 1. If floatation cost was given in problem then reduce floatation cost from
market price. { Mpo – Floatation cost }

2. If issue price differs with market price use issue price rather than market
price in the formula.
COST
COSTOFOFRETAINED
RETAINEDEARNINGS
EARNINGS[ [Kr
Kr] ]
{{Opportunity
OpportunityCost
CostApproach
Approach}}

Kr = Ke
Note:- If there is involvement of floatation cost, cost of retained earnings
are slighter cheaper than cost of equity.
WEIGHTED AVERAGE COST OF CAPITAL [ WACC / Ko ]
WEIGHTED AVERAGE COST OF CAPITAL [ WACC / Ko ]
A company cost of capital is nothing but the weighted arithmetic average of
The cost of various sources of finances that have been used by it.

WACC / Ko = [ Ko is also known as overall cost of capital ]

Source of Cost of Weighted Average

Fund Amount Weights Capital Cost of Capital
------------------------------------------------------------------------------------------------------------

Equity Capital 50 0.50 15% 7.5%

Preference Capital 25 0.25 14% 3.5%

Debt 25 0.25 8% 2%
----------- ----------- -------------
100 1 WACC 13
----------- ----------- --------------

{ OR }
WACC / Ko = Kd D + Kp P + Ke E
------ ------ -----
V V V

= 8% {25/100} + 14% {25/100} + 15% {50/100}

= 2% + 3.5% + 7.5%

= 13%
If you really want to judge of the character of a man, look not at his great

performance. Every fool may become a hero at one time or another. Watch

a man do his most common actions; those are indeed the things which will tell

you the real character of a great man.