Cost of capital-

Lecture Notes 1- Basics concept

Introduction:
The main objective of business firm is to maximize the wealth of shareholders in the long
run. The management should only invest in projects with give return in excess of cost of
funds invested in the project of business the difficulty will arise in determination of cost of
funds if it is raised from different sources of different countries the various sources of funds
to the company are in the form of equality and debt.

The cost of capital is the rate of return the company has to pay to various suppliers of fund in
the company there are variations in the cost of capital due to the fact that different kind of
investment carry different levels of which is compensated for the different level of return on
their investment.

There are two main sources of capital for a company:

Shareholders and lenders usually debutant holders are Financial Institutions the cost of equity
and cost of that are the rates of return that need to be offered to these two groups of suppliers
of capital in order to attract funds from them.

The cost of capital is a very important factor to be considered in deciding the firm's capital
structure. It is one of the bases of the theories of financial management. Of course, cost of
capital is to a certain extent debatable aspect of financial management. Yet it is a fact that
before determining the capital structure a company is required to compute the cost of capital
of various sources of finance and compare them. On that basis the company decides which
source of finance is the best and in the interest of the owners and even of creditors.

From the viewpoint of investors, cost of capital is the reward of postponement of his present
needs, so as to get a fair return on his investment in future. But from the viewpoint of the
company, the cost of capital refers to the financial burden that a company has to bear in
financing its business through various sources.
MEANING:
Hampton, John defines the term as "the rate of retur n the firm requires from investment
in order to increase the value of the firm in the market place".
The following are the basic characteristics of cost of capital:
1) Cost of capital is a rate of return, It is not a cost as such.
2) This return, however, is calculated on the basis of actual cost of different components
of capital.
3) A firm's cost of capital represents minimum rate of return that will result in at least
maintaining (If not increasing) the value of its equity shares.
4) It is related to long term capital funds.
5) Cost of capital consists of three components:
a. Return at Zero Risk Level. (r0)
b. Premium for Business Risk (b)
c. Premium for Financial Risk (f)
6) The cost of capital: K = ro + b + f
Where: K = Cost of Capital,
ro = Return at Zero Risk Level,
b = Premium for Business Risk
f = Premium for Financial Risk

COST OF CAPITAL IN CAPITAL BUDGETING:

Determination of cost of capital is essential for capital budgeting decision the cost of capital
is used as the discount rate in npv calculations and as targeted rate of return for comparing
with projects internal rate of return cost of capital is defined as the maximum rate of return
that form must earn on its investment so that the market value per share remains unchanged
when the internal rate of return i r method is used in a project appraisal the area of the project
is compared with the cost of capital it provides a yardstick to measure the worth of
investment proposal and performs the role accept or reject situation in it is also referred to as
cutoff rate target rate hurdle, rate minimum required rate of return and standard rate etc.

ELEMENTS OF COST OF CAPITAL

a) Cost of equity (Ke)
b) Cost of retained earnings (Kr)
c) Cost of preferred capital (Kp)
 d) Cost of debt (Kd)

The determination of the firm's cost of capital is important from the point of view of the
following:
1) It is the basis of appraising new capital expenditure proposals. This gives the
acceptance / rejection criterion for capital expenditure projects.
2) The finance manager must raise capital from different sources in a way that it
optimizes the risk and cost factors. The sources of funds which have less cost involve
high risk. Cost of capital helps the managers in determining the optimal capital
structure.
3) It is the basis for evaluating the financial performance of top management.
4) It helps in formulating appropriate dividend policy.
5) It also helps the organization in developing an appropriate working capital policy.
 COST OF CAPITAL-
LECTURE NOTES 2: COST OF EQUITY

COST OF EQUITY (KE)

The funds required for the project are raised from the equity shareholders which are the
permanent nature. These funds need not be repayable during the lifetime of organization.
Hence it is permanent source of funds full stops the equity shareholders are the owners of
company. The main objective of the firm is to maximize the wealth of the equity
shareholders. Equity share capital is there is capital of the company. If the company's
business is doing well the ultimate beneficial are equity shareholder who will get the return in
the form of dividend from the company and the capital appreciation for their investment. If
the company comes for liquidation due to losses the ultimate and worst sufferers are the
equity shareholders. Sometimes they may not get there investments points back during the
liquidation process.

Profit after taxation, less dividend paid out of the shareholders, are one that belong to the
equity shareholder which have been invested in the company and therefore those read and
find should be included in the category of equity, The cost of retained earnings is discuss
separately from the cost of equity capital.

The cost of equity may be defined as the minimum rate of return that a company must earn on
the equity finance portion of an investment project so that the market price of the share
remains unchanged.

METHODS OF COST OF CAPITAL :

DIVIDEND YIELD METHOD:

The dividend person is expected on the current market price per share. As per this method,
the cost of capital is defined as “the discount rate that liquids the present value of all accepted
future divider per share with the net proceeds of the sale ( or the current market price )of a
share”.

This method is based on the assumption that the market value of shares is directly related to
the Future dividend on the shares. Another assumption is that the future dividend per share is
accepted to be constant and the company is expected to earn at least this yield to keep the
shareholders content.
KE=D1/PE
KE=Cost of equity
D1 =Annual dividend per share
PE=Ex Dividend market price per share

This method emphasis of future dividend accepted to be constant. It does not allow any
growth rate. But in reality, shareholder expects the return from is equity investment to grow
overtime.

DIVIDEND GROWTH MODEL:

Shareholders will normally expect dividend to increase your after year and not to remain
constant in perpetuity. In this method and allowance for future growth in dividend is added to
the current dividend yield.
It is recognized that the current market price of a share reflex expected future dividend. The
dividend growth model is also called as “Gordon dividend growth model”

KE= Do(1+g) +g
PE
Do= Last dividend per share
g= constant annual growth rate of dividends
 PE=Ex dividend market price per share

Criticism:
The dividend growth model is criticized on the following reasons
1.The future growth pattern is impossible to predict because it will be inconsistent and uneven

2.Due to unnecessary and of future and in perfect information, only historical growth is to be used
for prediction of future growth

3.Calculation only cost of equity capital ignoring the cost of other forms of capital may not be valid.

4.The dividend growth depends on the retained earnings of the company and the growth is difficult
to assume

PRICE EARNING METHOD:

This method takes into consideration the Earning per share EPS and the market price of the share. It
is based on the assumption that the investor capitalizes the stream of future earnings of the share
and the earning of a person need not be in the form of dividend and also it need not be disturbed to
the shareholders. It based on argument that even if the earning are not disturb and dividend, it is
kept in the retained earnings and it causes future growth in the earning of the company as well as
the increase in market price of the share. In calculation of cost equity share capital The Earning per
share is divided by the current market price.
KE=E/M

E current earning per share

M = Market price per share

CAPITAL ASSET PRICING MODEL:

CAPM divide the cost of equity into two components:

The nearest risk free return available on investing in government Bond and additional risk Premium
for investing in a particular share or investment. This risk premium in turn comprises the average
return on the overall market portfolio and the beta factor or risk of the particular investment. Thus
CA PM assess the cost of equity for an investment.

KE=RF+Beta (RM-RF)
KE= cost of equity
RF= risk free rate of return
RM =average market Return
Beta of investment

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 Cost of capital-
Lecture Notes 3- Cost of Debt
a)Dividend yield method
b Dividend growth Model
c) Price earning method
COST OF Cost of Equity d)CapitalassetPricing Model
Capital model

Cost of Debt Redeemable

/Irredeemable

Cost of Preference
Redeemable
share
/Irredeemable

WEIGHTED AVERAGE COST OF CAPITAL(WACC):weight of equity *cost of

equity +weight of Debt* Cost of debt

The capital structure of a form normally includes the Debt component also. That may be in
the form of debenture, bonds, term loan from Financial Institutions and Bank etc. The debt is
carried of fixed rate of interest payable to them, irrespective of the profitability of the
company. Since the coupon rate is fixed the firm increases its earnings through
debt financing. Then after payment of fixed interest charges more surplus is available for
equity shareholders, and hence EPS will increase.
An important point to be remembered that dividends payable to equity shareholders and
preference shareholder is an appropriation of profit, whereas the interest payable on Dept is a
charge against profit. Therefore , any payment towards interest will reduce the profit of
ultimately the companies tax liabilities would decrease. This phenomena is called “Tax
shield”. The tax Shield is viewed as a beneficial accrues to the company which is geared. To
gain the full tax shield the following conditions apply.
The company must be able to show a taxable profit every year to take full advantage of the
tax shield.
If the company makes losses, the tax shield goes down and cost of borrowing increases.

The debt maybe perpetual Debt or redeemable Debt and for calculation of cost of debt the
following information is required

1.Net cash inflow for each source of Debt and cost of raising debt.
2. The amount of periodic interest payment and principal repayment on maturity.
3. Corporate taxation rate.

COST OF PERPETUAL DEBT: The cost of perpetual debt (Irredeemable debt) is calculated
with following :

KD=I(1-T)/D

Where
KD= cost of debt
I = annual Interest payment
T= company’s effective corporate tax rate
D= Net proceeds of issue of debenture , Bonds, term loan etc

COST OF REDEEMABLE DEBT :

KD= [I+(Rv-Sv/N)] (1-T)

(Rv+Sv/2)
KD= cost of debt
I = Annual Interest payment
T= company’s effective corporate tax rate
Rv= Redeemable value of debt at the time of maturity
Sv= sale value less discount and flotation expenses

Problems :
1.A company has 10% perpetual debt of Rs 1,00,000. The tax rate is 35%. Determine the cost
of capital (before tax as well as after tax) assuming the debt is issued at,
i. Par
ii. 10% discount
iii. 10% premium
Solution
i. Debt at Par
Before tax Kd = (I/NP) * 100
= (10,000/1,00,000) * 100
= 10%
After tax Kd = (I/NP)*(1-t) * 100
= (10,000/1,00,000)* (1-0.35) *100
= 6.5%

ii. At 10% discount

Before tax Kd = (I/NP) * 100%
= (10,000/1,00,00 - 10% of 1,00,000) *100%
= (10,000/ 90,000) * 100%
= 11.11%
After Tax Kd = I/NP * (1-t) * 100%
= (10,000/90,000) * (1-0.35) * 100%
= 7.22%

iii. At premium
Before tax Kd = I/NP * 100%
= (10,000/(1,00,000 + 10% of 1,00,000)) * 100%
= (10,000/1,10,000) *100%
= 9.09%
After tax Kd = I/NP * (1-t) *100%
= 10,000/1,10,000 *(1-0.35) *100%
 = 5.91%

2. Neelam Steel limited issued 30000 irredeemable 14% debentures of Rs 150 each. The cost
of flotation of debentures is 5% of the total issued amount. The Company’s taxation rate is
40% . Calculate the cost of debt.
Calculation of net proceeds :
Total issued amount 30000 debentures*150 4500000
Less Floataion cost 4500000*5/100 225000
Net Proceeds from issue 4275000

Annual charges =4500000*14/100=Rs630000

KD=I(1-T)/D
Where
KD= cost of debt
I = annual Interest payment
T= company’s effective corporate tax rate
D= Net proceeds of issue of debenture, Bonds, term loan etc

=630000(1-0.40)/4275000=8.84%

COST OF REDEEMABLE DEBT :

KD=[I+(Rv-Sv/N)] (1-T)

(Rv-Sv/2)
KD= cost of debt
I = Annual Interest payment
T= company’s effective corporate tax rate
Rv= Redeemable value of debt at the time of maturity
Sv= sale value less discount and flotation expenses
1. Surya industries limited have raised funds through issue of 10000 debenture of Rs 150
each at a discount of Rs 10Per debenture with 10 years maturity. the coupon rate is 16% . The
flotation cost is Rs 5 per Debenture. The debentures are redeemable with 10% premium. The
corporate taxation rate is 40% . Calculate cost of debt.
KD=[I+(Rv-Sv/N)] (1-T)

(Rv+Sv/2)

[24+(165-135/10)](1-0.40)
=
(165+135/2)
=10.8%

If the debt raised is certain of its redemption at the end of specified period IRR Method can
be used of calculating cost of debt .

Assignment:
Calculate the cost of Debt capital:
1.X limited issues 12% debentures of face value of Rs 100 each and realizes Rs95 per
debenture . The debentures are redeemable after 10 Years at a premium of 10%
2. A company has 10% perpetual debt of Rs 2,00,000. The tax rate is 40%. Determine the
cost of capital (before tax as well as after tax) assuming the debt is issued at, par, 10%
discount and10% premium .
3. X limited issues 10% debentures of face value of Rs 100 each and realizes Rs95 per
debenture. The debenture are redeemable after 20 Years at a premium of 10%.
4. Ganesh limited issued 60000 irredeemable 14% debentures of Rs 150 each. The cost of
flotation of debentures is 5% of the total issued amount. The Company’s taxation rate is
40% . Calculate the cost of debt.
5. Write a note on Cost of debt
 COST OF CAPITAL
LECTURE NOTES 4: COST OF RETAINED EARNINGS

The retained earnings is one of the sources of finance available for the established companies
to finance it is expansion and diversification programs. These are the funds accumulated over
years of the company by keeping part of the funds generate without distribution.

The equity shares holders of the company are entitled to these funds are also taken into
account while calculating the cost of equity. But so long as the retained profits are not
distributed to the shareholder, the company can use the funds within the company for further
profitable

Hence cost of equity includes retained earnings. But in practice, retained earnings are slightly
cheaper source of capital as compared to the cost of equity capital. Therefore the cost of
retained earnings is treated separately from the cost of equity capital.

The cost of retained earnings to the shareholders is basically the opportunity cost of such
fund to them.it is equal to the income that they would otherwise obtained by placing these
funds in alternative investment. The cost of retained earnings is determined based on the
opportunity of rate of earnings of Equity shareholders, which is being forgone continually. If
the retained earnings are distributed to equity share holders attract personal taxation of
individual shareholders and therefore , the cost of earnings is calculated as follows ;

KR=KE(1-T)
Where KR= Cost of retained earnings
KE=Cost of equity capital
T=Tax rate of individual
 COST OF CAPITAL
LECTURE NOTES 4: COST OF PREFRENCE SHARE

The cost of preference share capital is the rate of return that must be earned on preference
capital financed investments; to keep un changed the earnings available to equity share
holders.

Cost of irredeemable preference shares- The cost of irredeemable preference shares is the rate
of preference dividend also called the coupon rate divided by net issue proceeds

Kp=Dp/NP
KP=Cost of preference capital
DP = Preference dividend
NP= Net proceeds received from issue of preference share after meeting the issue expenses

EXAMPLE 1

ABC limited has issued 1000000 irredeemable preference share of Rs 150 each at coupon
rate of 14% p.a. The issue expenses are Rs 15 per share . calculate the cost of preference
share capital

Kp=Dp/NP

KP=Cost of preference capital

DP = Preference dividend

NP= Net proceeds received from issue of preference share after meeting the issue expenses

Kp=21/135(150-15)

Kp=15.55%

Cost of Redeemable preference share:

COST OF REDEEMABLE DEBT :
KP= D+(Rv-Sv/N)]

(Rv+Sv/2)
KP= cost of Preference shares
D=constant annual dividend payment
N= no of years to redemption
Rv= Redeemable value of Preference share at the time of redemption
Sv= sale value less discount and flotation expenses

Example 2:
PS LTD has Rs 100 preference share redeemable at premium of 10% with 15 year maturity .
The coupon rate is 12%, flotation cost is 5% sale price is Rs 95. Calculate the cost of
prefernce share .

KP= D+(Rv-Sv/N)]

(Rv+Sv/2)
KP= cost of Preference shares
D=constant annual dividend payment
N= no of years to redemption
Rv= Redeemable value of Preference share at the time of redemption
Sv= sale value less discount and flotation expenses

Kp=12+(110-90)/15

110+90/2

=13.33%
Assignment :

1.PQR limited has issued 2000000 irredeemable preference share of Rs 300 each at coupon
rate of 14% p.a. The issue expenses are Rs 30 per share . Calculate the cost of preference
share capital

2. SS LTD has Rs 200 preference share redeemable at premium of 20% with 30 year
maturity . The coupon rate is 12%, flotation cost is 5% sale price is Rs 100. Calculate the cost
of prefernce share .
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