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UNIT III-COST OF
C A P I TA L
 C O S T O F C A P I TA L ( C O C )

• Application and evaluation criterion of capital budgeting

techniques is dependent on two factors:
1. Estimated cash flows from projects
2. Discount rate 2

COC is the minimum required rate of return, a project must earn

in order to cover the cost of raising funds being used by the firm
in financing of the proposal.
 C O S T O F C A P I TA L ( C O C )
If a firm accepts an investment proposal, it will need
funds for its financing.

Funds can be procured from different types of

investors, i.e., equity shareholders, debt holders,
depositors etc.
3

These investors have an expectation of receiving a

minimum return from the firm.

Min. Return- risk perception of the investor as well

Proposal must earn at least as risk-return characteristics of the firm.
this much, which is sufficient
to pay to investors This return payable to investors would be earned out
of the revenues generated by the proposal wherein
funds are being used.
C O S T O F C A P I TA L ( C O C )
• A firm generally tends to undertake multiple projects.
• Every project has its own cost of capital.
• A firm’s cost of capital is known as overall/ average COC. This may be different from a
project’s COC.
• COC takes in consideration long term sources of funds. 4

Min. ROR a firm must earn

to satisfy the expectations of
the investors.
COC
ROR a firm must earn to
attract the supplier of funds.
SIGNIFICANCE OF COC

1. Evaluation of investment decisions

2. Determine the capital structure
3. Appraise the financial performance of top management

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 FACTORS AFFECTING COC

• COC depends on:

1. Riskiness of project
2. How much risk investor perceives in the project

Minimum Required ROR= Risk-free ROR+ Risk Premium 6

1. Risk-free ROR (Real Interest Rate, Inflation Rate)

2. Business Risk
3. Financial Risk
4. Liquidity of Investment

COC= Real Interest Rate + Inflation Rate+ Business Risk Premium+ Financial Risk Premium+ Premium
for other factors
 R E L AT I O N S H I P B E T W E E N R I S K A N D
RETURN

R
E
Q Equity shares
7
U Preference shares
I
Corporate Debt
R
Risk- E Govt. Security
Risk-free
free rate D
security
R
O
R

RISK
TYPES OF COC

Future Cost and

Historical Cost

TYPES
8

Specific Cost and

Combined COC

Explicit and Implicit COC

S P E C I F I C C O S T O F C A P I TA L

• The cost of each specific component of capital whether equity, debt or preference share
is known as specific cost of capital.

• The Effect of Taxes:

9
• In case of CB, CFs used in for evaluation of project are CFAT.
• Accordingly, cost should also be after tax.
• As dividends are distributed after tax, there is no tax benefit on such expenses.
• However, in case of debt, since interest is allowed as an expense for tax purposes, their
after-tax cost is less.
TAX RATE: 50% D: 30,000@20%; E: E: 50,000
20,000 (share price: (share price: Rs. 10)
Rs. 10)
SALES 500000 500000
LESS VARIABLE COST 200000 200000
CONTRIBUTION 300000 300000
LESS FIXED COST 200000 200000
EARNINGS BEFORE DEPRECIATION, INTEREST, AND 100000 100000
TAXES 10
LESS DEPRECIATION 10000 10000
EBIT (D: 30,000@20%; E: 20,000) 90000 90000
LESS INTEREST 6000 -
EBT 84000 90000
LESS TAX 42000 45000
PAT 42000 45000
- DIVIDEND TO PREFERENCE SHAREHOLDERS - -
PROFITS AVAILABLE TO EQUITY SHAREHOLDERS 42000/2000=21 45000/5000=9
 COST OF DEBT

• Cost of debt may be defined as the returns expected by potential investors of debt securities of
the firm.
COST OF PERPETUAL DEBT:
Ki= I / NP
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Ki :COC before Tax
I: Interest Payable
NP: Net Proceeds

NP = FV + P – D – F
FV= FACE VALUE; P= PREMIUM; D= DISCOUNT; F= FLOATATION COST
Kd= Ki ( 1- t)
N E T P RO C E E D S

• A bond having face value Rs. 1000 is issued at 10% premium and issue expenses are 2%.
Calculate the NP.

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FV+
PREMIUM
PREMIUM
FLOATATION
COST
DISCOUNT FACE VALUE
EXAMPLE

• A bond having face value Rs. 1000 is issued at 10% premium and issue expenses are 2%.
This bond is giving interest @ 12%. Calculate cost of debt ignoring redemption value
and taxes.

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EXAMPLE

• A bond having face value Rs. 1000 is issued at 10% premium and issue expenses are 2%.
This bond is giving interest @ 12%. Calculate cost of debt ignoring redemption value
and taking tax rate at 30%

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Z E RO C O U P O N B O N D S

• No payment of interest
• Redemption value is greater than Net Proceeds.
• Redemption value includes the interest element.

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REDEEMABLE DEBT

Kd=

16

• Kd= I (1- t) + (RV-NP)/N SHORT CUT

RV+NP/2 METHOD

N= LIFE OF DEBENTURE
 Q1

• A firm issues 15% debentures of face value of Rs. 100 each,

redeemable at the end of 7 years. The debentures are issued at a
discount rate of 5% and floatation cost is estimated to be 1%. Find out
the cost of debentures given that firm has tax rate of 50%.
17
Q2

• A company issues a new 10% debentures of Rs. 1000 face value

to be redeemed after 10 years. The debenture is expected to be
sold at 5% discount. It will always floatation costs of 5%.
Company’s tax rate is 35%. What would be cost of debt? 18

• Illustrate the computation using:

• 1) trial and error method
• 2) short cut method
C O S T O F P R E F E R E N C E S H A R E C A P I TA L

• Represents the dividend expected by preference shareholders

• Pay dividend at fixed rate
• Redeemed at predetermined value
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• Difference between debt and preference shares: Debt- interest is
charge against profits; Preference shares- appropriation of profit
C A L C U L AT I O N S

Irredeemable P.S. Redeemable P.S.

Kp= PD/ Po Kp= PD+ (Pn- Po)/N

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Pn+Po/2
PD- Preference Dividend
Po- Net Proceeds Pn- Redemption Amount
N- Number of years
Q4

A company issues 11% irredeemable preference shares of the

face value of Rs. 100 each.
Floatation costs: 5%.
Calculate Kp if 21

i) shares are issued at par

ii) at premium of 10%
iii) Also, compute Kp in these situations if assuming 13.125%
dividend tax.
Q5

• A company has issued 11% preference shares having face

value of Rs. 100 each to be redeemed after 10 years.
Floatation cost: 5%. Determine Kp.
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 COST OF EQUITY SHARES

• Difficult to measure in relation to debt and preference shares

• Rate at which equity dividends are paid generally keeps on changing
• Dividend amount is proposed by BOD and approved by shareholders
• To calculate cost of equity capital the expected stream of dividends is taken as base 23

Po= D1/ (1+Ke) 1+ D2/ (1+Ke)2 + D3/ (1+Ke)3 +…………… Pn/ (1+Ke)n
Po= Current Market Price of Equity Share
Pn= Market Price of Equity Share after year n
Di= Dividend redeemable on share capital at different years
Ke= Required rate of return of the shareholder or Cost of Equity Capital
COST OF EQUITY SHARES

ZERO GROWTH CONSTANT GROWTH VARYING GROWTH

DIVIDEND RATE RATE
Ke = D1/ Po Po= D1/Ke- g To be discussed along with
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Ke = 1/ P/E; Ke = D1/Po + g question
P/E=EPS/MPS
D1= Do (1+g)
Q6

• A company pays constant dividend of Rs. 5 p.a. . The market

price of the share currently is Rs. 70. Find Ke.

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Q7

• A company is expected to pay a dividend of Rs. 6 next year and

this dividend is expected to grow @ 5% p.a. forever. The
current market price of the share is Rs. 50. What is the cost of
equity? 26
Q8

• A company has just paid dividend of Rs. 6. This dividend is

expected to grow @ 5% p.a. forever. The current market price
of the share is Rs. 50. What is the cost of equity?
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Q8

• Z Ltd. is forecasting a growth rate of 12% p.a. in the next 2

years. The growth rate is likely to fall to 10% for the 3 rd year
and the 4th year. After that, growth rate is expected to stabilize
at 8% p.a. If the last dividend was Rs. 1.50 per share and the 28

investors’ ROR is 16%, find out the intrinsic value per share.
C O S T O F C A P I TA L O F N E W E Q U I T Y O R
EXTERNAL EQUITY
• Kn = D1/NP + g
• Kn= Cost of New Equity
• D1= Expected Dividends
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• NP= Net Proceeds
C O S T O F R E TA I N E D E A R N I N G S

• Retained earnings is that portion of the earnings which belongs

to the shareholders but has not been distributed to them in the
form of dividends.
• Cost of retained earnings is same as cost of equity assuming that 30

the shareholders have subscribed to the shares of company.

• Cost of retained earnings < Cost of new equity as no floatation
and advertisement costs are involved.
 W I E G H T E D AV E R A G E C O C / O V E R A L L C O C

• Once specific cost of capital of each of the long-term sources is ascertained, next step involves
calculation of overall COC.
• This overall COC is used as discount rate in evaluating the capital budgeting proposals.
• It may be defined as the rate of return that must be earned by the firm in order to satisfy the
requirements of different investors.
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• WACC is the minimum ROR on the assets of the firm.

• WACC= Ke*W1+ Kd*W2+Kp*W3

W= proportion of specific source in capital structure.

Book Value
Weights
Market Value
Q9

• A firm’s after-tax COC of specific sources is:

• Cost of debt: 8%
• Cost of preference share capital including preference dividend: 14%
• Cost of equity funds: 17% 32

Calculate WACC using book value

• Following is the capital structure weights.
Source Amount
Debt 3,00,000
Preference Capital 2,00,000
Equity Capital 5,00,000
10,00,000
Q10

• A company has on its books the following amounts and specific costs of each type of
capital:
Type of Capital Book Value Market Value Specific Cost (%)
Debt 4,00,000 3,80,000 5
Preference 1,00,000 1,10,000 8 33
Equity 6,00,000 15
Retained 2,00,000 12,00,000 13
13,00,000 16,90,000

Calculate WACC using book value weights and market value weights.
 Q11

• Aries Ltd. is planning to raise Rs. 10,00,000 for its investment plans. It currently has 210000
available in form of retained earnings. Further details include:
• Debt-equity mix: 30:70
• Cost of debt: Up to 180000- 10% before tax and beyond 180000-12% before tax.
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• Earnings per share: 4
• Dividend payout: 50% of earnings
• Expected growth rate in dividend: 10%
• Current market price per share: 44
• Tax rate: 35%

• Compute Weighted average after tax cost of additional finance.

MARGINAL COC

• Investment proposals may require funds to be raised from new internal/

external sources, and thus increase the total funds also.
• This COC of additional funds is called Marginal COC.
• Variables affecting COC: 35

Perceived increase in business risk

Change in financial risk of firm
Change in risk may change marginal COC and some proposals might
become unviable.
EXAMPLE

• Capital structure of a firm is given as:

Source Amount Weight Specific COC

Equity Share Capital 25,00,000 .50 11%
Retained Earnings 12,50,000 .25 11% 36
11% Debentures 12,50,000 .25 5.5%

WACC in this case:

.50*11% + .25*11% + .25*5.5% = 9.6%

Tax rate: 50%

 EXAMPLE

• Assume that now firm has investment proposal of Rs. 10L and firm expects to generate
retained earnings of Rs. 2L from current operations. Remaining funds are raised by the
issue of Equity share capital i.e., Rs. 6L @ 12% and 12% bonds of Rs. 2L.

• WMCC in this case would be: 0.2*11%+ 0.6*12% + 0.2*.06 = 10.6%

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Source Amount Weight Specific COC Weights*COC
Equity Share Capital 25,00,000 .417 11% .0458
Retained Earnings 12,50,000 .208 11% .0228
11% Debentures 12,50,000 .209 5.5% .0115
Retained Earnings 2,00,000 .033 11% .0036
Equity Share Capital 6,00,000 .10 12% .012
12% Bonds 2,00,000 .033 6% .0020
60,00,000 .0977