Unit-Iii, Coc
Unit-Iii, Coc
Unit-Iii, Coc
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 )
5
FACTORS AFFECTING COC
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
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U Preference shares
I
Corporate Debt
R
Risk- E Govt. Security
Risk-free
free rate D
security
R
O
R
RISK
TYPES OF COC
TYPES
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• The cost of each specific component of capital whether equity, debt or preference share
is known as specific cost of capital.
• 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=
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N= LIFE OF DEBENTURE
Q1
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
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Q7
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
• 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.
Book Value
Weights
Market Value
Q9
• 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%
• 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.