Cost of Capital

Cost of capital is the minimum rate of return expected by investors on their investments.

Meaning and Definition (Concept) of Cost of Capital

Cost of capital simply refers to cost of obtaining funds. Cost of capital is the rate a firm pays to
its investors for the use of their money.

From a firm's point of view, cost of capital is the rate at which a firm raises capital to invest in
various projects. The basic motive of raising capital is to invest in various projects for earning
profits. Out of that profit, the firm pays interest and dividend to those who provided the capital.
The amount paid as interest and dividend is considered as cost of capital.

From the investor's point of view, cost of capital is the rate of return which investors expect from
the or activity is e capital invested by them in the firm in to the short, cost of capital is the
payment for the use of capital.

Features of Cost of Capital

1. It is not a cost. It is a rate of return required on the projects. Hence it is a "hurdle rate.

2. It is the minimum rate of return a firm requires to earn in order to maintain the market value
of S its equity shares.

3. It is the reward for business risk and financial risk.

4. It consists of three elements - (a) riskless cost of the particular source (b) business risk
premium, and (c) financial risk premium.

Classification/ Types of Cost of Capital

1. Historical Cost and Future Cost

Historical cost refers to the cost which has already been incurred for financing a project. It is
calculated on the basis of past data.

Future cost refers to the expected cost of funds to be raised for financing a project.

2. Specific Cost and Composite Cost

Specific cost refers to the cost of a specific source of capital such as equity share, preference
share, debenture etc.

Composite cost of capital refers to the combined cost of various sources of capital. It is the
weighted average cost of capital. It is also called 'overall cost of capital".
3. Average Cost and Marginal Cost

Average cost of capital refers to the weighted average cost of capital calculated on the basis of
cost of each source of capital and weights are assigned to them in the ratio of their share to total
capital funds.

Marginal cost of capital refers to the cost of obtaining an extra Re. 1 of finance.

4. Explicit Cost and Implicit Cost

Explicit cost of capital refers to the discount rate which equates the present value of cash inflows
with the present value of cash outflows. Thus it is the internal rate of return which a firm pays for
procuring the finance,

Implicit cost of capital refers to the rate of return which can be earned by investing the funds in
alternative investments. In other words, it is the opportunity cost of capital.

Explicit cost of capital will arise only when funds are raised, but implicit cost arises when they
are used.

Assumptions of Cost of Capital

While computing cost of capital, the following assumptions are made:

1. The cost can be either explicit or implicit.

2. The firm's capital structure does not change.

3. Cost of each source of capital is determined on an after tax basis.

4. The financial and business risks are unaffected by the acceptance and financing of project

Importance of the Concept of Cost of Capital

The concept of cost of capital is very relevant in the managerial decisions. Its utility can be
studied under the following headings:

1. Useful in investment decision: The cost of capital is very useful in capital budgeting
decisions It helps in calculating profitability of various investment proposals.

2. Useful in designing capital structure: The cost of capital is very useful factor in designing
the firm's capital structure.

3. Useful in deciding the method of finance: A company usually prefers a method of financing
which bears the least cost of capital.
4. Useful evaluation of performance of management: The cost of capital can be used to
evaluate the financial performance of top management.

5. Useful in evaluation of expansion projects: It is on the basis of comparison of cost of capital

with marginal return on investment, the decision is taken whether to accept or reject the
expansion projects.

6. Optimum mobilization of resources: It enables an organization to mobilize its funds from

non-profitable to profitable areas. Resource mobilization helps in reducing the risk factor.

7. Other uses: The cost of capital is important in many areas of decision making such as
payment of dividend, retained earnings, capital structure, working capital management etc.

Factors Determining Cost of Capital

The various factors which determine the cost of capital are outlined as follows:

1. General economic conditions: The general economic conditions determine the demand for
and supply of capital within the economy as well as the level of expected inflation. If the demand
for money increases without an equivalent increase in supply, creditors will raise their required
rate of interest. Thus cost of capital changes. As inflation is expected, there would be
deterioration in the purchasing power of the money, investors require a higher rate of return to
compensate for this anticipated loss. Thus cost of capital increases.

2. Risk: The cost of capital has a direct relation with risk. If an investor is purchasing a security
where the risk is significant, the opportunity for additional return is necessary to make the
investment attractive. Thus if the risk associated with the capital is higher, the cost of capital will
also be higher.

3. Amount of finance required: When management approaches the market for large amount of
capital, suppliers of capital become hesitant to give relatively large amounts of funds without
assuring the management's capacity to absorb the capital into business. Therefore, for additional
funds, the investors may ask for higher required rate of return which means higher cost of
capital.

4. Flotation costs: Flotation costs refer to the cost of marketing new securities. These include all
costs involved in moving new securities from the issue to the ultimate investor. These include
legal fees, printing expenses, sales commissions, underwriting commission etc. These are called
so because these are incurred in floating new securities. When flotation costs are incurred, the
cost of capital will be increased.

5. Taxes: In capital budgeting, all cash flows are evaluated on an after tax basis. In order to be
consistent with this, the cost of capital, (which is to discount the cash flows in determining net
present values and profitability index and as the cut off rate for IRR) must also be measured on
an after tax basis. The specific cost of capital that actually requires any type of tax adjustment is
the cost of debt.

Determination of Cost of Capital

The items on the left side of a firm's balance sheet - Equity share capital, Preference share capital
and various types of debt - are called capital components. Any increase in total assets must be
financed by an increase in one or more of these capital components.

For the purpose of determination of cost of capital, all sources of capital are grouped under the
following four components:

Before calculating the overall cost of capital, an attempt may be made to calculate the cost of
each of the above components: (a) Cost of debt, (b) Cost of preference capital, (c) Cost of equity
capital, (d) Cost of retained earnings, and (e) Cost of weighted average cost of capital.

Cost of Debt

Debt capital comprises of debentures and long term loans. Cost of debt capital means the
payment of interest, on debentures or loans from financial institutions. For calculating the cost of
debt we need data regarding: (i) the net cash proceeds/inflows (the issue price of
debentures/amount of loan minus all floatation costs), and (ii) the net cash outflows in the form
of interest payment and the repayment of principal amount in installments or lump sum on
maturity.

Since interest is a tax-deductible expense, we have to consider the after-tax cost of debt,
especially if we want to judge its impact on the firm's after-tax profitability or compare it to the
cost of other types of securities such as preference and equity shares.

Cost of Irredeemable Debt

Irredeemable debt is also known as perpetual debt. In this case the time of maturity is not
specified. It is calculated by the following formula:

(i) Before tax cost of debt

Kd = I/NP × 100
I = Interest

NP= Principal or Net Proceeds of Debt Capital

(ii) After tax cost of debt

Kd = [I (1-T) / NP] * 100

T = Tax rate

or

Before tax cost of debt x (1-T)

In case the debt is raised at premium or discount, NP is the net proceeds received from the issue
and not the face value of securities. It means premium should be added to face value (if issued at
premium) and discount should be deducted from face value (if issued at discount) of securities.
Similarly, floatation cost should be deducted from the net proceeds. Floatation costs include all
types of expenses which are incurred in connection with issue of debentures or bonds or to obtain
the funds. Examples are advertisement charges, stationery and printing, stamp duty, brokerage,
underwriting commission etc. In short, floatation costs are expenses on issue.

The above mentioned facts may be summarized as below:

i) When debt is issued at par: NP = Face value - Floatation cost or issue expenses

ii) When debt is issued at premium: NP = Face value + Premium - issue expenses

iii) When debt is issued at discount: NP = Face value - Discount-issue expenses

Thus, when the net proceeds increase (when debt is issued at premium), the cost decreases (NP,
the denominator increases). On the other hand, when securities are issued at discount, NP
decrease (denominator decreases). Hence, the cost increases.

Cost of Redeemable Debt

Usually the debt is issued to be redeemed after a certain period during the life time of a firm. The
cost of redeemable debt is calculated as follows:

(i) Before tax cost of redeemable debt

Kd = {[ I + 1/N( RV – NP)] / ½ (RV + NP)} * 100

Where, I = Interest

N = Number of years in which debt is to be redeemed.

RV = Redeemable value of debt (i.e., the amount payable on redemption)

NP = Net proceeds of debentures

(ii) After tax cost of redeemable debt

Kd = {[ I ( 1 – T) + 1/N( RV – NP)] / ½ (RV + NP)} * 100

Here, 'T' means Tax rate.

The denominator is the simple average of redeemable value and net proceeds.

Cost of Preference Share Capital

Preference shares carry a fixed rate of dividend. It is paid before equity dividend is paid. The rate
of dividend is determined at the time of issue. The cost of preference capital is the dividend
expected by the preference shareholders. It is found by dividing annual preference dividend by
the net proceeds from the issue of preference shares. The formula to compute the cost of
preference capital is given below:

(i) Cost of irredeemable preference share capital

Kp = Dp / NP × 100

Kp = Cost of preference share capital

Dp = Preference share dividend

NP = Net Proceeds from the issue of preference shares. Floatation cost, if any, should be
deducted.

(ii) Cost of redeemable preference share capital

Kp = {[ Dp + 1/N( RV – NP)] / ½ (RV + NP)} * 100

RV = Redeemable value of preference share capital. (i.e., the amount payable on redemption)

Cost of Equity Share Capital

It is very difficult to calculate the cost of equity capital when compared to debt and preference
capital. The main reason is that the equity dividend is not fixed. It varies from year to year
depending upon the profit earned by the company. Risk factor also plays an important role in
deciding the rate of equity dividend.

The cost of equity capital is the minimum rate of return that the company must earn on its equity
share capital. It is the return which the shareholder expects on his investment. Thus the cost of
equity capital may be defined as the minimum rate of return that a firm must earn on the equity
investment so that the market value of shares remains unchanged.

There are various approaches to calculate cost of equity capital. They are: (1) Dividend yield
method; (2) Dividend yield plus growth method; (3) Earning price method; (4) Realized yield
method.

Dividend yield method:

This method is based on the assumption that each shareholder, while investing his savings in the
company, expects to receive dividend at the current rate of return. Therefore, dividend received
(expected) is capitalized by the market value of shares to ascertain the cost of shares. This
method is also known as dividend price ratio method. The formula is:

Ke = D / MP *100

Ke = Cost of equity capital

D= Dividend per share (expected)

MP= Market Price per share

In the case of newly issued equity shares, it is not possible to know the market price per share.
To ascertain the cost of capital, D is divided by NP (Net Proceeds per share). NP is calculated
after deducting expenses on new issue. The formula is:

D / NP * 100

Evaluation (Merits and Demerits): Though this approach is simple, it suffers from the
following limitations: (a) It does not take into consideration the changes of capital appreciation;
(b) it ignores the impact of retained earnings. The retained earnings affect both the market price
of shares and the amount of dividend paid.

Dividend yield plus growth method: When the dividends are expected to grow at a constant
rate and dividend payout ratio is constant, this method may be used to compute the cost of equity
capital. Under this method the cost of equity capital is based on the present rate of dividend and
expected growth rate of dividend) In the case of existing equity shares, the following formula is
used:

Ke = D1 / MP *100 + G

D1 = Expected dividend per share at the end of the year

( i.e D0 (1 + g). Here D0 = Previous years dividend or declared dividend

MP = Market price per share

G = Rate of growth in dividend

In case of new equity shares the formula is

Ke = D1 / NP *100 + G

NP = Net Proceeds per share

From the above equation MP or NP can be calculated as follows

MP or NP = D1 / Ke - G

Evaluation (Merits and Demerits): This method is the best method to evaluate the expectations
of investors and to calculate the cost of equity. It ensures the optimum capital budgeting
decisions. The main difficulty in this approach is to determine the rate of growth of price
appreciation expected by a shareholder when he is willing to pay a certain price for current
dividend.

Earning price/ Yield method: According to this method, the cost of equity capital is the
discount rate that equates the present value of expected future earnings per share with the current
market price or net proceeds per share. The formula is:

Ke = EPS/ (MP or NP) *100

EPS Earning Per Share

This method is used in the following cases:

(a) When the EPS is expected to remain constant

(b) When the dividend payout ratio is 100% (all the profit are distributed as dividend)

(c) When a firm is expected to earn an amount on new equity share capital, which is equal to the
current rate of earnings.

(d) When the share price is influenced by the EPS.

Evaluation (Merits and Demerits): The main advantage of earning price method is that it
considers the future earnings prospects of the company. This approach has three main
limitations: (a) All earnings are not distributed among the shareholders in the form of dividend,
(b) Earnings per share cannot be assumed to be constant, (c) Share price does not remain
constant because investment in retained earnings result in increase in market price of shares.

Earnings Growth model

Under this method, the cost of existing share capital is calculated by replacing ‘Net proceeds’
with ‘Market price’ and adding ‘Growth rate in Earnings’ as under
Ke = (EPS/ MP) * 100 + G

Where,

Ke = Cost of equity capital

E = Earnings per share

MP = Current market price of shares

G = Growth rate in earnings

Realized Yield Method:

Realized Yield Method is based on the actual earnings on all the investments. This method helps
in finding out the quantum of money financed from 'equity share capital' and 'revenue amount of
past profit'. This enables to calculate cost of equity capital by applying following formula:

Ke = (W 1 * W2 * W3 ......Wn) 1/n -1

The wealth/yield of equity for the year is:

Wt = ( Dt + Pt) / Pt-1

Where,

Ke = Cost of equity capital

Wt = Wealth/ Yield for the year t

Dt = Dividend per share at the end of the year t

Pt = Price per share at the end of the year t

Pt-1 = Price per share at the beginning and at the end of the year

Capital Asset Pricing Approach or Model (CAPM):

This approach was developed by William F. Sharpe (Nobel Prize winner). According to this
approach the return on equity shares depends on the amount of risk associated with it. If more
risk is associated with it, it will provide more return. If it is associated with less risk, it will
provide less return. Thus this model states that as the level of risk increases, the investors would
expect higher returns to compensate for the risk that they have taken. There are two types of risks
associated with an equity share. They are: Systematic risk and Unsystematic risk. The systematic
risk is measured by ẞ (beta).
When any change takes place in the market price of shares, it occurs due to the combination of
both systematic risks and unsystematic risks. If the value of beta is high, the risk is considered to
be high. Under CAPM approach, cost of equity capital is calculated by using the following
formula:

Ke = Rf + ẞi (Rm - Rf )

Rf = Risk free rate of return

ẞi = the beta co-efficient of the investment

Rm = Average market return

Merits of CAPM Approach

1. It is theoretically sound

2. It directly considers the risk as reflected in beta in order to determine the cost of equity,

Demerits of CAPM

1. It does not include the market price.

2. Some problems are involved in the practical application of CAPM model in collecting data.

3. Beta measure of risk considers only the systematic risk only. Some investors may be more
interested in total risk.

Gordon Dividend Growth Model:

This was developed by M. Gordon to calculate the cost of equity. As per this model, an investor
always prefers less risky investment. Therefore, a company should pay risk premium only on
risky investment. Gordon model also suggests that an investor would always prefer those
investments which provide him current income. Under this method the cost of equity capital is
calculated as follows:

Ke = D (I+G) / De +G

D = Current Dividend per share

G = Annual growth rate of dividend

De = Ex-dividend market price per share.

Cost of Retained Earnings

 The cost of retained earnings may be defined as the opportunity cost of the dividends foregone
by the equity shareholders. It is the rate at which the shareholder is not receiving the dividend. It
refers to the rate of return which shareholder can obtain by investing the after tax dividend in
securities. The cost of retained earnings is calculated as follows:

Kr = ((D or EPS)/MP) *100

Kr = Cost of retained earnings

Note: If the growth rate of dividend is given in the question, it should be adjusted in the formula,
the formula is:

(EPS/MP) * 100 + G

Where, G = Growth rate of dividends.

Cost of retained earnings is the same as that of equity capital. However, in actual practice, it is
stated that the cost of retained earnings is less than the cost of equity capital. This is because
there is no expense on brokerage, and tax paid on dividend. So, the formula is:

Kr = Ke * (1-T) * (1-B)

Note: The cost of retained earnings (to the company) would be always less than the cost of new
equity shares issued by the company. This is clear from the above formula.

Weighted Average Cost of Capital (WACC)

After ascertaining the specific cost of capital of each source (i.e., the cost of debt, cost of
preference share, cost of equity and cost of retained earnings), the next step is to calculate the (i)
overall cost of capital of the firm.

The capital raised from various sources is invested in different projects. The profitability of these
projects is evaluated by comparing the expected rate of return with overall cost of capital or
average cost of capital. For calculating the average cost of capital, we use not simple average but
weighted average.

WACC summarizes the after tax cost of the entire capital structure. It simply refers to the
average cost of the various sources of finance. It is an average of the costs of all sources of fund
in the capital structure, properly weighted by the proportion of each source in the total capital
structure. It is also known as composite cost of capital or overall cost of capital. Steps involved
in calculating WACC

In calculating the WACC, the following steps are involved:

1. Assignment of weights: First of all, weights have to be assigned to each source of capital
Weights can be either 'book value weights' or 'market value weights'.
Book value weights: Book value weights are the relative proportion of various sources of capital
to the total capital. These can be easily calculated by taking the relevant information (face
values) from the capital structure given in the balance sheet.

The book value weights have the following merits: (a) They are simple to calculate, (b) They can
be easily obtained from published records, (c) It is easier to evaluate the performance of t
management in procuring funds on the basis of book values, and (d) Investors are interested in
knowing the debt equity ratio on the basis of book values.

Market value weights: Market value weights may be calculated on the basis of the market value
of the different sources of capital, i.e., the proportion of each source at its market value b order to
calculate the market value weights, the firm has to find out the current market price of each
security in each category.

Market value weights have the following merits: (a) They represent the true expectation of the
investors, (b) The market value represents near to the opportunity cost of capital, (c) The cost of
each specific source of finance is calculated according to the prevailing market price. However,
the market value weights suffer from the following limitations: (a) They undergo frequent
changes; (b) Sometimes they may not be available, (c) external factors affecting the market value
will affect the cost of capital.

Even though market value weight is better than book value weight, the readily available is book
value weights. So book value weights may be used.

2. Computation of specific cost of each source: After assigning the weights, the next step is to
calculate the specific costs of each source (these have been explained earlier). In financial
decisions, all costs are used after tax costs.

3. Computation of WACC: After ascertaining the weights and cost of each source, the WACC
is calculated. This is calculated by multiplying the cost of each source by its respective weights.
Now we get weighted cost of each source. Then the weighted costs of all the sources are added.
This is the WACC.

Merits of WACC

1. It is a straight forward and logical approach.

2. It takes into consideration all changes in the capital structure.

3. It is more accurate when profits are normal.

4. It is very useful in capital budgeting decisions.

Limitations of WACC
1. It is not suitable in case of excessive low-cost debt.

2. It is not suitable in case low profits.

3. It is very difficult to assign weights to different components of capital.

4. It is not easy to select capital structure to be used for determining the weighted average cost of
capital.

Marginal Cost of Capital

When a firm raises new funds from different sources, the WACC is not suitable. The WACC is
based on the proportion of funds in the existing capital structure. Mostly firms do not raise new
or additional funds in the same proportion as the funds in the existing capital structure. In such
cases marginal cost of capital is used. The weighted average cost of new or additional capital is
called marginal cost of capital (or weighted marginal cost of capital). This is calculated by using
the marginal weights. The marginal weights represent the proportion in which the new sources of
funds are raised. If the new funds are raised from different sources in the same proportion as the
existing proportion, then the WACC will be equal to the marginal cost of capital. But in practice,
the proportion and/ or the component costs may change for additional funds to be raised. The
marginal cost of capital is more justified because of its following merits: (a) In the past the firm
may be using some source of finance, which may not be available to the firm now, (b) The firm
does not have control over arrangement of funds, (c) The finance manager will have note
freedom in making optimum mix of capital for financing new projects. However, the MCC
suffers from the following limitations: (a) It ignores the long-term implications of firm's current
financing; (b) It ignores the interrelationship among various sources of funds.

Problems
Cost of capital

Example 1

(a) A Ltd issued Rs. 1, 00,000 8% debentures at par. The tax rate applicable to the company is
50%. Compute the cost of debt capital.

(b) B Ltd issued Rs. 1, 00,000 8% debentures at a premium of 10%. The tax rate applicable to
the company is 60%. Compute the cost of debt capital.

(c) C Ltd issues Rs. 1, 00,000 8% debentures at a discount of 5%. The tax rate is 50%. Compute
the cost of debt capital.
(d) D Ltd issues Rs. 2, 00,000 9% debentures at a premium of 10%. The floatation costs are 2%.
The tax rate applicable is 60%. Compute cost of debt capital.

Example 2

Assuming that a firm pays tax at 50% rate, compute the after tax cost of debt capital in the
following cases:

(i)A perpetual bond sold at par, coupon rate of interest being 7%.

(ii) A 10 year, 8% Rs. 1,000 per bond sold at Rs. 950 less 4% underwriting commission.
Example 3

A company issued 20,000 5% preference shares of Rs. 100 each, Cost of issue is Rs. 2 per share.
Calculate cost of preference capital if these shares are issued (a) at par, (b) at a premium of 10%,
and (c) at a discount of 5%.
Example 4

A company issued 1,000 7% preference shares of Rs. 100 each at a premium of 10% redeemable
after 5 years at par. Compute the cost of preference capital.

Example5

A company issued 10,000 10% preference shares of Rs. 100 each redeemable after 10 years at a
premium of 5%. The cost of issue is Rs. 2 per share. Calculate the cost of preference capital.
Example 6

A company plans to issue 1,000 new shares of Rs. 100 each at par. The floatation costs are
expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share initially
and the growth in dividends is expected to be 5%. Compute the cost of new equity shares. If the
current market price of an equity share is s, 150 calculate the cost of existing equity share capital.

Example 7
The shares of a company are selling at Rs. 80 per share and the company had paid a dividend of
Rs. 8 per share last year. The investors expect a growth rate of 5% per year.

a) Calculate the equity cost of capital.

b) If the expected growth rate is 7% p.a., calculate the market price per share.

Solution

a. Ke = (D1/MP) + g

Example 8

The current price of an equity share of Rs 10 is quoted in the market at Rs 20.The earning per
share is Rs 3. Growth rate in earnings is given to be 10 % p.a. Calculate the cost of equity based
on earnings growth model.

Solution

Ke = (EPS/ MP) * 100 + G

EPS = 3

MP = 20

G = 10%

Cost of equity capital Ke = (3/20) * 100 + 10% = 25%

Example 9

The dividend per share for the last three years is Rs 10, Rs 12 and Rs 14 respectively. The price
per share at the beginning of the years was Rs 20, Rs 25, and Rs 30. What will be the cost of
equity?

Solution

Wt = ( Dt + Pt) / Pt-1

For 1st Year:

Dividend per share at the end of the year t Dt = 10

Price per share at the end of the year t Pt = 25

Price per share at the beginning and at the end of the year P t-1 = 20

Wt = (10 + 25) / 20 = 1.75

For 2nd Year:

Dividend per share at the end of the year t Dt = 12

Price per share at the end of the year t Pt = 30

Price per share at the beginning and at the end of the year P t-1 = 25

Wt = (12 + 30) / 25 = 1.68

Ke = (W 1 * W2 * W3 ......Wn) 1/n -1

= (1.75 * 1.68) 1/2 – 1

= 71.46%

Example 10

A company is considering an expenditure of Rs. 50 lakhs for expanding its operations. The
relevant information is as follows:

Number of existing equity shares Rs. 10 lakhs

Market value of existing share 60

Net earnings 90 lakhs

Compute the cost of existing equity share capital and of new equity share capital assuming that
new shares will be issued at a price of Rs. 55 per share and the cost of new issue will be Rs. 5 per
share.

Solution

Cost of existing equity share capital:

Ke = (EPS / MP) × 100

EPS or Earnings Per Share = 9000000/1000000 = Rs 9

Ke = (9 / 60) × 100 = 15%

Cost of new equity capital:

Ke = EPS/NP = [9/(55-5)] × 100 = (9 / 50) × 100 = 18%

Example 11

You are given the following data relating to a company.

(i) Risk free rate of return 11%

(ii) Beta co-efficient of the firm is 1.25

Compute the cost of equity capital under CAP model assuming a market return of 15% next year.
What would be the cost of equity if beta co-efficient increases to 1.75.

Solution

Ke = Rf + βi (Rm - Rf )

When βi = 1.25,

Ke = 11%+ 1.25 (15%-11%)

= 11%+5% = 16%

When βi = 1.75,

Ke =11%+1.75 (15%-11%)

= 11%+7% = 18%

Example 12
A firm's Ke , is 15%, the average tax rate of shareholders is 40% and it is expected that 2%
brokerage cost that shareholders will have to pay while investing their dividends in alternative
securities. What is the cost of retained earnings?

Solution

Kr = Ke (1-T) (1-B)

Kr = 15% (1-0.4) (1-0.02)

= 15% x 0.6 x 0.98 = 8.82%

Example 13

The following is the capital structure of A Ltd.

Cost of
Source Amount (Rs) capital
Equity Capital (2,00,000 shares of Rs. 10 each) 2000000 11%
Preference Share Capital (50,000 Rs. Of Rs. 10
each). 500000 8%
Retained Earnings 1000000 11%
9% Debentures (Rs. 1,000 each) 1500000 4.50%

Presently the debentures are being traded at 94%, preference shares at par and the equity shares
at Rs. 13 per share. Find out the WACC based on book value weights and market value weights.

Solution

On the basis of book value weights

Calculation of book value weights:

Preference Capital = (5, 00,000/ 50, 00,000) x 100 = 10% ог 0.1

Equity Share Capital = (20, 00,000/ 50, 00,000) x 100 = 40% or 0.4

Retained Earnings = (10, 00,000/ 50, 00,000) x 100 = 20% 0r 0.2 9%

Debenture = (15, 00,000/ 50, 00,000) x 100 = 30% or 0.3

BV COST (C Weighted Cost

SOURCE BV (RS) WEIGHTS(W) ) (W * C)
Preference
Share Capital 500000 10% 8% 0.80

Equity Capital 2000000 40% 11% 4.40

Retained
Earnings 1000000 20% 11% 2.20

9% Debentures 1500000 30% 4.5% 1.35

WACC 8.75%

On the basis of market value weights

Calculation of market values:

Total market value of equity=2, 00,000 x 13=Rs. 26, 00,000 (equity capital + retained earnings)

Total market value of retained earnings 26, 00,000 x 1/3 = 8, 66,667

Therefore market value of equity share = 26, 00,000 x 2/3 = 17, 33,333

(The ratio of equity capital and retained earnings is 2: 1 in the capital structure)

Total market value of preference share = 50,000 x 10 = 5, 00,000

Total market value of 9% debentures 15, 00,000 x 94/100 = 14, 10,000

Calculation of market value weights:

Preference Capital = 5, 00,000/ 45, 10,000 x 100 = 11.1%

Equity Capital = 17, 33,333/ 45, 10,000 x 100 = 38.4%

Retained Earnings 8, 66,667/ 45, 10,000 x 100 = 19.2%

9% Debentures = 14, 10,000/ 45, 10,000 x 100 =31.3%

SOURCE MV MV W COST W *C

Preference Share
Capital 500000 11.1 8% 0.89

Equity Capital 1733333 38.4 11% 4.22

866667 19.2 11% 2.11

Retained
Earnings

9% Debentures 1410000 31.3 4.5% 1.41

4510000 WACC 8.63%

Example 14

A firm has, the following capital structure and after tax costs for the different sources of funds
used:

Source of Funds Amount(Rs) Proportion After tax cost

DEBT 450000 30 7
Preference Share
Capital 375000 25 10
Equity Capital 675000 45 15
1500000 100

(a) Calculate the WACC using book value weights.

(b) The firm wishes to raise further Rs 600000 for the expansion of the project in the following
manner?

Rs
Debt 300000
Preference Capital 150000
Equity Capital 150000
Compute the weighted marginal cost of capital?

Ans.

(a) Weighted average cost of capital (WACC)

Source of Funds Proportion (%) After tax Cost (%) Weighted Cost
(BVW)

Debt 30 7 2.10

Preference Capital 25 10 2.50

Equity Capital 45 15 6.75

WACC 11.35%

(b) Weighted marginal cost of capital (WMCC)

Source of Funds Proportion (%) After tax Cost (%) Weighted

(Marginal Marginal Cost
Weights)

Debt 50 7 3.50

Preference Capital 25 10 2.50

Equity Capital 25 15 3.75

WMCC 9.75

Working note:

Marginal weights are calculated as follows:

Debt = (300000/600000)*100 = 50%

Preference capital = (150000/600000)*100 = 25%

Equity Capital = (150000/600000)*100 = 25%