Cost of Capital

overview
 Cost of Capital
• Introduction
• Cost of Capital: Concept and its Meaning
• Importance of Cost of Capital
• Types of Cost of Capital
– Explicit Cost and Implicit Cost
– Future Cost and Historical Cost
– Specific Cost and Combine Cost
– Average Cost and Marginal Cost
• Factors Affecting the Cost of Capital
• Measurement of Cost of Capital
• Measurement of Specific Cost
– Cost of Bonds and Debentures
– Cost of Preference Shares
– Cost of Equity Share Capital
– Cost of Retained Earnings
• Weighted Average Cost of Capital (WACC)
• Marginal Cost of Capital
 Introduction
• A firm raises funds from various sources of long
term finance like equity, preference, debt or
retained earnings.
• These are called the components of capital.
• Different sources of fund or the components of
capital have different costs.
• The cost of each source is the specific cost of
that source, the average of which gives the
overall cost for acquiring capital.
 Introduction
• The firm invests the funds in various assets.
• These assets help in earning returns for the
enterprise.
• In order to achieve the objective of shareholders’
wealth maximization, it is important that the
firm earns a return on these assets that is higher
than the cost of raising the funds.
• Therefore, the minimum return a firm earns
must be equal to the cost of raising the funds.
 Cost of Capital
• Cost of capital is the central concept in financial management.
• It is used for making all the business decisions related to
investing, financing and distribution of dividend.
– Milton H. Spencer says “cost of capital is the minimum required
rate of return which a firm requires as a condition for undertaking
an investment”.
– According to Ezra Solomon, “the cost of capital is the minimum
required rate of earnings or the cut-off rate of capital
expenditure”.
– L. J. Gitman defines the cost of capital as “the rate of return a firm
must earn on its investment so the market value of the firm
remains unchanged”
 Cost of Capital
• Cost of capital is a composite cost of the
individual sources of funds including equity
shares, preference shares, debt and retained
earnings.
• The overall cost of capital depends on the cost
of each source and the proportion of each
source used by the firm.
• It is also referred to as weighted average cost
of capital.
 Cost of Capital
It can be examined from the viewpoint of
– an enterprise and
– an investor

According to the point of view of an enterprise, the cost of capital

refers to the cost of obtaining funds.
• The cost of capital is used to evaluate new projects of a company, as
it is the minimum return that investors expect for providing capital
to the company.
• Thus, the cost of capital is a benchmark that a new project has to
meet.
 Cost of Capital

According to the point of view of an investor, the cost of

capital is the required rate of return an investment must
provide in order to be worth undertaking.
• When an investment is made, the investor has to forego the
return available on the next best alternative investment.
• This foregone return is the opportunity cost of undertaking
the investment and consequently, is the investor’s required
rate of return.
• This required rate of return is used as a discounting rate to
determine the present value of the estimated future cash
flows.
 Importance of cost of capital
• Designing the capital structure: In order to achieve the objective of wealth
maximization, the management makes an attempt to minimize the cost of capital. The
specific costs of different sources of funds are compared and the most economical
sources of finance are selected for a balanced capital structure.
• Capital budgeting decisions: The acceptance or rejection of any investment proposal
depends upon the cost of capital. It helps to evaluate a project. Various methods used
in investment decisions require the cost of capital as the cut-off rate.
• Formulating dividend policy: The firm may retain all the profit in the business if it has
the opportunity of investing in such projects that can provide higher rate of return
than the cost of capital. Therefore, cost of capital plays a key role in formulating the
dividend policy.
• Evaluating the performance: Cost of capital is the benchmark for evaluating the
performance of different projects. The evaluation of the financial performance
involves a comparison of the projected overall cost of capital and the actual cost
incurred in raising the required funds, actual and projected profitability. The activities
of different departments are expanded or cut down on the basis of their performance.
 Types of cost of capital
Cost of capital may be classified into the
following types on the basis of nature and
usage:
– Explicit and Implicit Cost.
– Specific and Combined Cost
– Average and Marginal Cost.
– Historical and Future Cost.
 Explicit and Implicit Cost.

Explicit Cost
• It is the rate that the firm pays towards the
procurement of funds.
• The raising of funds involves both
– Cash inflows (receipt of funds raised) and
– Cash outflows (repayment of principal and the interest
thereon).
• It may be defined as the discount rate that equates
the present value of the funds raised by a firm with
the present value of expected cash outflows.
 Explicit and Implicit Cost.

• Explicit cost is the internal rate of return and

computed as follows:
𝐧
𝐂𝐭
𝐂𝐈𝟎 = ෍
(𝟏 + 𝐤)𝐭
𝐭=𝟏
 Explicit and Implicit Cost.

Implicit Cost
• This cost arises because of an ability of a
firm to have an alternative use of funds.
• It is also known as the opportunity cost
as it is the cost of the opportunity foregone in
order to take up a particular project
 Difference between Explicit and Implicit Cost:

• Explicit costs involve cash outflows in terms of interest, dividend and so on

whereas implicit costs do not involve any cash outflows.
• Explicit cost is also known as out-of-pocket cost while implicit costs are known
as imputed cost.
• Explicit cost can be easily ascertained, but it is just opposite in the case of
implicit cost as it does not have any paper trail.
• The measurement of explicit cost is objective in nature because it is actually
incurred whereas implicit cost occurs indirectly and that is why its
measurement is subjective.
• Explicit cost helps in the calculation of both accounting profit and economic
profit. Conversely, implicit cost helps in the calculation of only economic
profit.
• Explicit Cost is recorded and reported to the management. On the other hand
implicit cost is neither recorded nor reported to the management of the firm
 Specific Cost and Composite Cost

• Specific Cost of Capital

– The cost of each component of capital is known as specific cost of
capital.
– A firm raises capital from different sources: such as equity,
preference, debentures, and so on.
– The cost of equity, the cost of debt, cost of preference capital and
cost of retained earnings are examples of specific costs of capital.
• Composite cost: When the specific cost of each source of
finance is combined together using an appropriate average,
K0 = Ke × ωe +K
it is called combined orp ×composite
ωp +Kd × ωd +Kr ×cost.
ωr It can be computed
as:
• Also called overall cost and weighted average cost of capital.
 Average Cost and Marginal Cost

Average Cost of Capital

same as composite cost
Marginal Cost of Capital
– It refers to the change in overall cost of capital that
results from the raising of one more rupee of fund.
– It is also called the incremental or differential
cost of capital.
– It can be computed on the basis of the
difference between new cost of capital and existing
cost of capital after additional financing.
 Example
• PQ Ltd. that has equity share capital of
`10,00,000 and debt capital of `10,00,000.
• The required return on equity capital is 12%
and cost of debt is 10%.
• The market value of equity shares is
`15,00,000 and market value of debt is the
same as its book value.
• Find WACC
 Average Cost
• The weighted average cost of capital of PQ
Ltd. may be computed as follows:
Book Market Specific
Sources of capital Weights WACC
value (`) value (`) cost
Equity shares 10,00,000 15,00,000 0.6 0.12 0.072
Long term debt 10,00,000 10,00,000 0.4 0.10 0.040
Total 20,00,000 25,00,000 0.112
 Example contd..
• PQ requires additional funds of `13,50,000,
which are raised by issuing equity shares of
`700,000 at 50% premium and balance
through 10% debentures and cost of equity
rises by 1%, with prices of equity and cost of
debt remaining unchanged, then the revised
WACC and MCC are computed as shown
below:
 Marginal cost
Revised weighted Average cost of capital

Sources Book Market Specific

of Weights WACC
value (`) value (`) cost
capital
Equity
17,00,000 25,50,000 0.6623 0.13 0.086
shares
Long
13,00,000 13,00,000 0.3377 0.10 0.034
term debt
Total 30,00,000 38,50,000 Revised WACC 0.1199
Differential cost of equity + cost of additional debt
MCC 
Additional equity+ additional debt
ሺ25,50,000𝑥 0.13−15,00,000 𝑥 0.12ሻ+ 0.1 𝑥 3,00,000
MCC=
10,50,000+3,00,000
3,31,500  1,80, 000   30, 0001,81,500
   0.1344 ; t h a t is 13.44%.
10,50, 000  3, 00, 000 13,50, 000
 Historical and future cost
• Historical cost:
– It is the cost which has already been incurred for
financing a particular project.
– It is based on the actual cost incurred in the
previous project.
• Future cost:
– It is the expected cost of financing the proposed
project.
– Expected cost is calculated on the basis of previous
experience..
 Factors affecting cost of capital
Internal Factors
• Capital structure composition: The composition of capital structure, that
is, debt-equity mix affects the cost of capital of a firm.
• Dividend Policy: The firm may use retained earnings to retire costly debts,
hence changing its overall cost of capital and debt equity ratio. Although
retained earnings have an implicit cost, yet they are considered to be a
cheaper source of finance.
• Amount of Financing: The cost of funds also depends on the level of
financing that the firm requires. As the financing requirements of the firm
become larger, the weighted cost of capital increases because of floatation
charges and higher expected return( by the investor);
• Business Risk: The more the business risk, the higher will be the cost of
capital because the providers of funds raise their required rate of return by
charging risk premium to compensate for increase in risk.
 Factors affecting cost of capital
External factors
Economic Conditions: The economic conditions in the form of demand and
supply of capital as well as expectations with respect to inflation also affect the
cost of capital.
Tax considerations: Corporate tax also influences in determining the cost of
capital in a firm. A higher rate of corporate tax makes the debt funds cheaper
because of the tax shield enjoyed by interest.
Market conditions: Funds required for risky projects increases the cost of capital,
as lenders demand a higher rate to compensate for the risk they encompass. On
the other hand, if the market conditions are such that it is expected to get a high
and secured return, then the risk will be lower and obviously the cost of capital is
expected to be less.
Marketability of security: If the security is not readily marketable when the
investor wants to sell, or even if a continuous demand for the security exists but
the price varies significantly, an investor will require a relatively high rate of return
 MEASUREMENT OF COST OF CAPITAL

Two basic assumptions underlying the

measurement of cost of capital:
• Constant business risk
• Constant financial risk
Why?
In the absence of these assumptions, the varied risk
associated with different components of capital or projects
would make it difficult to find out the cost of capital as the
selection of particular source of funds or investment proposal
would change the overall cost of capital.
 SPECIFIC COST OF CAPITAL AND ITS
MEASUREMENT
• A company obtains its capital from three major
sources: debt, preference shares and equity
shares.
• The holders of these securities have different
claims on the assets and cash flows of the firm.
• Since the securities have risk differences,
investors will want different rates of return on
various securities, the cost of each components of
capital is different and is called its specific cost.
 Cost of Bonds and Debentures

• Debt is the external source of finance.

• Firms borrow debt through the issuance of
debenture and bonds.
• Thus, the cost of debt is the cost associated with
the interest payment and other cost of issuing the
debenture and bonds.
• It is also defined as the rate of return that must be
earned on the debt financed portion of investment
so as to leave the earnings available to equity
shareholders unchanged.
 Cost of Bonds and Debentures
• The amounts received by the firm issuing a debenture
after deducting all issuing expenses (except interest) is
called net proceed.
• Net proceed is computed on the basis of:
• Face value of the debenture
• Discount or premium on issue
• Issuing cost or flotation cost
• Net proceed (NP)
= Gross selling price - Flotation cost
= Face value + Premium (or - discount) - Flotation cost
 Cost of Irredeemable (or perpetual) debt:

• It is computed as the amount of interest on

debt security divided by the net proceeds on
issuance of such debt. Mathematically, it is
expressed as:
Int
Ki =
NP
Wh er e Int = In t er est on deben t u r e
NP= N et pr oceeds on Issu e of deben t u r e
K i = cost of per pet u a l debt (befor e t a x)
Adju st m en t for t a x sh ield n eed t o be m a de beca u se in t er e st is a t a x dedu ct ible
ch a r ge. Accor din gly,
Int(1 − t)
Kd = = K i (1 − t)
NP
Wh er e K d = a ft er t a x cost of debt
t = cor por a t e t a x r a t e
 EXAMPLE: 10.1.
• M/s Nector Ltd. issued 12% debentures of
`1,00,000.
• The company pays corporate tax @ 40%.
• Determine the cost of debt on before tax and
after tax basis, assuming the debentures are
perpetual and issued at
(i) Par
(ii) 10% discount
(iii) 10% premium
with floatation costs of 2% of proceeds.
 Solution

Calculation of Cost of debt

When issued at par:
𝐈𝐧𝐭 𝟏𝟐,𝟎𝟎𝟎
Before Tax cost (K ) = = =. 𝟏𝟐𝟐𝟒 = 𝟏𝟐. 𝟐𝟒%
i 𝐍𝐏 𝟗𝟖,𝟎𝟎𝟎

After Tax cost (K )= K (1- t) = .1224(1-0.4) = .0734 = 7.34%

d i

(ii) When issued at discount of 10%:

𝐈𝐧𝐭 𝟏𝟐,𝟎𝟎𝟎
Before Tax cost (K ) = = =. 𝟏𝟑𝟔𝟏 = 𝟏𝟑. 𝟔𝟏%
i 𝐍𝐏 𝟖𝟖,𝟐𝟎𝟎

After Tax cost (K )= K (1- t) = .1361(1-0.4) = .0817 = 8.17%

d i

(iii) When issued at premium of 10%:

𝐈𝐧𝐭 𝟏𝟐,𝟎𝟎𝟎
Before Tax cost (K ) = = =. 𝟏𝟏𝟏𝟑 = 𝟏𝟏. 𝟏𝟑%
i 𝐍𝐏 𝟏𝟎𝟕,𝟖𝟎𝟎

After Tax cost (K )= K (1- t) = .1113(1-0.4) = .0668 = 6.68%

d i
 Cost of redeemable debenture

• In most cases, the face value of debt is

refunded at the end of maturity period.
• However, when bonds and debentures are
repayable at premium or discount,
– the amount of interest is computed on the basis
of face value and
– the cost is computed on the basis of interest
payment and payment on redemption.
 Cost of redeemable debenture
Given t h a t t h e pr in cipa l a m ou n t is r epa id in lu m p -su m a t t h e t im e of
m a t u r it y, t h e com pu t a t ion of cost of de bt ca n be expr essed a s:
n
COIt COPn
CI0 = ෍ +
(1 + K d )t (1 + K d )n
t=1

Wh er e, COIt = Ca sh ou t flow on in t er est in per iod, t .

K d = Cost of debt
CI0 = Net ca sh in flow fr om issu e of deben t u r es
COPn = Repa ym en t of pr in cipa l in m a t u r it y per iod, n .

I f t h e r ep a ym en t of p r in cip a l is p a id r egu la r ly a lon g wit h in t er est , t h e a bove

exp r ession is m od ified a s:
n
COIt + COPt
CI0 = ෍
(1 + K d )t
t =1
 EXAMPLE: 10.2.
• Pasco Ltd. Issues 12% bonds
• of the face value `1000 each,
• redeemable after 6 years
• at a discount of 5% and
• the floatation cost is estimated to be 1% of
face value.
• Find out cost of bonds, given that the
company pays taxes @ 35%.
 Solution
On a n a lysis, we fin d t h a t
CI = F a ce va lu e (`1000) – discou n t (`50) - floa t a t ion cost (`10) = `940
0

th
COP = Repa ym en t of pr in cipa l in 6 yea r .
6

COI = Ca sh ou t flow on In t er est (a ft er t a x) for t (1-6 yea r s) =12% (`1000)(1-.35) = `78

t

By a pplyin g t h e followin g for m u la e

n
COIt COPn
CI0 = ෍ +
(1 + K d )t (1 + K d )n
t=1
We get
6
78 1000
940 = ෍ +
(1 + K d )t (1 + K d )6
t=1
 To determine the approximate value of
𝐊𝐝

Sh or t -cu t m et h od (Redeem a ble Deben t u r es) t o fin d a ppr oxim a t e cost of debt
wh en t h e deben t u r es a r e t o be r edeem ed a ft er a specific per iod of t im e.

Intሺ1 − tሻ + (RV − NP) ÷ N

Kd =
(RV + NP) ÷ 2
Wh er e RV = Redem pt ion Va lu e
NP = Net pr oceeds fr om t h e issu e
In t = In t er est on deben t u r e, a n d t = t a x r a t e
Applyin g t h e a bove, for m u la e, we get
120ሺ1 − .35ሻ + (1000 − 940) ÷ 6
Kd =
(1000 + 940) ÷ 2
120 ሺ.65 ሻ+10 78+10 88
= = = = = 0.0907 = 9.07%
970 970 970
 To determine the value of 𝐊𝐝

It implies that the va lue of K d lies between 9% - 10%.

Now these rates can be used as the basis to apply trial and error method. By
evaluating the RHS expression u sing 9%, we get
RHS =78(PVIFA )+1000(PVIF )
9%,6 9%,6

= 78(4.486)+1000(.596)=349.91+596=945.91
This value is higher than LHS=940, Now apply a high er rate of say 10%;
Using 10% ra te, we get,
RHS = 78(4.355)+1000(.565)=339.69+565 = 904.69
Applying the interpolation , we get
945.91 − 940 5.91
Kd = 9% + = = 𝟗. 𝟏𝟒%
945.91 − 904.69 41.22
 Observation
• The short-cut method of computing the cost
of debt provides a good approximation but
not a conclusive computation of this cost
component.
• Note: This short-cut method is not applicable
when the principal amount is repaid in many
installments
 EXAMPLE:10.4.
• 2,00,000 debentures of `250 each are being
• issued at 5% discount.
• Coupon rate is 15%.
• Floatation costs are likely to be 5% of the face value.
• Redemption will be after 8 years at a premium of 5%.
• Tax rate is 40%.
Determine the cost of debt using the short cut method
Delhi Univ., B.Com (Hons) 2007 (Sol)
 Solution
• Redemption value of debentures = Par value + 10%
Premium
= 250 + 5 % x 250 = 250 + 12.50 = `262.50
• Net proceeds from the issue
= Par value – discount – floatation cost
= 250 - 5% x 250 - 5% x 250 = `225
• Interest amount on debentures
= 250 x 15% = `37.50
Maturity period of debentures = 8 years
Corporate tax rate = 40%
 Solution contd..
As t h e r edem ption per iod a n d r edem pt ion va lu es a r e kn own , th e tr u e cost of debt
m a y be com pu ted u sin g th e followin g for m u la :
Intሺ1 − tሻ + (RV − NP) ÷ N
Kd =
(RV + NP) ÷ 2

Accor din gly,

37.50(1  0.4)  (262.50  225)  8 22.50  4.6875 27.1875
Kd  =   0.1115
(262.50  225)  2 243.75 243.75
E xpr essed a s per cen ta ge t h e cost of debt = 11.15%
Cost of irredeemable preference capital
The cost of irredeemable preference shares is computed with
reference to dividend paid and the amount received by the firm
on account of preference capital.
Mathema tica lly, its computation is expressed a s:
PD
Kp =
NP
Where PD = constant annual preference dividend
NP= Net proceeds on Issue of preference share capital
Kp = cost of preference share capital

The computation may be done for a single preference share or for

all the preference shares issued.
 EXAMPLE: 10.5.
A company issues 12% irredeemable
preference shares of `100 each. The floatation
cost for such issue is 5% of issue price.
Estimate the cost of preference capital, if they
are issued at
(i) par,
(ii) 10% discount
(iii) 10% premium.
 SOLUTION
Calculation of Cost of preference capital
(i) When issued at par:
PD 12 12
K = = = = .1263 = 𝟏𝟐. 𝟔𝟑%
p NP 100(1−.05) 95

(ii) When issued at discount of 10%:

PD 12 12
K = = = = .1404 = 𝟏𝟒. 𝟎𝟒%
p NP 90(1−.05) 85.5

(iii) When issued at premium of 10%:

PD 12 12
K = = = = .1148 = 𝟏𝟏. 𝟒𝟖%
p NP 110(1−.05) 104.5
 Cost of Redeemable Preference capital

• Redeemable preference shares are those that are repaid after

a specific period of time.
• Hence, the cost of redeemable preference shares is calculated
after giving due consideration to the maturity period of the
preference shares and their redeemable value.
• Redeemable preference shares may also be issued at par,
discount or at a premium.
• Moreover, there may be floatation costs that are adjusted in
the net proceeds.
• The redeemable value may differ from its face value depending
on whether the preference shares are redeemed at par,
discount or at premium.
Cost of Redeemable Preference capital

Therefore, when the preference shares are

redeemable at some future date, their cost is
computed by taking into consideration the
amount payable at maturity besides expected
regular payment of dividend.
 Cost of Redeemable Preference capital

Ma t h em a t ica lly, it is expr essed a s:

n
PDt Pn
P0 = ෍ +
(1 + K p )t (1 + K p )n
t=1
Where, PDt = annual Cash outflow on dividend in period, t.
K p =Cost of preference capital
P0 = Net Cash inflow from issue of preference capital
Pn = Repayment of Principal in maturity period, n.
n = Redemption period of preference capital.
The above expression may be solved for K p by applying shortcut as well as trial and error
method.
 Short cut method

The short cut method, approximating the cost of preference capital is:
PD + (RV − NP) ÷ n
Kp =
(RV + NP) ÷ 2
Where RV = Redemption Value
NP = Net proceeds from the issue
PD = annual preference dividend
 EXAMPLE: 10.6.
• Bose Systems Ltd. has planned to issue 30,000
• 14% preference shares of `100 each
• that are redeemable after 10 years.
• Floatation costs are expected to be 2% of sale
proceeds of the issue.
• Calculate the cost of preference capital, using
the
– (a) short-cut method and
– (b) trial and error method.
 Solution

Using per share calcu lation and applying the short -cut formula as given below:
PD + (RV − NP) ÷ n
Kp =
(RV + NP) ÷ 2
We get
14  100  98   10 14.2
Kp    0.1434 = 14.34%
100  98  2 99
 Solution contd
N ow in or der t o a pply t r ia l a n d er r or m et h od, we ca n fin d t h e pr esen t va lu e of
r egu la r ca sh ou t flows a n d t er m in a l ou t flows t o com pa r e wit h t h e n et pr oceeds for
14% a n d 15%.
Applyin g t h e discou n t r a t e of 14% a n d 15% on t h e followin g m odel:
n
PDt Pn
P0 = ෍ +
(1 + K p )t (1 + K p )n
t=1
We get
At 14% P0  14  PVIFA14%,10   100  PVIF14%,10 
=14(5.216) + 100(.27) =73.024 + 27 =100.024
At 15% P0  14  PVIFA15%,10   100  PVIF15%,10 
=14(5.019) + 100(.247) = 70.266 + 24.7 = 94.966
U sin g In t er pola t ion
100 .024 −98
K p = 14% + 100 .024 −94.966
2.024
= 14% + % = 14.4%
5.058
It m a y be n ot ed t h a t t h e sh or t -cu t m et h od h a s given a good a ppr oxim a t ion of
t h e ou t com e obt a in ed u sin g t h e t r ia l a n d er r or m et h od.
 Cost of Equity Share Capital

• Equity shareholders receive the residual income.

• However, the equity shareholders expect a dividend
and/or capital gains against their investment and such
expectations give rise to an opportunity cost of capital.
• As the equity shareholders take the highest degree of
financial risk, they expect a higher return and thus, highest
costs are related to them.
• The equity holders' required rate of return is a cost from
the firm's perspective because if the firm does not deliver
this expected return, shareholders will simply sell their
shares, causing decrease in share prices.
 Cost of Equity
• Cost of equity refers to a shareholder's
required rate of return on an equity investment
• It is defined as the minimum rate of return that
a firm must earn on the equity financed portion
of an investment project so as to leave
unchanged the market price of the shares.
• The cost of equity is basically what it costs the
firm to maintain a share price that is
theoretically satisfactory to investors.
 Cost of Equity Share Capital

• On this basis, the present value of expected

future stream of dividend on shares plus sale
proceeds realized on sale of such share should
be the current market price of the share.

Ma t h em a t ica lly,
D1 D2 Dn Pn
P0 = + + ………….+ +
(1+K e )1 (1+K e )2 (1+K e )n (1+K e )n
Wh er e
P0 = Current market price of share
Pn = Market price of share while liquidating the shares
Dt = Dividend in different years: t = 1, 2,……n
K e = Cost of Equity Capital
 Approaches for computation of cost of
equity capital
• Dividend–Price Approach
• Dividend–growth Approach: both uniform and
varying growth rates
• Earnings-Price Approach
• Capital Asset Pricing Model (CAPM)
• Realized Yield Approach
 Dividend–Price Approach
• The cost of equity share may be calculated on
the basis of dividend and current market price
of shares.
• Accordingly, cost of equity (Ke) is defined as
the rate that equates the present value of all
expected future dividends per share with the
net proceeds of the sale (or the current
market price) of a share.
 Cost of Equity Share Capital

Therefore, when the dividend per share or total equity dividend is given and
there is no information regarding the growth rate, the cost of equity is measured by:
𝐷1
𝐾𝑒 =
𝑃0
Where 𝐾𝑒 = Cost of equity capital
𝐷1 =Expected dividend per share
𝑃0 =Net proceeds from new issue of equity after adjusting for any discount,
premium and floatation cost or current market price per share, net of
any brokerage in case of existing equity.
 EXAMPLE: 10.7
• . M/s Mukund Purifier Ltd. has issued equity
shares of `10 each at a premium of 10%, after
incurring a floatation cost of 4% of issue price.
In keeping with the dividend paid by similar
companies, shareholders expect a dividend of
15% per share. Determine the cost of equity
capital.
 Solution

Applyin g t h e followin g form u la e:

D
Ke  1
P0
Wh er e 𝐷1 = `1.5 a n d 𝑃0 = `10(1+.1)(1-.04) = `10.56, we get
1.5
Ke   0.1420 = 14.2%
10.56
Dividend-Price plus Growth Approach
• It is reasonable to expect that the dividend tends
to grow over a period of time in accordance with
growth in earnings of the company
• Dividend-price plus growth method takes into
account the growth prospect of dividend to
calculate the cost of equity.
• Under this approach, cost of equity capital is
determined on the basis of the expected
dividend plus the rate of growth in dividend.
Dividend-Price plus Growth Approach
The cost of equity is determined on the basis of the following
information:
i. Current dividend (Do)
ii. Growth rate in dividend (g)
iii. Expected Dividend (D1):
Expected dividend = Current dividend (1+ growth rate) or,
D1 = Do (1+g)
In year n , Dn = Do (1+g)ⁿ
iv. Net proceeds Or Net Market Price (NP):
Net proceed (NP) = Gross selling price - Flotation cost
= Gross selling price (1-Flotation cost) = Po(1-f)
Dividend-Price plus Growth Approach
The growth in dividend could be constant or may vary in
successive years. Accordingly, we can have two formulations:
– When the dividend grows at a constant rate
– When the dividend grows at variable rates.
• When the dividend grows at constant rate perpetually: In
case the rate of growth in dividend is expected to be constant,
the following formulation is used to compute the cost of
equity. 𝑫 𝟏
𝑲𝒆 = +g
𝑷𝟎
Wh e re 𝑲𝒆= Co s t o f e qu ity c ap ita l
𝑫𝟏 =Ex p e c te d d iv id e n d p e r s h a re in c u rre n t y e a r
g = Ex p e c te d g ro w th in th e d iv id e n d ra te
𝑷𝟎 =N e t c u rre n t m a rk e t p ric e (o r N e t p ro c e e d s o f
fre s h is s u e ) p e r sh are
 EXAMPLE:10.8.
The `100 equity share of M/s Ronak Industries
Ltd. is currently priced at `95.
The expected dividend for the current year is `8
which is expected to grow perpetually at 6%
year after year.
Calculate the cost of equity capital.
Also calculate the expected price of the share
for the first three years assuming constant
growth rate in dividend.
 Solution
We k n ow t h a t
𝐷1
𝐾𝑒 = +g
𝑃0
Th er efor e,
8
𝐾𝑒 = + 0.06 = 0.0842 + 0.06 = 0.1442 = 14.42%
95
P r ice a t t h e en d of fir st t h r ee yea r s ca n be com p u t ed , u sin g va lu a t ion m od el a s
u n d er :
𝐷1 𝐷0 (1+𝑔)
𝑃0 = =
𝐾𝑒 −𝑔 𝐾𝑒 −𝑔
Sim ila r ly
Price at the end of Firs t year
𝐷2 𝐷1 (1+𝑔 ) 8(1.06) 8.48
𝑃1 = = = = = `100.71
𝐾e −𝑔 𝐾𝑒 −𝑔 .1442 −.06 .0842
Price at the end of Second year
𝐷3 𝐷2 (1+𝑔) 8.48(1.06) 8.9888
𝑃2 = = = = = `106.76
𝐾𝑒 −𝑔 𝐾𝑒 −𝑔 .1442 −.06 .084 2
Price at the end of Third year
𝐷4 𝐷3 (1+𝑔) 8.9888 (1.06) 9.5281
𝑃3 = = = = `113.16
𝐾𝑒 −𝑔 𝐾𝑒 −𝑔 .1442 −.06 .0842
Th e a bove va lu a t ion m od el a s su m es t h a t :
𝐷0 > 0 cu r r en t d ivid en d is p osit ive
𝐾𝑒 > 𝑔 cost of ca p it a l exceed s t h e gr owt h in d ivid en d .
Divid en d p a you t r a t io is con st a n t .
 Dividend-Price plus Growth Approach
Wh e n th e d iv id e n d g ro w s a t v a ry in g ra te s : In c a s e th e ra te
o f g ro w th in d iv id e n d is e x p e c te d to c h a n g e o v e r tim e , th e
fo llo w in g fo rm u la tio n is u s e d to c o m p u te th e c o s t o f e qu ity .
𝟓 𝟏𝟎 ∞
𝒕 𝒕−𝟓
𝑫𝟎 (𝟏 + 𝒈𝟏 ) 𝑫𝟓 (𝟏 + 𝒈𝟐 ) 𝑫𝟏𝟎 (𝟏 + 𝒈𝟑 )𝒕−𝟏𝟎
𝑷𝟎 = ෍ +෍ +෍
(𝟏 + 𝑲𝒆 )𝒕 (𝟏 + 𝑲𝒆 )𝒕 (𝟏 + 𝑲𝒆 )𝒕
𝒕=𝟏 𝒕=𝟔 𝒕=𝟏𝟏

Wh e re 𝑲𝒆= Co s t o f e qu ity c a p ita l

𝒈𝟏 =Ex p e c te d g ro w th in d iv id e n d fo r 1 -5 y e a rs
𝒈𝟐 =Ex p e c te d g ro w th in d iv id e n d fo r 6 -10 y e a rs
𝒈𝟑 =Ex p e c te d g ro w th in d iv id e n d fo r 11 th y e a r
o n w a rd s
 EXAMPLE: 10.9.
RJ Ltd. is planning to declare a dividend of `25
next year.
It is expected that the company shall grow at
8% and
its shares are being transacted on an average
at `140 per share in the market.
Calculate the cost of equity capital and also
the price of share at the end of third year.
 Solution
The cost of equity capital as per growth formulation is as under:
𝑫𝟏
𝑲𝒆 = +g
𝑷𝟎
𝟐𝟓
= + 𝟖% = 𝟎. 𝟏𝟕𝟖𝟔 + 𝟎. 𝟎𝟖 =0.2586 = 25.85%
𝟏𝟒𝟎
The price at the end of third year can be computed by applying
the following formulation:
𝑫𝟒 𝑫𝟏 (𝟏+𝒈)𝟑
𝑷𝟑 = =
𝑲𝒆 −𝒈 𝑲𝒆 −𝒈
𝟐𝟓(𝟏+.𝟎𝟖)𝟑 𝟐𝟓(𝟏.𝟐𝟓𝟗𝟕) 𝟑𝟏.𝟒𝟗𝟐𝟓
= = = = `176.33
.𝟐𝟓𝟖𝟔−.𝟎𝟖 .𝟏𝟕𝟖𝟔 .𝟏𝟕𝟖𝟔

The price at the end of third year is expected to be `176.33

 Earnings Price approach
• This approach recognizes both dividends and retained earnings.

• This approach is based on the percept that the price of shares

depends on the earnings (a performance indicator) of the firm rather
than its appropriation in the form of dividends.

• The cost of equity is defined as that rate of return to the firm that
must be earned on its equity financed portion of investment so as to
leave unchanged the market price of the stock.

• Accordingly, the rate of return (or discount rate) that equates the
present value of future stream of earnings and (not just dividend)
with the price of shares is the cost of equity capital.
 Earnings Price approach
• When the earning per share or net income
after tax is known and there is no information
regarding the dividend on equity share, the
formulation to compute the cost of equity is:
𝑬𝟎 𝟏
𝑲𝒆 = =
𝑷𝟎 𝑷
𝑬
(P /E ra tio is a p e rfo rm a n c e in d ic a to r in th e m a rk e t)

Wh e re 𝑲𝒆 = Co s t o f e qu ity c a p ita l
𝑬𝟎 = Cu rre n t e a rn in g s p e r s h a re th a t is to c o n tin u e
p e rp e tu a lly .
𝑷𝟎 = Cu rre n t m a rk e t p ric e p e r s h a re , n e t o f a n y bro k e ra g e
(o r n e t p ro c e e d s in c a s e o f n e w e qu ity )
 EXAMPLE: 10.11.
• The current market price of a share is `100.
• The firm’s current earnings are `21 crores and
its share outstanding are `2 crores.
• It is contemplating to raise additional funds of
`6 crores by issuing equity at a premium of
10%.
• The floatation cost is `5 per share.
• Compute the cost of equity capital.
 Solution
𝑬𝟎
Using the above mentioned formulation, the cost of equity is 𝑲𝒆 =
𝑷𝟎
E = Earnings ÷ Existing shares
0

= `21 crores ÷ 2 crores = `10.50 = EPS

P = Face Value + Premium – floatation cost
0

= 100 +10 - 5 = ` 105 per share.

𝟏𝟎. 𝟓𝟎
𝑲𝒆 = = 𝟎. 𝟏 = 𝟏𝟎%
𝟏𝟎𝟓
 Realized Yield Approach
• The drawback of the dividend yield method or earning yield
method is that both the methods are based on estimation
of future dividend or earning.
• There are a number of uncontrollable and uncertain factors
that may affect such estimations.
• A realized yield is the actual amount of return earned on a
security investment over a period of time.
• In this approach, the cost of capital is calculated after
analyzing the past payments of dividends.
• The dividend per share is the real value and not the
expected value.
 Realized Yield Approach
• The cost of equity is given as follows:
Actual earnings per Share
Ke  100
Market price per share

• According to this approach, the realized yield is

discounted by using the present value factor and then
compared with the present value of the investment.
• This approach is based on the assumption that the
performance of an enterprise is consistent and
therefore, it is a good indicator of future.
 Capital-Asset Pricing Model (CAPM)
Approach
• According to this approach, the return on security
is determined by the degree of risk to which this
security is exposed.
• A security is exposed to two types of risk:
unsystematic and systematic
• As it is possible to eliminate unsystematic risk
through diversification, it is the systematic risk that
is considered relevant for the computation of cost
of equity. It is measured in terms of beta
coefficient
 Capital-Asset Pricing Model (CAPM)
Approach

Th e c o s t o f e qu ity , u s in g CAP M is c o m p u te d as :
𝑲𝒆 = 𝑲𝒇 + 𝜷(𝑲𝒎 − 𝑲𝒇 )
Wh e re
𝑲𝒆 = c os t o f e qu ity
𝑲𝒇 = 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐫𝐞𝐭𝐮𝐧 𝐨𝐧 𝐫𝐢𝐬𝐤 𝐟𝐫𝐞𝐞 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲
𝐊 𝐦 = Ex p e c te d re tu rn fro m th e m ark e t
𝛃 = 𝐂𝐨𝐞𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐭 𝐨𝐟 𝐬𝐲𝐬𝐭𝐞𝐦𝐚𝐭𝐢𝐜 𝐫𝐢𝐬𝐤
 Cost of Retained Earnings

• Retained earnings are internal source of long-term

financing.
• Generally, considered as cost free source as neither
dividend nor interest is payable. However, this is not
true.
• There is an opportunity cost of retained earnings. The
cost of retained earning must be at least equal to
shareholders rate of return on re-investment of
dividend paid by the company.
• The cost of retained earnings or internal funds within
a capital structure is similar to the cost of equity
capital since it is a component of equity.
 Cost of Retained Earnings
• In the absence of any information, the cost of
retained earnings is considered to be equal to
the cost of equity.
• However, there is no floatation cost to be
paid and there exists a personal tax rate of
shareholders.
 Cost of Retained Earnings
(i) Cost of r et a in ed ea r n in gs a ssu m in g n o flot a t ion cost a n d n o per son a l t a x
D1
Kr = Ke = +g
P0
Wh er e K e = cost of equ it y
K r = cost of retained earnings
D 1 = expect ed dividen d per sh a r e
P 0 = cu r r en t sellin g pr ice or n et pr oceed

(ii) Cost of r et a in ed ea r n in gs a ssu m in g flot a t ion cost a n d per son a l t a x

K r = K e (1 − T)(1 − B)
Wh er e
T = t a x r a t e a pplica ble t o sh a r eh older s
B = Brokerage costs
Weighted Average Cost Of Capital
WACC= 𝐊 𝟎 = 𝐊 𝐞 𝛚𝐞 + 𝐊 𝐝 𝛚𝐝 + 𝐊 𝐩 𝛚𝐩 + 𝐊 𝐫 𝛚𝐫
Wherein
𝐊 𝟎 refers to the overall cost of capital,
(𝐊 𝐞 , 𝐊 𝐝 , 𝐊 𝐩 , 𝐊 𝐫 ) are specific costs and
(𝛚𝐞 , 𝛚𝐝 , 𝛚𝐩 , 𝛚𝐫 ) are their respective weights.
 Weighted Average Cost Of Capital
Assigning weights: Three types
• Historical Weights
– Book Value ( proportion of different sources in the existing
capital structure at values given in financial statements)
– Market value ( proportion of different sources in the existing
capital structure at their current market price)
• Marginal Weights (correspond to the proportion of
sources of finance a firm intends to employ for a new
project)
• Target Weights (correspond to the proportion of
sources of finance a firm aspires to achieve)
 Example 10.26

The capital structure of XYZ Ltd. is as under:

Book Value Structure Rupees
9% Debentures 2,75,000
11% Preference Shares 2,25,000
Equity shares (face value `10 per share) 5,00,000
Additional Information: (i). `100 per debenture redeemable at par; has 2% floatation cost
and 10 year of maturity. The market price per debenture is `105. (ii) `100 per preference share
redeemable at par, has 3% floatation cost and 10 years of maturity. The market price per
preference share is `106. (iii) Equity share has `4 floatation cost and market price per share of `24.
the expected dividend is `2 per share with annual growth of 5%. (iv) Corporate income tax rate is
35%. Calculate weighted average cost of capital (WACC) using market value weights.
Delhi Univ., B.Com (Hons), 2012
 (i) Cost of Debt with maturity period given
Intሺ1 − tሻ + (RV − NP) ÷ N
Kd =
(RV + NP) ÷ 2
Given that
RV = Redemption value of Debenture at par = `100
NP = Net proceeds from the issue =105 x (1- 0.02) = `102.90
I = Interest on debentures = 100 x 9% = `9
N = Maturity period of bond (in years) = `10
t = Corporate tax rate =35%
9(1  0.35)  (100  102.9)  10 5.85  0.29 5.56
Kd    =0.0548 = 5.48%
(100  102.9)  2 101.45 101.45
 Solution contd

(ii) Cost of Preference Capital (Using Market Price)

Given that
RV = Redemption value of preference share at par = `100
NP = Net proceeds from the issue =106 x (1- 0.03) = `102.82
PD= Annual preference dividend = 100 x 11% = `11
n = Maturity period (in years) = 10
11  (100  102.82)  10 11  0.282 10.718
Kp    =0.1057 = 10.57%
(100  102.82)  2 101.41 101.41
 Solution contd

(i) Cost of Equity:

Ke = 𝑫𝟏 /𝑷𝒐 + g = 2/20 +0.05 =15%

Weighted Average Cost of Capital (WACC): Market Value basis

Specific Weighted
Capital Structure Amount (`) Weights
Cost Costs
9% Debentures 2,88,750 0.167 0.0548 0.9152
11% Preference Capital 2,38,500 0.138 0.1057 0.0146
Equity Capital 12,00,000 0.695 0.1500 0.1042
Total Capital 17,27,250 1.0 0.1280
WACC (expressed as percentage) 12.80%
 Example 10.22
. Following is the capital structure of ABC Ltd.
Book Value Structure Rupees
Equity shares (F.V: `10 each) 5,00,000
12% Preference Shares (Fv.`100 each) 4,00,000
8% Debentures (Face Value `100 ) 6,00,000
Equity shares are currently selling at `15 each. The Company paid a dividend of `2 per
share for the last year. The dividends are expected to increase at 5% p.a. The preference
shares and debentures are being traded at 90% and 80%. Tax Rate applicable to company
is 40%. Find out the weighted average cost of capital of the firm using (i) book value
weights and (ii) Market value weights. State under what situation the WACC calculated on
BV and MV bases would be the same.
Delhi Univ., B.Com (Hons), 2008 (R)
 Solution
The specific cost of debt, preference and equity capital need to be computed
as:
(i) Cost of Debt (Using value of Debt):
Int. rate (1- t)  par value
Kd = ; as Int. rate 8%; t = 40%, par value = `100
Price of debenture
Price of debenture = `80, we get
0.08(1- 0.4)  100 0.048  100
Kd =   0.06 =6.0%
80 80
(ii) Cost of Preference Capital (Using Market Price)
PD rate  par value
Kp = ; as PD rate 12%; par value = `100 and
Market Price
Market price =`90, we get
0.12  100 12 2
Kp =    0.1333 = 13.33%
90 90 15
(iii) Cost of Equity: We know that
D1 D 1  g ) 
Ke = +g = 0 + g ; as D0 = `2, P1 = `15 and g = 5%, we get
P0 P0
2(1  0.05) 2.1
Ke = + 0.05 = +0.05= 0.14 + 0.05 = 0.19 = 19.0%
15 15
 Solution contd.

Calculating the WACC: Book Value basis

Amount Specific Weighted
Capital Structure Weights
(`) Cost Costs
Equity Capital 5,00,000 0.3333 0.1900 0.0633
12% Preference Capital 4,00,000 0.2667 0.1333 0.0356
8% Debentures 6,00,000 0.4000 0.0600 0.024
Total Capital 15,00,000 1.0000 0.1229
WACC (expressed as percentage) 12.29%
Calculating WACC: Market Value basis
Specific Weighted
Capital Structure Amount Weights
Cost Costs
Equity Capital 7,50,000 0.4717 0.1900 0.0896
12% Preference Capital 3,60,000 0.2264 0.1333 0.0302
8% Debentures 4,80,000 0.3019 0.0600 0.0181
Total Capital 15,90,000 1.0000 0.1379
WACC (expressed as percentage) 13.79%
 Example 10.27
A limited company has the following capital structure:
Book Value Structure Rupees
Equity Share Capital:( 200,000 shares) 40,00,000
6% Preference Share Capital 10,00,000
8% Debentures 30,00,000
The market price of company's equity share is `20. It is expected that the company will pay
current dividend of `2 per share and will grow at 7% forever. The tax may be presumed at 50%.
You are required to compute the following: (i) A weighted average cost of capital, (ii) The new
weighted average cost of capital if the company raises an additional `20,00,000 debt by issuing
10% debentures. This would result in increasing the expected dividend to `3 and leave the growth
rate unchanged but the price of share will fall to `15 per share.
Delhi Univ., B.Com (Hons), 2013
 Solution
(i) Cost of Debt (Using value of Debt):
Kd = Interest rate (1 - t) x 100 =0.08 x(1-0.5) = 0.04 = 4%
(ii) Cost of Preference Capital (Using Market Price)
Kp = (that is the rate of preference dividend) = 6%
(iii) Cost of Equity
Ke = D1 +g  2
 0.07  0.10  0.07  0.17 = 17%
P0 20
 Solution

Calculating the WACC: Book Value basis

Weighted
Capital Structure Amount (`) Ratio Specific Cost
Costs
Equity Capital 40,00,000 0.50 0.1700 0.0850
Preference Capital 10,00,000 0.13 0.0600 0.0075
Debentures 30,00,000 0.38 0.0400 0.0150
Total Capital 80,00,000 1.00 0.1075
WACC (expressed as percentage) 10.75%
 Solution
Cost of Capital after additional Borrowings
(i) Cost of Debt (Using value of Debt)
For 10% Debt: Kd = Interest Rate (1 - t) = 0.10(1-0.5) = 0.05= 5%
(ii) Cost of Preference Capital (Using book value)
Kp = (that is the rate of preference dividend) = 6%
(i) Cost of Equity:
D1 3
Ke = +g   0.07  0.20  0.07  0.27 = 27%
P0 15

Calculating the WACC: Book Value basis

Specific Weighted
Capital Structure Amount (`) Weights
Cost Costs
Equity Capital 40,00,000 0.4 0.2700 0.1080
6% Preference Capital 10,00,000 0.1 0.0600 0.0060
8% Debentures 30,00,000 0.3 0.0400 0.0120
10% Debentures 20,00,000 0.2 0.0500 0.0100
Total Capital 1,00,00,000 1.0 0.1360
WACC (expressed as percentage) 13.60%
 EXAMPLE: 10.17
• A company's share is quoted in the market at `40 currently.
• The company pays a dividend of `2 per share and investors
expect a growth rate of 10% per year.
• Compute
(i) The Company’s cost of equity capital.
(ii) If anticipated growth rate is 11% p.a., calculate the market
price per share using cost of equity capital calculated above.
(iii) If the company's cost of equity capital is 16% and
anticipated growth rate is 10% p.a., calculate market price,
if the expected dividend after two years is `2.42 per share.
Delhi Univ., B.Com (Hons), 2005(Sol), modified
 Solution
We know that
D1 D0 1  g )  D1
Ke =
P0
+g =
P0
+g , and also P0 
Ke  g
Where
D1 = Expected dividend per share at the end of 1st year;
D0 = current dividend per share as at present;
g = rate of growth in dividend per share;
P0 = current market price of the share.
Ke = cost of equity capital
 Solution contd..

( i). Calculating the Cost of Equity:

Given that D1 =10%, g= 105 and P0 =` 40, we get
2 1  0.1
 0.1  0.055  0.1  0.155 = 15.5%
2.2
K =
e + 0.1 =
40 40

ii) Calculating Market Price, when cost of equity and

(
growth rate are known:
Given that Ke =15.5% and D1 =2 and g=11%, we get
0.155 =
2(1  0.11)
P0
+ 0.11 = 0.045 
2.22
P0
 P0 
2.22
0.045
= `49.33
 Solution contd..

iii. Calculating Market Price, when cost of equity, growth rate and DPS are
known:
Given that Ke =16%, D2 =2.42 and g =10%, we compute
D1= (1D g )  (12.42
2

 0.1)
 2.2 and therefore, P0 =
D1
Ke - g
= 2.2

2.2
 0.16  0.1 0.06
= `36.67
 Breaks in specific cost of capital:

 Th e specific cost of ca pit a l in crea ses a s m ore a n d m ore fu n ds a re ra ised

from a pa rt icu la r sou rce.
 Th e cost st ru ct u re of a pa rt icu la r sou rce of fu n din g m a y be st ra t ified in
su ch a m a n n er so a s t o ca u se a n in crea se in it s cost a s t h e level of fu n din g
in crea ses. F or exa m ple
Equity Debt
Amounts (`) Cost Amounts (`) Cost
Up to 9 lakhs 12% Up to 4 lakhs 8%
up to 15 Lakhs 15% up to 10 Lakhs 10%
up to 21 Lakhs 18% up to 14 Lakhs 12%

 Th e overa ll level of fu n din g, beyon d wh ich t h e specific cost of ca pit a l

regist ers a n in crea se, is kn own a s t h e break point.
 Th e m a rgin a l cost of ca pit a l, a s a resu lt , increa ses in su ch a sit u a t ion , even
wh en t h e proport ion of ca pit a l st ru ct u re com pon en t s rem a in s u n ch a n ged.
Ma xim u m overa ll level of fu n din g or Brea k P oin t is com pu t ed a s:
Maximum funding from a specific source at a certain cost
proportion of source of finance
=
 Example 10.16
. GLS Lt d. h a s t h e ca pit a l st r u ct u r e t h a t con sist s of 40% debt a n d 60% equ it y. Th e
followin g a r e det a ils of cost of debt a n d equ it y a t va r iou s levels of fin a n ce fr om ea ch sou r ce.
Equity Debt
Amounts (`) Cost Amounts (`) Cost
Up to 9 lakhs 12% Up to 4 lakhs 8%
up to 15 Lakhs 15% up to 10 Lakhs 10%
up to 21 Lakhs 18% up to 14 Lakhs 12%
Assu m in g cor por a t e t a x r a t e of 40%, fin d ou t WACC for differ en t levels of fu n din g: (a )
`10 La kh s, (b) `15 La kh s, (c) 20 la kh s (d) 25 la kh s (e) `35 La kh s, a n d fin d br ea k poin t s.
 Solution

Ba sed u pon above com pila tion s, we can deter m in e specific cost at differ en t
level of fu n din g.
Overall Source of
funding Funds (`lakhs) Specific Cost
(`lakhs) Debt Equity Debt Equity
10 4 6 4.80% 12%
15 6 9 6.00% 12%
20 8 12 6.00% 15%
25 10 15 6.00% 15%
30 12 18 7.20% 18%
35 14 21 7.20% 18%
 Computation of WACC at different level of funding
Funding Level WACC
(in Lakhs) %
10 0.4(4.8%) + 0.6(12%) = 0.0192+.072 = 0.0912 = 9.12%
15 0.4(6.0%) + 0.6(12%) = 0.024 +.072 = 0.096 = 9.60%
20 0.4(6.0%) + 0.6(15%) = 0.024 +0.09 = 0 .114 = 11.40%
25 0.4(6.0%) + 0.6(15%) = 0.024 +0.09 = 0 .114 = 11.40%
30 0.4(7.2%) + 0.6(18%) = 0.0288+0.108 = 0.1368 = 13.68%
35 0.4(7.2%) + 0.6(18%) = 0.0288+0.108 = 0.1368 = 13.68%
0-10, 10-15, 15-25 a n d 25-35 a r e t h e br ea k poin t r a n ges a s t h e va lu es of
WACC a r e differ en t for t h e u pper va lu es of t h ese r a n ges fu n din g r a n ges.
 Solution
Break Points in debt financing:
Maximum Overall funding at 8% cost of debt (after tax K = 4.8%)
d
4Lakhs
= = `10 Lakhs
40%
Maximum Overall funding at 10 % cost of debt (after tax K = 6%)
d
10 Lakhs
= = `25 Lakhs
40%
Maximum Overall funding at 12% cost of debt (after tax K = 7.2%)
d
14 Lakhs
= = `35 Lakhs
40%
Therefore, `10 Lakhs, `25 Lakhs, `35 Lakhs are respective break points at
4.8%, 6% and 7.2% after tax cost of debt.
 Solution
Break Points in equity financing:
Maximum Overall funding at 12% cost of equity
9 Lakhs
= = `15 Lakhs
60%
Maximum Overall funding at 15% cost of equity
15 Lakhs
= = `25 Lakhs
60%
Maximum Overall funding at 18% cost of equity
21 Lakhs
= = `35 Lakhs
60%