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27 Final Selections in RBI Grade B 2017

Final Results Awaited for RBI Grade B 2018

Summary Sheet – Helpful for Retention


For

Cost of Capital

Important Points

1. This Summary Sheet shall only be used for Quick Revision after you have
read the Complete Notes

2. For Building Concepts along with examples/concept checks you should


rely only on Complete Notes

3. It would be useful to go through this Summary sheet just before the


exam or before any Mock Test

4. Questions in the exam are concept based and reading only summary
sheets shall not be sufficient to answer all the questions

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1 Summary Points

➢ Cost of Capital: It is the cost of a company's funds (both debt and equity), or, from an
investor's point of view "the required rate of return on a company's existing securities or
investments". It is the minimum return that investors expect for providing capital to the
company, thus setting a benchmark that a new project has to meet
➢ Importance of Cost of Capital:
✓ For making capital budgeting decisions (selection of investment proposals)
✓ For making Firm’s capital structure decisions (proportion of debt and equity)
✓ For evaluation of Firm’s performance (Profitability occurs when cost of capital is low)
✓ For making important financial decisions (dividend policy, selection between debt
and equity for financing projects, etc.)
➢ Opportunity Cost: It is the rate of return available on the next best alternative which you
have not chosen. That is, it is the rate of return that could have been earned by putting the
same money into a different investment with equal risk
➢ Rate of return demanded by each investor varies depending on the amount of risk born
➢ Risk Premium: It is the return in excess of the risk-free rate of return (return earned on
investments that are immune to default)an investment is expected to yield
➢ Cost of capital for a firm would be weighted average rate of returns required by all the
investors
➢ Different Components which provide capital to the company:

Components of Capital

Debt Preference Shares Equity

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➢ Weighted average cost of capital:

𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑎𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙


= (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 × 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝐷𝑒𝑏𝑡 )
+ (𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 × 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑜𝑛 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦)
+ (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
× 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙)

➢ Cost Of Debt:

Debt Components/Types

Irredeemable Debt Redeemable Debt

Cost of Debt issued at Premium or


Cost of Debt issued at Par
Discount

After Tax or before Tax

➢ Cost of Debt Issued at Par – Before Tax: Debt issued at par means Face value = Issue price

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Short cut for Cost of Debt Issued at Par before tax
Cost of Debt = Kd = I/Bo
Where Kd is cost of debt
I is the interest
Bo is the price of the bond

➢ Note: When debt is issued at par then required rate of return is equal to rate at which
debt is issued

Example: A company decided to issue a bond of face value 100 at 100 itself. The coupon rate is
15% and duration is 7 years. Find the required rate of return or cost of capital before tax
Solution: Using the short cut,

Kd = I/Bo

I = 15% of 100 = 15

Bo = 100 (since bond is issued at par)

So Kd = 15/100 = 15%

➢ Cost of Debt Issued at Discount or Premium – Before Tax (Redeemable Debt)

Short Cut for Cost of Debt


Cost of Debt = Coupon Interest Payment + (Maturity Value – Net Proceeds) / n
-----------------------------------------------------------------------------
(Maturity Value + Net Proceeds) / 2

Where Coupon Payment is Interest Payment on Bond


Maturity Value is the value obtained on Maturity
Net Proceeds is issue price minus any expenses in issuing
N = number of time periods

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➢ Example: A company decided to issue a bond of face value 100 at 94 itself. The coupon rate
is 15% and duration is 7 years. Find the required rate of return or cost of capital before tax
assuming cost of issuing at 2% of face value

Solution: Using Shortcut Formula,

Coupon Interest Payment = 15% of 100 = 15


Maturity Value = 100
Net Proceeds = Market Price - Cost of issuing = 94 – 2% of 100 = 92
N=7

Cost of Capital Kd = [15 + (100-92) / 7] / [(100+92)/2]


= [15 + 8/7] / 96
= 16.81

➢ Cost of Irredeemable Debt – Before Tax (Perpetual Debt)

Formula for Cost of Debt issued for Infinite Period or Irredeemable Debt

Net Proceeds will be = Issue Price – any expenses

➢ Example: Company Y issued debentures worth 200000 at a premium of 10%. The rate of
interest is 9%. Compute the before tax cost of debt assuming infinite period of debt
Solution: Using the formula for Irredeemable Debt,
I = 9% of 200000 = 18000
Po = 200000 + 10% of 200000 = 220000
So Kd = 18/220000 = 8.18%

➢ Cost of Debt – After Tax


Cost of Capital After Tax
The formula for Cost of Capital after tax = Kd (1 – T)

Where Kd is cost of capital before tax


T is tax rate

➢ Example: A company decided to issue a bond of face value 100 at 94 itself. The coupon rate
is 15% and duration is 7 years. Find the required rate of return or cost of capital after tax if
the corporate tax is 35%
Solution: Coupon Interest Payment = 15% of 100 = 15
Maturity Value = 100

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Proceeds = Market Price = 94
N=7
Cost of Capital Kd = [15 + (100-94) / 7] / [(100+94)/2]
= [15 + 6/7] / 97
= 15.85/95
= 16.4%
Using Cost of Capital after Tax Formula,
After tax cost of capital = .164 (1-.35) = 10.66%

➢ Cost of Preference Shares: These can also be of two types: Redeemable and Irredeemable
Preference Shares
➢ Redeemable preference share: It has a maturity date on which date the company will repay
the capital amount to the preference shareholders and discontinue the dividend payment
thereon
➢ Irredeemable preference shares (Perpetual Preference Shares): It does not have any
maturity date but it has fixed dividend and enjoy priority in payment of both dividend and
capital over the equity shares
➢ Cost of Irredeemable Preference Shares:
Formula for Perpetual or Irredeemable Shares
Kp = D1 / V

D1 is the expected preference share dividend


Kp is the required rate of return or cost of capital
V is the issue price of preference shares

But sometimes some expenses are involved in the issuing and in such a case
we use the following formula

Kp = D1 / P

D1 is the expected preference share dividend


Kp is the required rate of return or cost of capital
P is the issue price of preference shares – Expenses involved in issuing

➢ Example: Company issues 10% perpetual preference shares. Face value is 100 but the issue
price is 95. What is the cost of the preference share?
Solution: Using the Formula for Perpetual Shares,
D1 = 10% of 100 = 10
V = 95
Kp = 10/95 = 10.53%

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➢ Cost of Redeemable Preference Shares
Short Cut for Cost of Preference Shares - Kp
Cost of Preference Shares = Dividend Payment + (Maturity Value – Net Proceeds) / n
----------------------------------------------------------------------------
(Maturity Value + Net Proceeds) / 2

Where Dividend Payment is Dividend Payment on Preference Share


Maturity Value is the value obtained at Maturity
Net Proceeds is issue price minus any expenses in issuing
N = number of time periods

➢ Example: A company issues 1,00,000 10% preference share of 10 each. Calculate the cost of
preference capital if it is redeemable after 10 years at 5% premium.
Solution: Using the formula for Redeemable Preference Shares,
Dividend Payment = 10% of 10 = 1
N = 10
Maturity Value = 10 + 5% of 10 = 10.5
Net Proceeds = Market Value – Expenses = 10 – 0 = 10
Kp = (1 + ([10.5-10]/10)) / (10.5+10)/ 2 = 10.24%

➢ Cost of Equity

➢ Cost of Internal Equity – Stable Dividends (Zero Growth) for N years

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Where,

V = Present Value of Share


D1, D2 are Dividends each year till the nth year
Pn = Sell price of the stock in nth year
K or Ke= required rate of return or cost of Capital

Short Cut for Cost of Equity – Ke


Cost of Equity = Dividend Payment + (Maturity Value – Net Proceeds) / n
--------------------------------------------------------------------------------
(Maturity Value + Net Proceeds) / 2

Where Dividend Payment is Dividend Payment on Equity Shares


Maturity Value is the value obtained at Maturity
Net Proceeds is Market Price. There would be no issuing expenses involved as it is internal cost of
equity which is being used from retained earnings
N = number of time periods

➢ Example: A Company is expected to give dividend of Rs. 20 for next 3 years. The current
price is 119.2. What is the cost of capital or required rate of return assuming after 3 years
the sell price of share is 100?

Solution: Using Shortcut Formula,

Dividend Payment = 20
N=3
Maturity Value = 100
Net Proceeds = Market Value = 119.2
Ke = (20 + ([100-119.2]/3)) / (100+119.2)/ 2 = 12.4%

➢ Cost of Internal Equity – Stable Dividends (Zero Growth) for Infinite Years

Formula for Cost of Equity


Ke = D1 / V

D1 is the expected preference share dividend


Kp is the required rate of return or cost of capital
V is the market price of shares

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➢ Example: A market price of share is 150 and face value is 100. The company has been
paying 20% dividend to equity shareholders for the past five years and expected to maintain
the same in the future also. Compute cost of equity capital.

Solution: Using formula,

Ke = D1 / V
D = 20% of 100 = 20
V = 150
Ke = 20/150 = 13.33%

➢ Cost of Internal Equity – Dividends with Normal Growth G for N years


Formula for Dividend growing at Constant growth for N years
V = D0 (1+g)/ (1+K) + D0 (1+g) 2/ (1+K) 2 + D0 (1+g) 3/ (1+K) 3…………….. (D0 (1+g) n + Pn )/ (1+K)n

➢ Example: The Company gave a dividend of 20 this year and is expected to give dividends for
next 3 years with growth of 5% each year. What is the Cost of Capital if the required rate
present value is 129.83 and price after 3 years is 100?
Solution: V =129.83
g = 5% or .05
D0 = 20
D1 = 20 * (1+.05) = 21
D2 = 20 * (1+.05)2 = 22.05
D3 = 20 * (1+.05) 3 = 23.15
K =?
P =100

V = 21/ (1+k) + 22.05 / (1+k)2 + 23.15 / (1+k)3 + 100 / (1+k)3


By hit and trial K will come out to be 10%

➢ Cost of Internal Equity – Dividends with Normal Growth G for Infinite Years

Where,
V = Present Value or Market Price
D1 = Dividend in first year
K = Rate of return or Cost of Capital
G = Growth Rate of Dividend

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➢ Example: If a stock pays a 4 dividend this year, and the dividend has been growing 6%
annually, then what will be Cost of Capital assuming market price as 70.66

Solution: V =70.66
K =?
G = 6% 0r .06
D0 = 4
D1 = D0 (1+g) = 4 * (1+.06) = 4.24
70.66 = 4.24 / (K - .06)
K = 12%
➢ Cost of External Equity – Stable Dividends (Zero Growth) for Infinite Years

Formula for Cost of Equity


Ke = D1 / V

D1 is the expected preference share dividend


Kp is the required rate of return or cost of capital
V is the issue price (not market price) of shares

In case there are some expenses involved in issuing than

Ke = D1 / P

D1 is the expected preference share dividend


Kp is the required rate of return or cost of capital
P is the issue price (not market price) of shares minus the expenses
➢ Example: A company issues, 10,000 equity shares of Rs. 100 each at a premium of 10%. The
company has been paying 20% dividend to equity shareholders for the past five years and
expected to maintain the same in the future also. Compute cost of equity capital if the
market price is 150

Solution: D = 20% of 100 = 20


V = 100 + 10% of 100 = 110
Ke = 20/110 = 18.18 %

➢ Cost of External Equity – Constant Growth for Infinite Years

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Where,
V = Issue Price and not the Market Price
D1 = Dividend in first year
K = Rate of return or Cost of Capital
G = Growth Rate of Dividend
In case there is an issuing cost involved then we have to subtract the same from V

➢ Example: ABC Ltd plans to issue 1, 00,000 new equity share of Rs. 10 each at par. The
floatation costs are expected to be 5% of the share price. The company pays a dividend of
Rs. 1 per share next year and from there onwards the growth rate in dividend is expected to
be 5%. Compute the cost of new issue share if the market price is 12
Solution V = 10
P = 10 – 5% of 10 = 9.5
D1 = 1
K =?
G = 5% or .05
9.5 = 1 / (K - .05)
K = 15.53%

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