SCMS Journal of Indian Management, July - September, 2008.

18

Concept and Measurement:

Cost of Capital
Hitesh J.Shu k la

The cost of capital is an integral part of investment and financing decision as it is used to measure
the worth of investment proposal. It has received considerable attention from both theorists and
practitioners. The concept of cost of capital is useful in determining optimal capital structure,
investment evaluation, and financial performance appraisal. It is a difficult decision that involves a
complex trade off among several considerations like income, risks, flexibility, control, timing and so
on. The rationale of this study is to understand the concept of cost of capital and measuring cost
of each component as well overall cost of capital of a business firm. To help one, in understanding
the concept better, researcher uses the example of ACC Limited, and analyse cost of capital for
a period of six years i.e. 2000-01 to 2005-06. With the help of necessary secondary data, drawn
from the annual reports of the firm. The CAPM based cost of equity for ACC was much lower than
the estimates according to the dividend growth model. CAPM was theoretically superior to the
dividend-growth model. ACC’s market value weighted average cost of capital was found higher
than the book value weighted average cost of capital.

C
ost of capital is a central concept in financial concept of cost of capital is useful in determining optimal
management, viewed as one of the corner stones capital structure, investment evaluation, and financial
in t h e t h e o r y o f f i n a n c i a l performance appraisal. (Sudhindra
management. It has received Bhat, 2008) It is an important concept
considerable attention from both in formulating a firm’s capital
theorists and practitioners. Cost of structure. Capital structure, the par t
capital from the firm’s point of view, of financial structure that represents
is the minimum required rate of long-term sources, is generally
return needed to justify the use of defined to include only long term
capital. It is the rate of return that a debt and total stockholder
firm must pay to the fund suppliers, investment (Solomon, Ezra, 1963). To
who have provided the capital. In quote Bogen (1957) it may consist
other word, cost of capital is the of single class of stock or several
weighted average cost of various D r. H i t e s h J . S h u k l a , A s s o c i a t e P r o f e s s o r, issues may complicate it. The inherent
sources of finance used by the firm. Depar tment of Business Management, financial stability of an enterprise and
These sources are equity, S a u r a s h t r a U n i v e r s i t y , R a j k o t - 3 6 0 0 0 5 , risk of insolvency to which it is
preference, long-term debts and Email: h j s h k u l a @ r e d i f f m a i l . c o m exposed, primarily depends on the
shor t-ter m per manent debt. The source of its funds as well as the type

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SCMS Journal of Indian Management, July - September, 2008.
of assets it holds and relative magnitude of such assets
categories (Leopold 1974). To quote Ezra optimum leverage
is the mix of debt and equity that maximizes market value of
the firm and minimises the firm’s overall cost of capital. As
obser ved by Van Hor n (1996), in the optimum capital
structure, the marginal real cost of each available financing
is the same. To Guthmann and Dougall (1962), the capital
structure balances the financing, so as to achieve the lowest
average cost of long-term funds. A study of capital structure
involves a study of the debt-equity mix with the object of
lowering the overall cost of capital and with a view to
maximizing the market value of the firm’s securities (Weston
1972). The theory of cost of capital is based on cer tain
assumption. A basic assumption of traditional cost of capital
analysis is that the firm’s business and financial risk are
unaffected by the acceptance and financing of projects
(Gitam 1997).
The rationale of this study is to understand the concept of
cost of capital and measuring cost of each component as
well overall cost of capital of a business firm. Understanding
and measuring cost of different sources of fund can be
studied from different perspectives but to remain focused,
the study limits its scope to levered firm through ACC Ltd.
for a period of six years star ting from 2000-01 to 2005-06,
with the help of necessary secondary data, drawn from the
annual repor ts of the entity. Since the research is mostly
based on the information collected from the annual repor ts
of the sample unit, the limitations of the data are
apprehended to be the limitations of the study. In unison it
is believed that such type of limitations, if any, will not affect
the validity and reliability of the study to a great extent.
Table 1: Capital Structure – 2006
(mn Rs.)
Source of Capital BV
Share Capital 187.48
Reserves 2,955.16
Total Debt 915.98
Total Capital 4,058.62
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19
The Sample
ACC is India’s foremost manufacturer of cement and
concrete. It was incorporated in the year 1936. It came into
existence consequent to ten existing cement companies
belonging to four prominent business groups - Tatas,
Khataus, Killick Nixon and F.E.Dinshaw groups joined under
one umbrella in a historic merger. The company has been a
trendsetter and important benchmark for the cement industry
in respect of its production, marketing and personal
management process. The company has 14 cement plants
all over India, three refractory plants and 6 Ready Mix
Concrete plants near to four metro cities of India. It has also
extended its services overseas to the Middle East, Africa
and South America, where it has provided technical and
managerial consultancy to a variety of consumers, and also
helps in the operation and maintenance of cement plants
abroad. In September 2006, the company has changed its
name from Associated Cement Companies Limited to ACC
Limited.
Analysis
A firm may obtain its capital through equity capital in two
ways, retention of earnings and issue of additional shares
to the public. Cost of equity or the required returns by the
shareholders is the same in both the cases, since in both
cases; the shareholders are providing funds to the firm to
finance their investment proposals. The cost of retained
earning involves oppor tunity cost (Khan and Jain 2007). A
firm can raise capital even through debt to get benefits of
leverage. Sample firm has raised its capital through equity as
BV Weights MV MV Weights
0.0462 16,754.85 0.8123
0.7281 2,955.16 0.1433
0.2257 915.98 0.0444
1.0000 20,625.99 1.0000
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SCMS Journal of Indian Management, July - September, 2008. 20

Table 2: Financial Indicators

ACC EPS DPS Dividend Pay- Book Market ROCE RONW Div
Ltd (Rs.) (Rs.) (%) out Value Value (%) (%) Yield
(%) (Rs.) (Rs.) (%)
Dec-06 63.60 15.07 150.00 23.70 167.63 1,085.55 41.28 41.56 1.38

Dec-05 37.79 10.68 106.67 28.26 115.63 534.20 19.08 22.08 1.50

Mar-05 20.19 7.02 70.00 34.76 89.36 360.45 18.46 25.65 1.94

Mar-04 10.78 4.00 40.00 37.08 76.28 254.55 13.86 16.48 1.57

Mar-03 5.75 2.50 25.00 43.42 62.92 138.50 8.46 6.67 1.81

Mar-02 7.63 3.00 30.00 39.29 59.64 153.95 12.56 13.77 1.95

Mar-01 2.57 1.99 20.00 77.59 67.40 129.80 9.73 7.26 1.54

well debt. Table - 1 provides the details of capital structure
of ACC during 2006. It leads to the conclusion that the unit
has huge reserves and surplus in compare to its paid up
capital that shows the internal financial strength of the unit.
While looking to the market capitalization, paid up capital
has the highest weight due to high market price.
Table 2 provides data on ACC’s EPS, DPS, Payout Ratio, Market
Value, Book Value, Dividend Yield, ROCE (percent), and
RONW (percent) for the years March 2001 to December
2006. All the above variables move in upward direction
during the period of the study. Since 2003 all the variables
were doubling-up year-to-year it was a positive indication
for the investors. The market capitalization (the market value
of equity) of ACC in December 2006 was Rs.20,625.99
million. The market value of debt was assumed to be the
book value.
Cost of equity can be calculated through dividend growth
model (Panda I M 2005). The basic formula for calculation
of equity is as;
Ke = (DIV 1 / Po) + g
yield of the sample has varied from 1.38 to 1.95 percent
with an average yield of 1.67 percent. The researcher
assumed that the current dividend yield of 1.38 percent
was a fair approximation of ACC ’s expected yield. To
understand the estimation of growth rate, two methods
can be used, one, internal growth: Where internal growth is
the product of retention ratio and return on equity. It can be
calculated as (Panda I M 2005);
g = Retention ratio x ROE
This approach may be used when the firm has a stable
dividend policy. ACC’s pay out ratio has fluctuated over
years. However, on an average, it has distributed about 40.58
percent of its net profit and retained 59.42 percent in the
past few years. In 2006, it retained about 76.30 percent of
its profit. The company ’s RONW in 2006 is 41.56 percent.
Assuming that the current retention ratio of 76.30 percent
and RONW will continue in future, then ACC’s dividend was
expected to grow at 31.71 percent per year.
= 76.30 percent x 41.56 percent
= 31.71 percent = g

Here, term, DIV 1 / Po represents expected dividend yield The constant growth model has its limitations. It cannot be
and g represents expected (constant) growth in dividends. applicable to those companies that have highly unstable
ACC’s dividend yield in 2006 was 1.38 percent. The dividend dividend policy (or retention ratio) and fluctuating ROE. In

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SCMS Journal of Indian Management, July - September, 2008. 21

practice, to estimate ACC’s cost of equity may be relatively
more reliable based exclusively on its own data.
Past Average Growth
In practice, growth may be based on past EPS rather
than DPS since companies do not change their DPS
frequently with changes in EPS. Thus, DPS grows at a
slower rate. The average of EPS past growth rates may
be used as a proxy, for the future growth. There are two
alternatives available for calculating the average (1) the
Arithmetic Average and (2) Geometric Average would
give a compounded average and is preferable when
there is much variability in EPS data. Table 3 provides
calculation of the arithmetic average and the geometric
average. The EPS growth in 2001 was calculated as; g 1
= (EPS00-EPS01) / EPS00. Growth for other years was
calculated similarly. The arithmetic average growth for
the period from (2001-06) was founded as follows
(Panda I M 2005):
Arithmetic average = g 1 + g 2 + ….. + g n
N
The geometric mean is calculated as follows:
Geometric mean = (1 + g 1) x (1 + g2) x …… x (1 + g n) 1/n – 1

Table 3: EPS Growth of ACC

ACC Ltd EPS (Rs.) gEPS 1+gEPS

06-Dec 63.60 0.6800 1.68

05-Dec 37.79 0.8717 1.87

05-Mar 20.19 0.8729 1.87

04-Mar 10.78 0.8747 1.87

03-Mar 05.75 -0.2464 0.75

02-Mar 07.63 1.9689 2.97

01-Mar 02.57 1.5700 2.57

AM 1.6880

Avg. Geometric Mean 1.98

Table 4: Estimate of Growth Rates and Cost of Equity

Method Growth Rate Cost of Equity

(%) (%)

Arithmetic Avg. 168.80% 170.19%

Geometric Avg. 198.00% 199.39%

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SCMS Journal of Indian Management, July - September, 2008.
Above data makes us clear that EPS of the sample
w a s d o u b l i n g - u p y e a r -t o -y e a r. A r i t h m e t i c a v e r a g e
of growth of EPS for the period was found 1.69
while average geometric mean of the same was
found 1.98 for the unit for the period.
For different growth rates of ACC’s cost of
e q u i t y w a s c a l c u l a t e d i n Ta b l e 4 . I t v a r i e s f r o m
170.19 percent to 199.39 percent for the study
period.
Table 5: Return Annually
Year
December 2006
December 2005
December 2004
December 2003
December 2002
December 2001
Above table provides annual returns of the sample unit for
the study period. It varies from –5.48 percent to 103.21
percent. The risk free rate is generally approximated by the
highly liquid government security. The yield on 91-day T-
bills in India in December 2006 was about six percent. This
rate could be used as a proxy of the risk-free rate. The
market premium was excess of the expected market return
over the expected risk-free rate of return. One could use
the historical average over a very long period as a proxy for
the market premium. There were no estimates of the market
premium available in India. Researcher has used nine percent
as the market premium for the calculations. Beta was 1.0353
for the sample unit. Table 5 shows ACC’s yearly return on
market (Sensex) and ACC’s share prices.
ACC’s cost of equity = Risk free rate + (Market rate – Risk
free rate)
ACC’s Beta
= 0.06 + (0.09 x 1.0353)
= 0.1532 # 0.153 or 15.3 percent
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22
Cost of Equity through Capital Asset Pricing Model
CAPM model was developed by William F. Sharpe (1964).
It explains the relationship between the required rate of
return / the cost of equity capital and the non-diversifiable
or relevant risk, of the firm as reflected in its index of non-
diversifiable risk that is beta. A more objective alternative
model for calculating cost of equity is the CAPM. The use
of CAPM requires information like expected risk-free rate
of return, expected risk premium and Beta of returns.
Return
103.21%
57.72%
27.33%
49.50%
12.01%
-5.48%
The CAPM based cost of equity for ACC (15.3 percent) was
much lower than the estimates according to the dividend
growth model. CAPM is theoretically superior to the
dividend-growth model. One could use 15.3 percent as
ACC’s cost of equity.
ACC has both shor t-term and long-term debt in its capital
structure. It has also shor t-term current liabilities that might
be carrying some cost. As there was no bifurcation of the
interest paid to whom and nothing was specification about
the interest to be paid on each debt. So researcher has
considered total debt and total interest for the calculation.
Thus, researcher has assumed that the interest was paid to
all type of debt of the company and the corporate tax was
to be assumed at 35 percent. The after-tax weighted cost
of ACC’s debt would be:
= 0.0821 (1 – 0.35)
= 0.0534
= 5.34 percent approx.
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SCMS Journal of Indian Management, July - September, 2008. 23

Researcher has estimated ACC’s cost of equity and
c o s t o f t o t a l d e b t . T h e c o s t o f e q u i t y a l s o i n c l u d es
the reserves and surplus. The composite cost of
ca p ita l im plies a n a v e ra ge of t h e c o s t o f e a c h o f the
s o u r c e o f f u n d s e m p l o y e d b y t h e f i r m p r o p e r t y,
w e i g h t e d b y t h e p r o p o r t i o n t h e y h o l d i n t h e f i r m’s
capital structure. As the weights are being assigned
in two different forms i.e. book value of the company
and the market value of the company, the weighted
average cost of capital will be also calculated on two
different weights – book value weights and market
value weights, which could be calculated as under :

Table No. 6: Weighted Average Cost of Capital (Book Value and Market Value)

Source of Cost of BV W MV W WACC BV WACC

Capital Capital MV

Equity 0.1532 0.7743 0.9556 0.1186 0.1464

Debt 0.0534 0.2257 0.0444 0.0121 0.0024

Total 1.0000 1.0000 0.1307 0.1488

13.07% 14.88%

Above table makes clear that the weighted average value weights. Its market value weighted average cost
cost of capital was approximately 13.07 percent at of capital was higher than the book value weighted
the book value weight and 14.88 percent at the market average cost of capital.

Table No.7: Interest Coverage Ratio and Interest to Sales Ratio

Year Net Sales Interest Interest to Interest

Sales Ratio Cover Ratio

200612 5660.34 75.19 1.33 20.21

200512 3160.18 66.19 2.09 6.92

200503 3887.40 96.32 2.48 5.61

200403 3274.61 112.17 3.43 3.26

200303 2853.56 134.29 4.71 1.59

200203 2827.91 146.71 5.19 2.28

200103 2576.37 170.18 6.61 1.52

Above table shows the two different financial aspects show the decrease in interest paid by the company or in
interest to sales ratio and interest coverage ratio. The interest other words increases in sales of the company. On the other
to sales ratio was highest in the year 2001 at 6.61 whereas it side, the interest coverage ratio of the company was
was declining year after year to 1.33 for the year 2006 that showing volatile trend over the years but it has shown much

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SCMS Journal of Indian Management, July - September, 2008. 24

higher growth in last year to 20.21 highest of all in References

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