Cost of capital

Meaning & definition

• To a firm, it is the cost of obtaining funds

• To an investor, it is the minimum rate of

return expected by it without which the
market value of shares would fall

• In accounting sense, it is the weighted

average cost of various sources of finance
used by a firm
 Definition
 James C Van Horne ,”It is the cut-off
rate for the allocation of capital to
investments of projects. It is the rate
of return on a project that will leave
unchanged the market price of the
stock”
 Definition
 Solomon Ezra, “Cost of Capital is the
minimum required rate of
earnings or the cut-off rate of
capital expenditures”.
 Definition
 JohnJ. Hampton , “Cost of capital is
the rate of return the firm requires
from the investment in order to
increase the value of the firm in
the market place”.
 Significance of cost of
capital
• The acceptance criterion in capital
budgeting (in NPV, as a discounting factor
and in IRR it is used as a cut off rate to
compare with)
• The determinant of optimum capital mix in
capital structure decision (ie., the mix that
minimizes the overall cost of capital)
 Significance of cost of
capital
• A basis for evaluating the financial
performance (ie., Economic value added =
capital employed (ROI – cost of capital) )
• A basis for taking other financial decisions
(dividend policy, making rights issue ,
working capital decisions)
Co mputation o f cost of
capit al
 Computation of cost of specific source of
finance
 Computation of weighted average cost of
capital
Cost of debt (rate of
interest basis)
 Cost of debt (rate of
interest basis)
• Kdb=I / P
• Kdb= Before tax cost of debt
• I = Interest
• P = Principal
• Where debt is issued at premium or discount
• Kdb=I / NP
• NP = net proceeds ie cost + premium – floatation
cost
 Cost of debt (rate of
interest basis)
• Kda=Kdb(1-t)
• Or Kda=Int (1-t) / NP
• Kda= after tax cost of debt
• Cost of redeemable debt
• Kdb = Int + 1/n (RV-NP)
------------------------
½ (RV + NP)

• RV = Redeemable value of debt

 Cost of debt
• After tax Cost of redeemable debt
• Kda = Int (1 – t) + 1/n (RV-NP)
--------------------------------
½ (RV + NP)

• Cost of debt redeemable in instalments

• n
• Vd = ∑ (It + Pt) / (1 + kd) t
• t = 1
• Cost of existing debt : MP is taken as NP
 Cost of debt
• Cost of Zero coupon bonds is found
by method similar to IRR method
• Zero coupon bonds are the bonds or
debentures issued at a discount from
their maturity value having zero
interest rate
Cost of debt

 Real or inflation adjusted cost of

debt =
1 + NOMINAL COST OF DEBT

------------------------
1 + INFLATION RATE
 Cost of PREFERENCE
CAPITAL
• KP=D / P
• KP=D / NP
• KP = D + 1/n (MV-NP)
------------------------
½ (MV + NP)
Cost of Equity Share
Capital
 Dividend Yield Method or
Dividend/Price Ratio method
• According to this method, ‘the cost of
equity capital is the ‘discount rate that
equates the present value of expected
future dividends per share with the net
proceeds or current market price of a
share’
• Ke=D / NP
• Ke=D / MP
 basic assumptions

• the investors give prime importance

to dividends and
• risk in the firm remains unchanged
 limitations
• It does not consider the growth in
dividends
• It does not consider future earnings or
retained earnings
• It does not take into account capital gains
 suitability
• This method is suitable only when the
company has stable earnings and
stable dividend policy over a period
of time
 Dividend Yield Plus growth
Method
• This method is used when the dividends
of the firm are expected to grow at a
constant rate and the dividend payout
ratio is constant

• Ke=(D1 / NP) + G
• D1 = D0 (1 + G )
• Ke=(D1 / MP) + G
• Ke=(D1 / NP) + G
• D1 = D0 (1 + G )
• Ke=(D1 / MP) + G

• Ke= cost of equity

• D1 = expected dividend at the end of
the year
• MP = market price per share
• G = rate of growth in the dividend
• D0 = Previous year dividend
 Earning Yield Method
• Cost of equity capital is the discount rate
that equates the present value of
expected future earnings per share with
the net proceeds (or current market price)
of a share
• Earning Yield Method = EPS / NP or MP
• EARNINGS PER SHARE

----------------------------
MARKET PRICE PER SHARE or NP
 Earning Yield Method

• This method is used when

• The earnings per share are expected to remain
constant
• When the dividend payout ratio is 100% or when the
retention ratio is zero
• When the firm is expected to earn an amount on new
equity shares capital, which is equal to the current
rate of earnings
• The market price is influenced only by earnings per
share
 Realised yield method ie
RE/MP or NP
In this method instead of estimating the future dividends
the past earning are considered. Realised Earnings =
average past earnings + capital gain
The assumptions are :
3. The firm will remain in the same risk class over the
period
4. The shareholders’ expectations are based on the past
realised yield
5. The investors get the same rate of return as the
realised yield even if they invest elsewhere
6. The market price of shares does not change
significantly
Cost of retained
earnings
Cost of retained earnings

• Though the firm is not required to pay

dividends on retained earnings but the
shareholders expect a return on retained
profits. As this is the amount sacrificed by
the shareholders.
• Thus, its cost can be computed as the rate
of return which the existing shareholders
can obtain by investing the after-tax
dividends in alternative opportunity of
equal quality.
Cost of retained earnings
• Kr=(D1 / NP) + G
• Kr=(D1 / MP) + G
• Kr=Ke (1-t) (1-b)
• t = tax rate on dividends
• b = brokerage costs
 Supernormal growth
• If the dividends of a firm are expected to grow at a super
normal rate during the periods when it is experiencing very
high demand for its products and then, the dividends grow
at a normal rate when the demand reaches the normal level,
Ke is estimated from the following formula by trial and
error method
Supernormal growth normal growth
n ∞

• P0 = ∑ (D0 (1+gs)t +
∑ (Dn (1+gn)t-n
t = 1
(1 + Ke)t t = n +1
(1 + Ke)t

OR
n

• P0 = ∑ (D0 (1+gs)t +
Dn+1___ x 1_
t = 1 (1 + Ke)t Ke – gn (1+Ke)n
CAPM Capital Asset Pricing
Model
• The value of an equity share is a function of cash
inflows expected by the investors and the risk
associated with the cash inflows. It is calculated
by discounting the future stream of dividends at
the required rate of return, called the
capitalisation rate. The required rate of return
depends upon the element of risk associated with
investment in shares. It will be equal to the risk
free rate of interest plus the premium for risk.
Thus the required rate of return will be:
CAPM Capital Asset Pricing
Model
• Ke = Risk free rate of interest +
Premium for risk
• Ke = Rf + BI ( Rm – Rf)
• Rf = Risk free rate of return
• BI = Beta coefficient of firm’s
portfolio
• Rm = Market return of a diversified
portfolio
Composite Cost of Capital
Or overall cost of capital
Or average cost of capital
 Weighted Average Cost of
Capital
• Once the specific cost of individual sources of
finance is determined, we can compute the
weighted average cost of capital by putting
weights to the specific costs of capital in
proportion of the various sources of funds to the
total.
• The weights may be given either by using the
book value of the source or the market value of
the source.
 Weighted Average Cost of
Capital
• The market value weights get preference due the
the fact that they represent the true value of
the investors however they suffer from the
following limitations:
• It is very difficult to determine the market
values because of frequent fluctuations
• Secondly, with the use of market value weights,
equity capital gets greater importance
Weighted Average Cost of
Capital
• Kw = ∑XW / ∑W
• Kw = Weighted average cost of
capital
• X = Cost of specific source of
finance
• W = weight ie proportion of specific
source of finance
 Marginal Cost of Capital
• It is the weighted average cost of
new capital calculated by marginal
weights
the
end