Cost Of

Capital
so that the value of the companys equity share does
The rate of the return that
market not
the firm must earn on that the firm earn on its
of return
investment
fall
The minimum investment
Importance of the cost of capital
rate so that from
Importance value
the of the equity does not fall
capital
the market
The NPV is
budgeting calculated using the cost of capital as the discount factor
decisions
The IRR calculated is compared with the IRR while selected
and rejecting the project
 Cost of

capital

Cost of Cost of
Debt Cost of
Preferen
Equity
ce

Share
Retaine
Redeemabl Irredeemabl Normal
d
e e Equity
earning

Irredeemabl Redeemabl

e e
 CostOf Debt

Cost of

Irredeemable
Debt
AT Par
AT
Discount/Premium
Redeemable
AT Par
AT
Discount/Premium
 Cost Of Debt

Cost of
kd= (1-T)
Irredeemable Debt( at
issued
XI
k = cost of capital ( to be calculated) par)
T= tax rate
I= annual interest rate to be paid to the
creditor ( in percentage)

Example: A company has issued debentured
rateis 9%.Wha
worth Rs
100 Debentures of par value of Rs 1000.The coupon
t
is the cost of debt. Tax rate is 50%
There is no mention of the maturity date Thus this
is the
K
case of irredeemable debt kd= (1-T)I
d = 0.5X9% =
 Cost Of Debt

Cost of Irredeemable Debt( issued at or Discount

kd=
Premium (1-T) X I
)
Net Proceeds
k = cost of capital ( to be calculated)
T= tax rate
I= annual interest rate to be paid to the
creditor( in Rs) issuin
Net Proceeds = Total amount raised by the g

company
Incas of by
par --- It is equal to the par value

of discount
theedebentures --- it is less than par
( in Rs)
In of value premium--- it is more than
case the par value
 Cost Of

Debt

Cost of Irredeemable Debt(Par/Discount/Premium)

Example : A company
55%.Calculate the issues
of debt the debentures
if the debenture are issue
worth Rs 1,00,000 at coupon rate 10%.The
1. At PAR
cost s d
company is inof the tax bracket of
2. At a discount
3. 10% At a
kd (1-T) X I
premium of 10%
Net Proceeds

I = Rs 10,000

T= .55

In case of Par Net Rs1,00,0 Kd =
proceeds =
In case of Discount Net Proceeds
00 = 4.5%

Kd =
Rs 90,000
In case
5% of Premium Net Proceeds =

Kd=
Rs1,10,000
 Cost Of
Debt
Cost

In the previous case we have assumed that the not
of Redeemable
bonds are
In caseDebt
the bond matures after certai period of time
maturing and thus are continuously going on
the n

kd then it istax)
(before called =
redeemable
I + (P-Net
debt
Proceeds)/n

IThe
= annual interest
formula topayment
be ( in RS)
used is
(P + Net
Net Proceeds = Total amount raised by the company
Proceeds)/2
by issuing the debentures ( in Rs)

P = Par value of debenture (the value that the
creditor gets at maturity) (in Rs)
n = Maturity period of the bond
 Cost Of
Debt
Example

A firm issues debenture of Rs 1,00,000 but is able

to realize only
carry an interest rate of 10%The debentures are for
98,000
maturitydue to 10
after 2%years.
commission to the
Calculate thebroker. The
capita
due
debentures
cost of l
kd (before = I + (P-Net
tax) (P + Net
Proceeds)/n
Proceeds)/2

kd (after tax)P=
I = 10,000, =(1,00,000,
1-T) X kdNP
=98000, n= 10
(before tax)
Kd ( before Tax) = 10.30%
Calculate after tax cost of capital if the firm is in the tax
 Cost of Preference
Capital

Cost
Kp = of
D Preference Capital
p
CostNof Irredeemable Preference
Capital
p
Dp= Total Preference dividend to

be given
Np = Net proceeds generated
Example: A company raises the capital of Rs 1,00,000 by
by the firm
issuing 10000

1. preference
Preferenceshare
shareofare
Rs issued
10 each.
at The
par dividend rate on the
2 preference
Preference shares are issued at
. 10% premium
share is 10%. Calculate the cost of preference share
3 Preference share are issued at
 Cost of Preference Capital

Cost of Preference Capital

Kp =
(DIrredeemable)
p

Np

1. Preference shares are issued at 10%

1. Dp = Rs
premium
2 10,000
.
Np =
3 1,10,000 share are issued at 10%
2. Preference
.
1. Kp =Rs
Dp =
discount
9.09%
2 10,000
.
Np =
3 90,000
.
Kp =
11.11%
 Cost of Preference
Capital Capita ( redeemable
Costof Preferenc

Kp = eD + (P-Net lProceeds)/n
)
(P + Net Proceeds)/2

D = Dividend on preference shares

P = Principal to be paid to the creditors

Net Proceed= Amount actually received

by the firm n = Maturity period
 Cost of Preference

Capital

Example: A firm has issued preference share of

Floatation is Rs 100 each
5%.Determine the cost of

Kpgenerating
cost
= Da+proceed
about of Rs 1,00,000.The dividend rate
preference
(P-Net
Proceeds)/n
is
share.
14%.The(P Preference
+ Net Proceeds)/2
shares will be redeemed after 10

D years. to be paid ) = 14% of 1,00,000 = RS

P = Principal 14,000
( Dividend

Net
to Proceed= be paid to the creditors =

95,000 1,00,000

 Cost of Preference
Kp = D + (P-Net Proceeds)/n
Capital
(P + Net Proceeds)/2

= 14,000+( 1,00,000-95000)/10 =
14500/97500 = 14.87%
(1,00,000+95000)/2
 Cost of Preference

Capital
redeemable at the end of 10 years. The costis
aboutExample 2: A the
2 %.Calculate firm 10 %
preference cost
underwriting
redeemable shares of Rs 1,00,000,
share

Kp = D + (P-Net
(P + Net
Proceeds)/n
Proceeds)/2
D ( Dividend to be paid ) = 10% of RS

P = Principal
1,00,000 = to be paid to the creditors10,000
=

1,00,000
Net Proceed= 98,000
Kp = n
10,200/99000
= 10 X 100
 Cost Of
Capital

Cost of Equity
Capital
Very difficult to calculate as there is no apparent
cost involved as compared to the cost of debt

Some people argue that equity capital does not

have any cost , since it is not legally binding on
them to pay dividends, but this argument is wrong

People invest in the equity with an

expectation of
Getting the dividends
Increase in the price of the share
 Cost of

Equity
Dividend
Price
Approach
Without Growth
Dividend With Growth
in
s in

Dividend

New Issue Already

of Existing
Already Equity Equity
New Issue
existing
of
equity
Equity
 Cost Of
Capital
Approaches to finding Costof Equit

the y
Without growth in
Dividend
1. NewPrice
issue Approach
of equity
dividends
2 Already existing
. Equity
With growth in
1. New issue of equity
dividends
2 Already existing
. Equity
 Cost Of

Capital

Without in dividend (New issu of equity
Dividend Price Approach
Ke
growth s e )
= Np D

K = Cost of
Equity
e

NpDividend
D = Net
Given
=
proceeds

Example : A offers publi subscription the

of Rs 10 at a premium of 10%.The commission cost
company for c shares
for the

company is 5%.The dividend rate is 20 % .Calculate

 Cost Of

Capital
issu of equity
Dividend Price Approach
Ke = D X 100
Without growth in dividends e )
%(New

Ke = To be calculated
Np
D= Rs 2

Np = 11- (5% of 11) =

Rs 10.45
Ke = (2/10.45)X 100
= 19%
 Cost Of Capital

Existing Share ( No Dividend

Growth) Rs 10,has a
value of Rs: 15.The
Example expected
A company s share bepai is20 of th
market
face
of value.
face valueCalculate the of equit
dividend to d % e
Ke = D X
cost y.
100 %
M
p
D = Dividend given
Mp = Market Price of
the share

= Rs 2/15 =

0.133
 Cost Of Capital

Dividend Price Approach

With
Ke = growth
D in dividends (New issue
of equity)
+ g
Np

Ke = Cost of Equity

D= Dividend

Np = Net proceeds

g = expected growth in
dividends
 Cost Of

Capital
Example: A company issues
dividend history of the company. The dividen
new equity with each share
onth ne shar isR 14.1 . th cos of equit
at RsYear
expected Dividend per share ( in Rs) d
e1994
w
150.e The s 0 Find e cost
underwriting
10.50 t y. 2%.
is
Following
1995 11 is the
1996 12.50
1997 12.75
1998 13.40

Calculate the cost of

 Cost Of

Capital

With growth in (New issu of equity
Dividend
Price Approach
So formula be used is
dividends e )
Ke = D +
to
g

Np
K = Cost of

e Equity

Np = 98% of Rs 150 = Rs 147

D Rs 14 .10
g
= = expected growth in Can be fro
dividends???
calculated m
the table
 Cost Of

Rs 10.50 is invested Capital

year and become Rs 13.40

for 4 s s .
10.50(1+g)4 =
=
(1+g)
13.40 13.40/10.5
4
Calculat 0

e g
Easie way :>>>>
Divide the latest dividend by dividen
r
the first
Look in the compound value table for
d 4 year the

row for above

From both ways g= 6%.
calculated factor to find g.
Put in the formula to calculate Ke = 14.10/147
+ .06 = 15.6%
 Cost Of

Capital

With growth in (Existin equity
Dividend
Price Approach
So formula be used g
dividends )
Ke = D +
to is
g

Mp
K = Cost of

e Equity

Mp = Market of the
D Dividend
g
= =given
expected growth
price sharein
dividends
 Cost Of

Capital
Example:
expect A company's
a growth rate of 5 pershare
year Calculat the costof
has a market price of Rs
% 20.The company pays. a e
So formula to usedis
Ke = of Rs
dividend
equity. D 1 per share. The
be
+ g shareholders
Mp

K = Cost of

e Equity

Mp = Market price of the = Rs

D Rs 1
g
= = expected growth in
share 20
dividends = 5%
 Cost Of Retained

Earnings
The net Profit after tax that is not distributed by the
Cost of Retained
company to the earnings

share holders is called retained earnings.
Such earnings are used by the companies for the
future expansions
Some people think that these earnings are free of
cost and does not
cost anything to the company, WHICH IS
ABSOLUTLEY WRONG!
Because if theses earnings were given to the
share holders then they would have invested
them somewhere and in turn have earned on that
investment.
Thus the cost of the retained earnings is the
Earnings Sacrificed or the Opportunity Lost by
 Cost Of Retained Earnings

Adjustment Required in Retained earnings

The money retained by the company is not equal
to that given to the investors.
Investors pay tax on the money given as

dividends
This
Theymeans if the
also incur company
brokerage hason
cost 50,000 Rs as retained
making adjustment
earnings and it

decides to give it to the investors then the investors will

have less than

50,000 to invest while the company will have Rs 50,000 to

invest.
 Cost Of Retained Earnings

ABC limited is earning a net profit of Rs 50,000 per annum.

The shareholders require a rate of return of 10%.It is
expected that the retained earning if distributed among the
shareholders can be invested in a security of similar type
carrying a rate of return of 10% per annum. It is further
expected that the shareholders will incur a brokerage cost of
2% on the dividend received to make the new investment.
The shareholders are in the tax bracket of
Solution: In order to
30%.Calculate thecalculate
cost ofthe cost of earnings
retained retained earning
for thewe should first
company.
calculate the net dividend available to the share holders net of tax and

other

costs.
 Cost Of Retained Earnings
Thus the expectation of the investors is to earn Rs 3430
from the retained earnings. Which in other words mean if
the money is not distributed to the share holders the
company need to earn Rs 3430 but on 50,000.
Therefore Kr = 3430/50,000 = 6.86%
Kr = Ke X (1-T)(1-
In
B)
general
 Weighted Average Cost of Capital
The capital of the company consists of various
components. Thus the company wants to calculate the
total cost of the capital. This total overall or the total
cost of capital is calculated based on the weights of
each component on the total capital. Thus the total
cost of capital is also called the weighted cost of
capital
1. Calculate the cost of different capital components like
Stepscost
involved in calculating the weighted average cost
of debt,
of 2.
capital.
cost of preference shares, cost of equity, cost of retained
Ways to calculate the
earnings etc.
1. Weights based on the book value of the capital ( Book value
weights
2 Assign weights to each components.
Weights)
. Both of the above together is called the HISTORICAL WEIGHT METHOD of
Weights based on the basis of Market value of the capital
( Market
calculating theValue weights)

weight
 Weighted Average Cost of

Capital
1. Example: From the following capital structure
2 calculate the overall cost of
.After tax by
capital cost of different components is as follows
cost of equity
Book Valuecapital
method=14%, Cost of Debt = 5%, cost of
Preference
Market Valueshares = 10%, Cost of retained earnings =
method
13%.
Source Book Value
Market Value
Equity Share Capital Rs 45,000
90,000 ( Rs 10 pr share)
Retained earnings 15,000
Preference Share 10,000
10,000
Debenture 30,000
30,000
 Weighted Average Cost of

1. Capital
2. Steps: ( Book Value Method)
3. Calculate the weights of different
Source Weights After cost of
components Multiply diff weights with
Weights cost
after tax cost of capital. Add all to get
Equity Share Rs capita 14%
the
6.30weights average cost of capital
l
Capital ( Rs 10 pr 45,000/1,00,000
Retained earnings 15,000/100,000 = 13%
share) 0.45
1.95
Preference Share0.15 10,000/1,00,000 = 10%
1
Debenture 0.10 30,000/1,00,000 5%
1.5
=0.30 TOTAL
10.75%
 Weighted Average Cost of Capital
Example: Excel industries ltd has the assets of Rs 1,60,000
which have been financed by Rs 52,000 of debt, Rs 90,000
8%
ofinterest
equityon theaborrowed
and general funds .It has
reserves of900 equity shares of FV Rs 100
Rs 18,000.The forms Profit after tax for the firm has Rs 13,500.It

been pays
each, selling in the market at a price of Rs 120 per share. Calculate the

weighted average cost of capitalboth by market value method and book

value
1. Calculate the
method. Tax Rate is 50%.
1. Total capital =MV of Debt + MV of
Steps(weights
by
1. Market Value Method)
Rs 52,000+108,000 =
Equity
ke=2.13500/900=
Wt of1,60,000 15 EPS: MPPS = 120: 15/120= 12.5
debt = 52,000/1,60,000
3. =0.325
2. Calculate the cost
Wt of Equity of various
= 0.675
1. Kd =4%
components
2. Ke= Not given so need to be calculated. EPS/MPPS = Ke
3. Calculate the total cost of capital = .325X4% +0.675X12.5%
 Weighted Average Cost of Capital
Exercise : Calculate the Overall cost of capital from

book value method

In the absence of any specific cost of retained earning the cost equity
Hint :
calculated can be

used as the cost of retained earnings

From Book Value perspective total equity base = Reserves

ANS WACC ( Book Value Method) = 9.74% as per
+ share capital at face value ( = 18,000+90,000 =
1,08,000)
previous calculation
 Weighted Average Cost of

1. Capital
2. Example: A limited company has the following
3. capital Structure
TheEquity
MPPS =Share
Rs 20. Capital
It is expected
= Rs that the company
40,00,000 will give a
( 2,00,000
shares)
current
6% preference shares = Rs 10,00,000
dividend of Rs 2 per share which will grow at a rate
8% debentures = Rs 30,00,000
of 7% forever. Tax rate is 50%. Find the weights
1. Existing
average costcapital
of capital based on
Ans 10.75
Structure
Exercise:
2. The
. % Below
new weightedfor Assignment:
average cost of capital if the company raises an

additional

debt of Rs 20,00,000 by issuing 10% debenture which would result in an

Ans 13.60
increase in the expected dividend to Rs 3 and will leave the growth rate
3. The %total cost of capital in in (2) the growth rate increase to
unchanged,
14.80 but the price of the share will fall to Rs 15 per share
Ans.