Tata McGraw-Hill Publishing Company Limited, Financial Management

11-1
Chapter 11

Concept and Measurement
of Cost of Capital
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-2
CONCEPT AND MEASUREMENT OF
COST OF CAPITAL
Importance and Concept
Measurement of Specific Costs
Computation of Overall Cost of
Capital
Solved Problem
Mini Case
Cost of Capital Practices in India
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-3
Cost of Capital
The cost of capital is an integral part of investment decisions as it is used
to measure the worth of investment proposal. It is used as a discount rate
in determining the present value of future cash flows associated with
capital projects. Conceptually, it is the minimum rate of return that a firm
must earn on its investments so as to leave market price of its shares
unchanged. It is also referred to as cut-off rate, target rate, hurdle rate,
required rate of return and so on.
In operational terms, it is defined as the weighted average cost of capital
(k
0
) of all long-term sources of finance. The major long-term sources of
funds are
1) Debt,
2) Preference shares,
3) Equity capital, and
4) Retained earnings.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-4
Assumptions
The theory of cost of capital is based on certain assumptions. A
basic assumption of traditional cost of capital analysis is that the
firms business and financial risks are unaffected by the acceptance
and financing of projects
Business Risk
Business risk is the risk to the firm of being unable to cover fixed
operating costs.
Business risk measures the variability in operating profits [earnings
before interest and taxes (EBIT)] due to change in sales
Financial Risk
Financial risk is the risk of being unable to cover required financial
obligations such as interest and preference dividends.
Capital budgeting decision determines the business risk
complexion of the firm. The financing decision determines its
financial risk.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-5
Explicit and Implicit Costs
Explicit Cost
The explicit cost of capital is associated with the raising of funds (from
debt, preference shares and equity). The explicit cost of any source of
capital (C) is the discount rate that equates the present value of the
cash inflows (CI
o
) that are incremental to the taking of financing
opportunity with the present value of its incremental cash outflows
(CO
t
). Symbolically,
where CI
0
= initial cash inflow, that is, net cash proceeds received by
the firm from the capital source at time O, CO
1
+ CO
2
... + CO
n
= cash
outflows at times 1, 2 ... n, that is, cash payment from the firm to the
capital source.
( )
) 1 (
C 1
CO
CI
n
1 t
t
t
0

= +
=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-6
If CI
0
is received in instalments, then, CI
0
It is evident from the above mathematical formulation that the explicit
cost of capital is the rate of return of the cash flows of the financing
opportunity
Implicit Cost
Retained earnings involve no future cash flows to, or from, the firm.
Therefore, the retained earnings do not have explicit cost. However,
they carry implicit cost in terms of the opportunity cost of the
foregone alternative (s) in terms of the rate of return at which the
shareholders could have invested these funds had they been
distributed to them/or not retained by the firm.
( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
) 2 (
C 1
CO
...
C 1
CO
C 1
CO
C 1
CO
C 1
CI
...
C 1
CI
C 1
CI
C 1
CI
CI
n
n
3
3
2
2
1
1
n
n
3
3
2
2
1
1
0
+
+
+
+
+
+
+
=
+
+
+
+
+
+
+
+
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-7
Measurement of Specific Costs
There are four types of specific costs
1) Cost of Debt
2) Cost of Preference Shares
3) Cost of Equity Capital
4) Cost of Retained Earnings
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-8
Cost of Debt
Cost of debt is the after tax cost of long-term funds
through borrowing. The debt carries a certain rate of
interest. Interest qualifies for tax deduction in
determining tax liability. Therefore, the effective cost
of debt is less than the actual interest payment made
by the firm by the amount of tax shield it provides.
The debt can be either
1) Perpetual/ irredeemable Debt
2) Redeemable Debt
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-9
Perpetual Debt
In the case of perpetual debt, it is computed dividing effective interest
payment, i.e., I (1 t) by the amount of debt/sale proceeds of debentures or
bonds (SV). Symbolically
k
i
= Before-tax cost of debt
k
d
= Tax-adjusted cost of debt
I = Annual interest payment
SV = Sale proceeds of the bond/debenture
t = Tax rate
( )
) 4 (
SV
t 1 I
k
) 3 (
SV
1
k
d
t

=
=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-10
Solution
(i) Debt issued at par
Before-tax cost, k
i
= (Rs 10,000 / Rs 1,00,000) = 10 per cent
After-tax cost, k
d
= k
i
(1 t) = 10% (1 0.35) = 6.5 per cent
(ii) Issued at discount
Before-tax cost, k
i
= (Rs 10,000 / Rs 90,000) = 11.11 per cent
After-tax cost, k
d
= 11.11% (1 0.35) = 7.22 per cent
(iii) Issued at premium
Before-tax cost, k
i
= (Rs 10,000 / Rs 1,10,000) = 9.09 per cent
After-tax cost, k
d
= 9.09% (1 0.35) = 5.91 per cent
Example 1
A company has 10 per cent perpetual debt of Rs 1,00,000.
The tax rate is 35 per cent. Determine the cost of capital
(before tax as well as after tax) assuming the debt is issued
at (i) par, (ii) 10 per cent discount, and (iii) 10 per cent
premium.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-11
Redeemable Debt
In the case of redeemable debt, the repayment of debt principal (COP)
either in instalments or in lump sum (besides interest, COI) is also taken
into account. k
d
is computed based on the following equations:
where CI
0
= Net cash proceeds from issue of debentures or from raising debt
COI
1
+ COI
2
+ ... + COI
n
= Cash outflow on interest payments in time period 1,2 and
so on up to the year of maturity after adjusting tax savings on interest payment.
COP
n
= Principal repayment in the year of maturity k
d
= Cost of debt.
The cost of debt is generally the lowest among all sources partly because the risk
involved is low but mainly because interest paid on debt is tax deductible.
( )
( )
( )
( ) ( )
( )
( )
( )
( )
(6)
k 1
COP
t 1
k 1
COI
CI s, instalment in paid is debt When
/2 SV RV
SV/N - RV value, Redeemable t 1 I
K ely, Alternativ
(5)
k 1
COP
t 1
k 1
COI
CI sum, lump in paid is principal When
n
1 t
t
d
t
t
d
t
0
d
n
1 t
n
d
n
t
d
t
0

=
=
+
+
+
=
+
+
=
+
+
+
=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-12
Example 2
A company issues a new 10 per cent debentures of Rs 1,000
face value to be redeemed after 10 years The debenture is
expected to be sold at 5 per cent discount. It will also involve
floatation costs of 5 per cent of face value. The companys
tax rate is 35 per cent. What would the cost of debt be?
Illustrate the computations using (1) trial and error approach
and (2) shortcut method.
Solution
(1) Trial and Error/Long Approach
Cash Flow Pattern of the Debentures
Years Cashflow
0

1-10
10
+ Rs 900 (Rs 1,000 Rs 100, that is, par value
less flotation cost less discount)
- Rs 100 (interest outgo)
- Rs 1,000 (repayment of principal at maturity)
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-13
The value of k
d
for this equation would be the cost of debt. The
value of k
d
can be obtained, as in the case of IRR, by trial and error.

=
+
+
+
=
|
.
|

\
|
|
.
|

\
|
10
1 t
10
d
k 1
1,000 Rs
t
d
k 1
65 Rs
900 Rs
: equation following the in
d
k of value the determine to are We
Determination of PV at 7% and 8% Rate of Interest
Year(s) Cash
outflows
PV factor at Total PV at
7% 8% 7% 8%
1 10 Rs 65 7.024 6.710
(Table A-4)
Rs 456.56 Rs 436.15
10 1,000 0.508 0.463
(Table A-3)
508.00
______
964.56
463.00
______
899.15
The value of k
d
would be 8 per cent.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-14
(2) Shortcut Method
The formula for approximating the effective cost of debt can, as a shortcut,
be shown in the Equation
where I = Annual interest payment
RV = Redeemable value of debentures/debt
SV = Net sales proceeds from the issue of debenture/debt
(face value of debt minus issue expenses)
N
m
= Term of debt
f = Flotation cost
d = Discount on issue of debentures
pi = Premium on issue of debentures
pr = Premium on redemption of debentures
t = Tax rate
( ) ( )
( )
(7)
/2 SV RV
m
/N pi pr d f t 1 I
d
k
+
+ + +
=
( ) ( )
( )
7.9%
/2 1,000 Rs 900 Rs
/10 50 Rs 50 Rs 0.35 1 100 Rs
k
d
=
+
+ +
=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-15
Example 3 A company has issued 10 per cent debentures aggregating Rs
1,00,000. The flotation cost is 4 per cent. The company has agreed to repay the
debentures at par in 5 equal annual instalments starting at the end of year 1.
The companys rate of tax is 35 per cent. Find the cost of debt.a
Solution
Net proceeds from the sale of debenture = Rs 96,000.
Since the cash outflows are higher in the initial years than the average (Rs
24,500), let us try to determine PV at 7 per cent and 8 per cent.
Cash outflows PV factor at Total PV at
7% 8% 7% 8%
26,500 0.935 0.926 Rs 24,777 Rs 24,539
25,200 0.873 0.857 22,000 21,596
23,900 0.816 0.794 19,502 18,977
22,600 0.763 0.735 17,244 16,611
21,300 0.713 0.681 15,187 14,505
98,710 96,228
@Rs 20,000 principal + Rs 10,000 interest (1 0.35)
The value of k
d
= 8 per cent.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-16
Cost of Preference Shares
The cost of preference share (k
p
) is akin to k
d
.
However, unlike interest payment on debt, dividend
payable on preference shares is not tax deductible
from the point of view assessing tax liability. On the
contrary, tax (D
t
) may be required to be paid on the
payment of preference dividend.
n Irredeemable Preference Shares
n Redeemable Preference Shares
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-17
Irredeemable Preference Shares
The cost of preference shares in the case of irredeemable
preference shares is based on dividends payable on them and the
sale proceeds obtained by issuing such preference shares, P
0
(1
f ). In terms of equation:
where k
p
= Cost of preference capital
D
p
= Constant annual dividend payment
P
0
= Expected sales price of preference shares
f = Flotation costs as a percentage of sales price
D
t
= Tax on preference dividend
( )
( )
( )
) A 8 (
f 1 P
D 1 D
k
) 8 (
f 1 P
D
K
0
t p
p
0
p
p

+
=

=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-18
Example 4
A company issues 11 per cent irredeemable preference shares of the face
value of Rs 100 each. Flotation costs are estimated at 5 per cent of the
expected sale price. (a) What is the k
p
, if preference shares are issued at (i)
par value, (ii) 10 per cent premium, and (iii) 5 per cent discount? (b) Also,
compute k
p
in these situations assuming 13.125 per cent dividend tax
Solution
( )
( )
( )
% 2 . 12
05 . 0 1 95 Rs
11 Rs
) iii (
% 5 . 10
05 . 0 1 110 Rs
11 Rs
) ii (
% 6 . 11
05 . 0 1 100 Rs
11 Rs
) i ( ) a (
=

=
=

=
=

=
p
p
p
k
Discount at Issued
k
Premium at Issued
k
par at Issued
% 8 . 13
25 . 90 Rs
44 . 12 Rs
) iii (
% 9 . 11
5 . 104 Rs
44 . 12 Rs
) ii (
% 1 . 13
95 Rs
44 . 12 Rs ) 13125 . 1 ( 11 Rs
) i ( ) b (
= =
= =
=
=
=
p
p
p
k
Discount at Issued
k
Premium at Issued
k
par at Issued
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-19
Redeemable Preference Shares
The cost of redeemable preference shares requiring lump sum
repayment (P) is determined on the basis of the following equation:
where P
0
= Expected sale price of preference shares
f = Floatation cost as percentage of P
0

D
p
= Dividends paid on preference shares
P
n
= Repayment of preference capital amount
( )
( )
( ) ( )
( )
( )
( ) ( )
(9)
k 1
P
k 1
1 D
f 1 P
: s instalment in required repayment of case the In
k 1
P
k 1
1 D
f 1 P
n
1 t
t
p
t
t
p
t p
0
n
1 t
n
p
n
t
p
t p
0

=
=
+
+
+
+
=
+
+
+
+
=
D
D
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-20
Example 5
ABC Ltd has issued 11 per cent preference shares of the face value of Rs
100 each to be redeemed after 10 years. Flotation cost is expected to be 5
per cent. Determine the cost of preference shares (k
p
).
Solution
( ) ( )
cent. per 11 is dividend of rate the as cent per 12 and 11 between be to likely k of value The
p
is
k 1
100 Rs
k 1
11 Rs
95 Rs
10
1 t
10
p
t
p

= +
+
+
=
Determination of PV at 11% and 12%
Year Cash
outflows
PV factor at Total PV at
11% 12% 11% 12%
1 10 Rs 11 5.889 5.65 Rs 64.78 Rs 62.15
10 100 0.352 0.322 35.15
99.93
32.20
94.35
K
p
=11.9 per cent
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-21
The computation of cost of equity capital (k
e
) is
conceptually more difficult as the return to the equity-
holders solely depends upon the discretion of the
company management. It is defined as the minimum
rate of return that a corporate must earn on the
equity-financed portion of an investment project in
order to leave unchanged the market price of the
shares. There are two approaches to measure k
e
:
1) Dividend Valuation Model Approach
2) Capital Asset Pricing Model (CAPM) Approach.
Cost of Equity Capital
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-22
As per the dividend approach, cost of equity capital is defined as the
discount 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.
The cost of equity capital can be measured with the following equations:
(A) When dividends are expected to grow at a uniform rate perpetually:
where D
1
= Expected dividend per share
P
0
= Net proceeds per share/current market price
g = Growth in expected dividends
Dividend Valuation Approach
( )
( )
( )
( )
( )
( )
( )
( )
( )
(12) g
P
D
k (11)
g k
D
P
get we 10, Eq. g Simplifyin equation. the of
sides two the equates which rate) (discount return of rate the is 10 Eq. in k
(10)
k 1
g 1 D
k 1
g 1 D
...
k 1
g 1 D
k 1
g 1 D
f 1 P
0
1
e
e
1
0
e
n
1 t
t
e
1 t
1
n
e
n
0
2
e
2
0
1
e
1
0
0
+ =

=
+
+
=
+
+
+ +
+
+
+
+
+
=

=

Tata McGraw-Hill Publishing Company Limited, Financial Management

11-23
The calculation of k
e
on the basis of Eq. 12 is based on certain
assumptions with respect to the behaviour of investors and their
ability to forecast future values:
the market value of shares depends upon the expected dividends;
investors can formulate subjective probability distribution of
dividends per share expected to be paid in various future periods;
the initial dividend, D
0
, is greater than zero (D
0
> 0);
the dividend pay-out ratio is constant;
investors can accurately measure the riskiness of the firm so as
to agree on the rate at which to discount the dividends.
Note: Under the provisions of Section 115(O), of the Income Tax Act,
1961, a domestic company is liable to pay tax at a flat rate of 11.5 per
cent (plus surcharge) on dividends declared/distributed/paid on/after
April 1, 2003. The payment of the dividend tax will reduce the growth
(g) in dividends:
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-24
(B) Under different growth assumptions of dividends over the
years:
Equation 12 will have to be modified to take into account two (or
more, if necessary) growth rates. The solution in the following
Equation 13 for k
e
would give the cost of equity capital:
( ) ( )
( ) | | ( )
higher. be would Dt without g Obviously,
A) (12
P
D 1 DPS EPS
EPS
Dt 1 DPS EPS
P
EPS
b.r g
EPS/P r
tax Dividend Dt where
EPS
Dt 1 DPS EPS
EPS
Dt 1 DPS
1 b
return. of rate r rate, retention b where b.r, g
0
t
0
0

+
=
+
= =
=
=
(

+
=
(

+
=
= = =
( )
( )
( )
( )
years later in growth Constant g
years earlier in growth of Rate whereg
(13)
k 1
g 1 D
k 1
g 1 D
P
c
h
n
1 t 1 n t
t
e
1 t
c n
t
e
1 t
b 0
0
=
=
+
+
+
+
+
=

=

+ =

Tata McGraw-Hill Publishing Company Limited, Financial Management
11-25
Example 6
Suppose that dividend per share of a firm is expected to be Re 1 per share
next year and is expected to grow at 6 per cent per year perpetually.
Determine the cost of equity capital, assuming the market price per share is
Rs 25.
Solution: This is a case of constant growth of expected dividends. The k
e
can
be calculated by using Equation
The dividend approach can be used to determine the expected
market value of a share in different years. The expected value of a
share of the hypothetical firm in Example 6 at the end of years 1 and
2 would be as follows
% 10 06 . 0
25 Rs
1 Rs
g
0
P
1
D
e
k = + = + =
28 Rs
0.06 0.10
1.124 Rs
g
e
k
3
D
2
P (ii)
26.50 Rs
0.06 0.10
1.06 Rs
g
e
k
2
D
)
1
(P year first the of end the at Price (i)
=

=
=

=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-26
Example 7
From the undermentioned facts determine the cost of equity shares of
company X:
(i) Current market price of a share = Rs 150.
(ii) Cost of floatation per share on new shares, Rs 3.
(iii) Dividend paid on the outstanding shares over the past five years:
Year Dividend per share
1
2
3
4
5
6
Rs 10.50
11.02
11.58
12.16
12.76
13.40
(iv) Assume a fixed dividend pay out ratio.
(v) Expected dividend on the new shares at the end of the current year is Rs
14.10 per share.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-27
Solution
As a first step, we have to estimate the growth rate in
dividends. Using the compound interest table (Table A-1), the
annual growth rate of dividends would be approximately 5 per
cent. (During the five years the dividends have increased from
Rs 10.50 to Rs 13.40, giving a compound factor of 1.276, that is,
Rs 13.40/Rs 10.50. The sum of Re 1 would accumulate to Rs
1.276 in five years @ 5 per cent interest).
( )
% 6 . 14 % 5
3 Rs 150 Rs 147 Rs
10 . 14 Rs
k
e
= +

=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-28
CAPITAL ASSET PRICING MODEL
(CAPM) APPROACH
The CAPM describes the relationship between the required rate of return or
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.
Symbolically,
K
e
= R
f
+ b (K
m
R
f
) (14)
R
f
= Required rate of return on risk-free investment
b = Beta coefficient**, and
K
m
= Required rate of return on market portfolio, that is, the average rate or
return on all assets
M = Excess in market return over risk-free rate,
J = Excess in security returns over risk-free rate,
MJ = Cross product of M and J and
N = Number of years
( )

=
2
2
M N M
J M N MJ
* *
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-29
Example 8
The Hypothetical Ltd wishes to calculate its cost of equity
capital using the capital asset pricing model approach. From
the information provided to the firm by its investment advisors
along with the firms own analysis, it is found that the risk-free
rate of return equals 10 per cent; the firms beta equals 1.50
and the return on the market portfolio equals 12.5 per cent.
Compute the cost of equity capital.
Solution
K
e
= 10% + [1.5 (12.5% 10%)] = 13.75 per cent
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-30
Example 9: As an investment manager you are given the following
information
Investment in equity
shares of
Initial
price
Dividends Year-end
market price
Beta risk
factor
A Cement Ltd
Steel Ltd
Liquor Ltd
B Government of India
Bonds
Risk-free return, 8 per cent
Rs 25
35
45
1,000
Rs 2
2
2
140
Rs 50
60
135
1,005
0.80
0.70
0.50
0.99
You are required to calculate (i) expected rate of returns of market portfolio,
and (ii) expected return in each security, using capital asset pricing model
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-31
Solution
(i) Expected Returns on Market Portfolio
Security Return Investment
Dividends Capital
Appreciation
Total
A Cement Ltd
Steel Ltd
Liquor Ltd
B Government
of India Bonds
Rs 2
2
2
140
146
Rs 25
25
90
5
145
Rs 27
27
92
145
291
Rs 25
35
45
1,000
1.105
Rate of return (expected) on market portfolio = Rs 291/Rs 1,105 = 26.33 per
cent
(ii) Expected Returns on Individual Security (in percent)
k
e
= R
f
+ b(k
m
R
f
)
Cement Ltd = 8% + 0.8 (26.33% 8%) 22.66
Steel Ltd = 8% + 0.7 (26.33% 8%) 20.83
Liquor Ltd = 8% + 0.5 (26.33% 8%) 17.16
Government of India Bonds = 8% + 0.99 (26.33% 8%) 26.15
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-32
The capital assets pricing model (CAPM) approach to calculate the
cost of equity capital is different from the dividend valuation
approach in some respects. In the first place, the CAPM approach
directly considers the risk as reflected in beta in order to determine
the K
e
. The valuation model does not consider the risk; it rather uses
the market price as a reflection of the expected risk-return preference
of investors in the market.
Secondly, the dividend model can be adjusted for flotation cost to
estimate the cost of the new equity shares. The CAPM approach is
incapable of such adjustment as the model does not include the
market price which has to be adjusted.
Both the dividend and CAPM approaches are theoretically sound. But
major problems are encountered in the practical application of the
CAPM approach in collecting datawhich may not be readily
available or in a country like India may be altogether absent
regarding expected future returns, the most appropriate estimate of
the risk-free rate and the best estimates of the securitys beta.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-33
Cost of Retained Earnings
The cost of retained earning (k
r
) is equally difficult to
calculate in theoretical terms. Since retained earnings
essentially involves use of funds, it is associated with an
opportunity/implicit cost. The alternative to retained earnings
is the investment of the funds by the firm itself in a
homogeneous outside investment. Therefore, k
r
is equal to
k
e
. However, it might be slightly lower than k
e
in the case of
new equity issue due to flotation costs.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-34
Computation of Overall Cost of Capital
Weighted Average Cost of Capital
Weighted average cost of capital is the expected average
future cost of funds over the long run found by weighting the
cost of each specific type of capital by its proportion in the
firm;s capital structure.
Assignment of Weights
The aspects relevant to the selection of appropriate weights
are:
1) Historical weights
a) Book value weights or
b) Market value weights
2) Marginal Weights
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-35
Historical Weights Historic weights either book or market
value weights are based on actual capital structure
proportion to calculate weights.
Market Value Weights Market value weights use market
values to measure the proportion of each type of capital to
calculate weighted average cost of capital.
Book Value Weights Book value weights use accounting
(book) values to measure the proportion of each type of
capital to calculate the weighted average cost of capital
Marginal Weights Marginal weights use proportion of each
type of capital to the total capital to be raised.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-36
Mechanics of Computation
Example 10: Book Value Weights
(a) A firms after-tax cost of capital of the specific sources is as
follows:
Cost of debt
Cost of preference shares (including dividend tax)
Cost of equity funds
8%
14
17
(b) The following is the capital structure
Source Amount
Debt
Preference capital
Equity capital
Rs 3,00,000
2,00,000
5,00,000
10,00,000
(c) Calculate the weighted average cost of capital, k
0
using
book value weights.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-37
Table 1: Solution Computation of weighted average cost of capital (Book
Value Methods)
Source of funds
(1)
Amount
(2)
Proportion
(3)
Cost (%)
(4)
Weighted cost
(3 x 4)
(5)
Debt
Preference capital
Equity capital
Rs 3,00,000
2,00,000
5,00,000
10,00,000
0.3 (30)
0.2 (20)
0.5 (50)
1.00 (100)
0.08
0.14
0.17
0.024
0.028
0.085
0.137
Weighted average cost of capital 13.7%
An alternative method of determining the k0 is to compute, as shown in Table 2, the total
cost of capital and then divide this figure by the total capital. This procedure obviously
avoids fractional calculations.
TABLE 2 Computation of Weighted Average Cost of Capital (Alternative Method)
Sources Amount Cost (%) Total cost (2 3)
(1) (2) (3) (4)
Debt
Preference capital
Equity capital
Total
Rs 3,00,000
2,00,000
5,00,000
10,00,000
8
14
17
Rs 24,000
28,000
85,000
1,37,000
Weighted average cost of capital = [(Rs 1,37,000 / Rs 10,00,000) x 100] = 13.7 per cent
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-38
Example 11 (Market Value Weights)
From the information contained in Example 10, calculate the weighted average
cost of capital, assuming that the market values of different sources of funds
are as follows:
Source Market value
Debt Rs 2,70,000
Preference shares 2,30,000
Equity and retained earnings 7,50,000
Total 12,50,000
Solution
(1) The determination of the market value of retained earnings presents
operational difficulties. The market value of retained earnings can be indirectly
estimated. A possible criterion has been suggested by Gitman,19 according to
which, since retained earnings are treated as equity capital for purpose of
calculation of cost of specific source of funds, the market value of the ordinary
shares may be taken to represent the combined market value of equity shares
and retained earnings. The separate market values of retained earnings and
ordinary shares may be found by allocating to each of these a percentage of
the total market value equal to their percentage share of the total based on
book values.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-39
On the basis of the foregoing criterion, the sum of Rs 7,50,000 in Example 11 is
allocated between equity capital and retained earnings as follows:
Source of funds Book value Per cent of book value Market value
(1) (2) (3) (4)
Equity shares Rs 4,00,000 80 Rs 6,00,000*
Retained earnings 1,00,000 20 1,50,000**
*(0.8 Rs 7,50,000) **(0.20 Rs 7,50,000)
(2) After the determination of market value, k
0
is calculated as shown in Table 3.
TABLE 3 Computation of Weighted Average Cost of Capital (Market Value Weights)
Sources Market value Cost (per cent) Total cost (3 2)
(1) (2) (3) (4)
Debt Rs 2,70,000 8 Rs 21,600
Preference shares 2,30,000 14 32,200
Equity capital 6,00,000 17 1,02,000
Retained earnings 1,50,000 17 25,500
Total 12,50,000 1,81,300
k
0
= (Rs 1,81,300/Rs 12,50,000) 100 = 14.5 per cent
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-40
Solution The computation is illustrated in Table 4.
TABLE 4 Weighted Average Cost of Capital (Marginal Weights)
Sources of funds Amount Proportion Cost (%) (2 4) Total cost
(1) (2) (3) (4) (5)
Debt Rs 3,00,000 0.60 (60) 8 Rs 24,000
Preference
shares
1,00,000 0.20 (20) 14 14,000
Retained earnings 1,00,000 0.20 (20) 17 17,000
5,00,000 1.00 (100) 55,000
Weighted average cost of capital = (Rs 55,000/Rs 5,00,000) 100 = 11 per cent
Example 12 The firm of Example 10 wishes to raise Rs 5,00,000 for expansion of its
plant. It estimates that Rs 1,00,000 will be available as retained earnings and the
balance of the additional funds will be raised as follows:
Long-term debt Rs 3,00,000
Preference shares 1,00,000
Using marginal weights, compute the weighted average cost of capital.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-41
COST OF CAPITAL PRACTICES IN INDIA
The main features of the cost of capital practices followed by the corporates in India
are as follows:
The most frequently used (67 per cent of cases) discount rate (i.e., minimum
acceptable/required rate of return) to evaluate capital budgeting decision is
based on the overall cost (WACC) of the corporate.
Depending on the risk characteristics of the project, multiple risk-adjusted
discount rates are used by about one-fifth of the corporate enterprises.
The specific cost of capital used to finance the project (i.e. if the discount rate for
a project that will be financed entirely with retained earnings is the cost of
retained funds) is used by one-fourth of the sample corporates.
The CAPM is the most popular method of estimating the cost of equity capital (54
per cent). The Gordons dividend model is equally popular method to compute
the cost of equity capital (52 per cent). The earnings yield approach is used by
one-third of the sample corporates to estimate the cost of equity capital. The use
of the multi-factor model is used by very few corporates (7 per cent).
A significant feature of the methods used to estimate the cost of equity capital is
that while the CAPM is significantly used by the large corporates, the Gordons
discount model is more popular with small firms. Moreover, the highly profitable
corporate (based on ROCE and EAV) give significantly low importance to
dividend yield and earnings yield to compute the cost of equity capital than the
less profitable corporates.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-42
The Government of India (GOI) 10-year bonds are the most widely used risk-free
rate to compute the cost of capital using the CAPM approach. The industry
average beta is the most popular measure of the systematic risk used by the
corporates. Each of the published sources of beta and the self-calculated beta
are also used by about one-fifth of the corporates respectively.
The self-calculated beta is more popularly used by the large and/highly profitable
corporates. The small and low profitable corporates rely more on the published
sources of beta.
The majority of corporates (two-thirds) considers the last 5-year monthly share
price data to estimate the equity beta. The highly profitable firms use weekly
share price data for the purpose.
The average market risk premium (9-10 per cent) is the most widely used
measure by the corporates. The average of historical return and the implied
return on the market portfolio are also fairly popular as an input while using the
CAPM.
As regards the cost of debt, the most widely used method is the interest tax
shield (i.e., tax advantage of interest on debt).
While the majority of the corporates revise their estimates of cost of capital
annually, some of the sample corporates continuously revise it with every
investment.
Apart from project choice criterion, the cost of capital is also used widely for (a)
divisional performance measurement , (b) EVA computation and (c) CVA
computations.
CONTD.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-43
Majority of the sample companies adopt theoretically sound and
conceptually correct basis of determining the cost of capital, namely, the
weighted average cost of long-term sources of finance. However, there is no
systematic procedure followed to compute it. It is more likely to be subjective
in nature. The Indian corporates use of mix of the WACC, marginal cost of
capital of additional funds and management judgment in this regard.
There is wide divergence in the corporate practices as regards the
computation of the cost of equity capital. About one-tenth of the corporates
do not attach any cost to equity capital. Another one-tenth treat the cost of
equity capital as equivalent to primary rate of return available on securities of
balanced mutual funds and debentures issued by blue chip companies.
However, the vast majority of companies (two-thirds of the sample) follow the
conceptually sound methods (i.e. primary rate of return plus risk premium,
dividend valuation model and CAPM) of determining the cost of equity
capital.
About one-fifth of the sample corporates consider retained earnings as a
cost-free source of finance. However, a sizeable proportion of the sample
companies (75 per cent) regard cost of retained earnings either as equivalent
to opportunity cost of using these funds by the corporate/equity-holders or
equal to the cost of equity capital.
CONTD.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-44
SOLVED PROBLEM
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-45
As a financial analyst of a large electronics company, you are required to
determine the weighted average cost of capital of the company using (a) book
value weights and (b) market value weights. The following information is
available for your perusal.
The companys present book value capital structure is:
Debentures (Rs 100 per debenture) Rs 8,00,000
Preference shares (Rs 100 per share) 2,00,000
Equity shares (Rs 10 per share) 10,00,000
20,00,000
All these securities are traded in the capital markets. Recent prices are:
Debentures, Rs 110 per debenture
Preference shares, Rs 120 per share
Equity shares, Rs 22 per share
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-46
Anticipated external financing opportunities are:
(i) Rs 100 per debenture redeemable at par; 10 year maturity, 11 per cent
coupon rate, 4 per cent flotation costs, sale price, Rs 100.
(ii) Rs 100 preference share redeemable at par; 10 year maturity, 12 per cent
dividend rate, 5 per cent flotation costs, sale price, Rs 100.
(iii) Equity shares: Rs 2 per share flotation costs, sale price = Rs 22.
In addition , the dividend expected on the equity share at the end of the year is
Rs 2 per share; the anticipated growth rate in dividends is 7 per cent and the
firm has the practice of paying all its earnings in the form of dividends. The
corporate tax rate is 35 per cent.
Solution: Determination of specific costs:
( )
( )
( ) ( )
( )
( )
( )
( )
( )
( )
17% 0.07
20 Rs
2 Rs
g
f 1 P
D
) (k shares equity of (iii)Cost
12.8% 100
2 95 Rs 100 Rs
10 5 Rs 12 Rs
2 SV RV
N f D
) (k shares preference of (ii)Cost
7.7% 100
2 96 Rs 100 Rs
10 4 Rs 0.35 11 Rs
2 SV RV
N f t) - 1(1
) (k debt, of (i)Cost
0
1
e
m
p
m
d
= + = +

=
=
+
+
=
+
+
=
=
+
+
=
+
+
=
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-47
Using these specific costs we can calculate the book value and market value
weights as follows:
(a) k
0
based on book value weights
Source of capital Book value (BV) Specific cost (k) (%) Total costs [BV () k]
Debentures Rs 8,00,000 7.7 Rs 61,600
Preference shares 2,00,000 12.8 25,600
Equity shares 10,00,000 17.0 1,70,000
20,00,000 2,57,200
k
0
= Rs 2,57,200/Rs 20,00,000 = 12.86 per cent
(b) k
0
based on market value weights
Source of capital Market value
(MV)
Specific cost (k) (%) Total costs [MV () k]
Debentures Rs 8,80,000 7.7 Rs 67,760
Preference shares 2,40,000 12.8 30,720
Equity shares 22,00,000 17.0 3,74,000
Total capital 33,20,000 4,72,480
k
0
= Rs 4,72,480/Rs 33,20,000 = 14.23 per cent
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-48
MINI CASE
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-49
Mr Aggarwal recently attended an investors meet in Mumbai
wherein he came across some brokers who advised him to
measure the systematic risk of shares using beta before finally
investing money in the same. Mr. Aggarwal picked the old
financial newspapers and prepared the following table
containing the data of equity share prices of Infotech Limited,
Cantaxy Limited and S&P CNX Nifty, collected on the last trading
day of the month for the last thirteen months.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-50
Date Share price of
Infotech Ltd
Share price of
Cantaxy Ltd
S&P CNX
Nifty
February 28 Rs 115 Rs 28 976
March 29 125 26 985
April 30 140 21 991
May 31 167 20 1035
June 28 189 20 1049
July 31 177 15 989
August 30 142 19 977
September 30 121 21 965
October 31 102 32 956
November 29 94 29 951
December 31 102 31 957
January 31 126 28 962
February 28 149 39 975
Calculate beta for Infotech Limited and Cantaxy Limited. Use S&P CNX Nifty data as
a proxy for market portfolio and comment.
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-51
Solution


Y = Return on security
X = Return on market portfolio (index)
N = Total number of observations
X = (Market index level on last trading day of t month Market index
level on last trading day of t 1 month) 100]/Market index
level on last trading day of t 1 month.
Y = Price of share on last trading day of t month Price of share on
last trading day of t 1 month) 100)/Price of share on last
trading day of t 1 month.
( )( )
( )
2
2
X X N
Y X N
BETA
E E
E E E
=

- XY
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-52
Determination of beta in respect of equity shares of Infotech Limited
Date Infotech
limited
S&P
CNX
Nifty
Return on
Infotech limited
Return on
Nifty index
Y X X Y X
2
February 28
March 29
April 30
May 31
June 28
July 31
August 30
September 30
October 31
November 29
December 31
January 31
February 28
115
125
140
167
189
177
142
121
102
94
102
126
149
976
985
991
1035
1049
989
977
965
956
951
957
962
975
8.70
12.00
19.29
13.17
6.35
19.77
14.79
15.70
7.84
8.51
23.53
18.25
0.92
0.61
4.44
1.35
5.72
1.21
1.23
0.93
0.52
0.63
0.52
1.35
8.02
7.31
85.63
17.82
36.32
23.99
18.16
14.64
4.10
5.37
12.29
24.67
0.85
0.37
19.71
1.83
32.72
1.47
1.51
0.87
0.27
0.40
0.27
1.83
Sum 38.99 0.21 258.33 62.10
Average 3.25 0.02
Observations (N) 12
BETA = 12 258.33 (0.21 38.99)/12 62.10 (0.21 0.21) = 4.15
Tata McGraw-Hill Publishing Company Limited, Financial Management
11-53
Determination of beta in respect of equity shares of Cantaxy Limited
Date Cantaxy
limited
S&P CNX
Nifty
Return on
Infotech
limited
Return on
Nifty index
Y X X Y X2
February 28
March 29
April 30
May 31
June 28
July 31
August 30
September 30
October 31
November 29
December 31
January 31
February 28
Sum
Average
Observations
(N)
28
26
21
20
20
15
19
21
32
29
31
28
39
976
985
991
1035
1049
989
977
965
956
951
957
962
975

7.14
19.23
4.76
0.00
25.00
26.67
10.53
52.38
9.38
6.90
9.68
39.29
60.57
5.05
12

0.92
0.61
4.44
1.35
5.72
1.21
1.23
0.93
0.52
0.63
0.52
1.35
0.21
0.02

6.59
11.71
21.14
0.00
142.99
32.36
12.93
48.85
4.90
4.35
5.06
53.09
66.70

0.85
0.37
19.71
1.83
32.72
1.47
1.51
0.87
0.27
0.40
0.27
1.83
62.10
BETA = 12 66.70 (0.21 60.57)/12 62.10 (0.21 0.21) = 1.06
Comment: Since the beta of Infotech Limited is substantially higher (4.15) than that of
Cantaxy Limited (1.06), the equity shares of Infotech Limited are evidently more risky
compared to those of Cantaxy Limited.