MEANING

The cost of capital of a firm is the minimum rate of

return expected by investors. A decision to invest in a particular project depends upon the cost of capital of the firm or the cut-off rate which is the minimum rate of return expected by the investors. The main objective is to achieve wealth maximization, a firm must earn a rate of return more than its cost of capital. Higher the risk involved in business, higher is the cost of capital

DEFINITION
In the words of Hunt, William and Donaldson

Cost of capital for a firm may be defined as the rate that must be earned on the net proceeds to provide the cost of elements of the burden at the time they are due.

It must include three aspects

Cost of capital is not a cost as such

It is the minimum rate of return that a firm requires to earn from its projects. It is the minimum rate of return Which will at least maintain the market value of the firm. It comprises of three components 1. Expected Normal rate of return at zero risk level 2. The premium of the business risk 3. The premium for financial risk on account of pattern of capital structure

SIGNIFICANCE OF COST OF CAPITAL

As an Acceptance Criterion in Capital Budgeting

It helps in estimating the total capital budget, if the present value of expected returns are more then the project is likely to be accepted.
As a Determinant of Capital Mix in Capital Structure

decisions While designing the optimal capital structure, the management has to keep in mind the objective of maximizing the vale of firm and minimizing the cost of capital.

 As a Basis for Evaluating the Financial Performance

Evaluate the financial performance of the top management. Actual cost of capital is compared to projected cost of capital.
As a Basis for taking other Financial Decisions

Dividend policy, making the right issue and working capital decisions etc

Problems in Determination of Cost of Capital

Conceptual controversies regarding the relationship

between the cost of capital and the capital structure. Net Income Approach VS Net Operating Income
Historic Cost and Future Cost (Concept of Cost itself )
Problems in computation of cost of equity Problems in computation of cost of retained earnings Problems in assigning weights

A)

COMPUTATION OF COST OF SPECIFIC

SOURCE OF FINANCE

Cost

of Debt

Cost of Perpetual/Irredeemable Debt The cost of debt is the rate of interest payable on debt i. Before Tax Kdb = I/P Where, Kdb= Before tax cost of debt I= Interest P=Principal

ii. After Tax

Kda = Kdb (1-t)= I/NP (1-t) Where, Kda= After tax cost of debt t=Rate of tax

QUESTIONS
1.

X Ltd issues Rs. 50000 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital. Kda = I/NP (1-t) = 4000/50000 (1-0.5) = 4000/50000 * 0.5 = 4%

DO SOLVE
2. Y Ltd issues Rs 50000 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute the cost of debt capital. Ans: 2.91% 3. A Ltd issues Rs 50000 8% debentures at a discount of 5%. The tax rate is 50%. Compute the cost of debt capital. Ans: 4.21%

2.

Kda = I/NP (1-t) = 4000/(50000+5000) (1-0.6) = 4000/55000 *0.4 = 2.91%

3.

Kda = I/NP (1-t) = 4000/(50000-2500) (1-0.5) = 4000/47500 *0.5 = 4.21%

Cost of Redeemable Debt The debt that is issued to be redeemed after a certain period the life time of a firm.

Short Cut method i. Before tax Kdb = I+ 1/n(RV-NP) (RV+NP) Where, I= Annual Interest n=number of years to be redeemed RV= Redeemable value of Debt NP= Net proceeds of Debentures

ii. After tax

Kda = I(1-t)+ 1/n(RV-NP) (RV+NP) Where, I= Annual Interest t=tax rate n=number of years to be redeemed RV= Redeemable value of Debt NP= Net proceeds of Debentures

QUESTIONS
1.

A Company issues Rs 10,00,000 10% redeemable debentures at a discount of 5%. The costs of floatation amount to Rs 30000. The debentures are redeemable after 5 years. Calculate before tax and after tax cost of debt assuming a tax rate of 50%.

Before Tax Kdb = I+ 1/n(RV-NP) (RV+NP)

= 100000+1/5(1000000-920000) (1000000+920000) = 12.08% NP= 1000000- 50000(discount)-30000(floatation) After Tax Kda = I(1-t)+ 1/n(RV-NP) (RV+NP) =100000(1-0.5)+1/5(1000000-920000) (1000000+920000) = 6.875%

DO SOLVE
2. A 5 year Rs 100 debenture of a firm can be sold for a net price of Rs 96.50. The coupon rate of interest is 14% per annum and the debenture will be redeemed at 5 per cent premium on maturity. The firms tax rate is 40 per cent. Compute before and after tax cost of debenture. Ans: 15.58% and 10.025%

 Cost

of Preference Capital

A fixed rate of dividend is payable on preference shares. Dividends are usually paid regularly on preference shares except when there are no profits to pay them. Kp = D/P Where, Kp-Cost of Preference Capital D-Dividend, P-Preference share capital In case of Premium or Discount Kp = D/NP, (NP-Net Proceeds)

Redeemable Preference Shares Preference shares are issued which redeemed or cancelled on maturity date.

can

be

Kpr=D+(MV-NP)/n (MV+NP) Where, Kpr=Cost of Redeemable PreferenceCapital D= Annual Preference Dividend MV= Maturity Value NP=Net Proceeds of Preference Share

QUESTIONS
1.

A company issues 10,000 10% Preference Shares of Rs 100 each. Cost of issue is Rs 2 per share. Calculate cost of preference share if these shares are issued (a) at par (b) at a premium of 10% at a discount of 5% Kp= 100000 *100 (1000000-20000)

(a)

=10.2%

(b)

Kp= 100000 *100 1000000+100000-20000 =9.26%

Kp=

100000 *100 1000000-50000-20000

=10.75%

DO SOLVE
2. A company issues 10000 10% preference shares of Rs 100 each redeemable after 10 years at a premium of 5%. The cost of issue is Rs 2 per share. Calculate the cost of preference capital Ans: 10.54% 3. A company issues 1000 7% Preference shares of Rs 100 each at a premium of 10% redeemable after 5 years at par. Compute the cost of preference capital Ans: 4.76%

Cost of Equity Share Capital

The cost of equity is the maximum rate of return that a company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock Dividend Yield Method/ Price Ratio Method Stable earnings and dividend policy over a time Ke= D/NP or D/MP Where, Ke= Cost of Equity Capital D= Expected Dividend per share NP= Net proceeds per share MP= Market Price per share

QUESTIONS
1.

A company issues 1000 equity share of Rs 100 each at a premium of 10%. The company has been paying 20% dividend to equity share holders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs 160? Ke= D/NP or D/MP Ke= D/NP Ke= D/MP =20/110 *100 = 20/160 *100 =18.18% = 12.5%

Dividend Yield Plus Growth in Dividend Method When dividends are expected to grow at a constant rate and the dividend pay out ratio is constant. Ke= (D1/NP) + G = D0 (1+g) + G NP/MP Where, Ke= Cost of Equity Capital D1= Expected Dividend per share at the end of a year NP= Net proceeds per share G= Rate of Growth of Dividends MP= Market Price per share

QUESTIONS
1.

A company plans to issue 1000 new shares of rs 100 each at par. The floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares. If the current market price of an equity share is Rs 150, calculate the cost of existing equity share capital. Ke = D0 (1+g) + G NP/MP

Ke =

D1 + G NP = 10/(100-5) *100 +5% =15.53%

Ke =

D1 + G MP =10/150 *100 + 5% = 11.67%

DO SOLVE
1.

(a)

(b)

Your companys share is quoted in the market at Rs. 20 currently. The company pays a dividend of Re 1 per share and the investors market expects a growth of 5 % per year. Compute the companys equity cost of capital If the anticipated growth rate is 6% p.a Calculate the indicated market price per share.

Ans: 10%, Rs. 26.5

Cost of Retained Earnings The cost of retained earnings may be considered as the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities. Kr = D1 +G NP/MP Where, Kr= Cost of Retained Earnings D= Expected Dividend per share G=Growth Rate NP= Net proceeds of Equity Issue MP= Market Price per share

Adjustments for tax and costs of purchasing new securities Kr = D1 + G (1-t) (1-b) NP/MP

where, t= tax rate b=brokerage cost

QUESTIONS
1.

A firms Ke (return available to shareholders) is 15%, the average tax rate of shareholders is 40% and it is expected that 2% is the brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings. Kr = Ke (1-t) (1-b) = 15% (1-0.4) (1-0.02) = 8.82%

DO SOLVE
2. A firms Ke (return available to shareholders) is 12%, the average tax rate of shareholders is 60% and cost of retained earnings is 9.75%. What must be the brokerage cost that the shareholders must pay for investing their dividends in alternate securities? Ans: 0.979%

B) COMPUTATION OF WEIGHTED AVERAGE

COST OF CAPITAL

Weighted Average Cost of Capital is the average cost of the costs of various sources of financing. It is also known as Composite cost of capital, Overall cost of Capital or 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 (MV or BV) to the specific costs of capital in proportion of the various sources of fund to the total. Kw= XW W X= Cost of specific sources of finance, W=Proportion of finance

QUESTIONS 1. A firm has the following capital structure and after-tax costs for the different sources of funds. Find the Weighted Average cost
Sources of Funds Debt Preference Shares Equity Shares Retained Earnings TOTAL Amount (Rs) Proportion % After-tax cost % 5 10 12 11

1500000 1200000 1800000 1500000 6000000

25 20 30 25 100

Solution:
Sources of Funds Proportion % (W) After-tax cost % (X) XW/100

Debt
Preference Shares Equity Shares

25
20 30

5
10 12

1.25
2.00 3.60

Retained Earnings
WEIGHTED AVERAGE COST

25
100

11

2.75
9.60%

DO SOLVE
2. Calculate the weighted average cost of capital (before tax and after tax) from the following information. Assume that the tax rate is 55%.
Type of Capital Proportion in New Capital Structure %
25 10 50 15

Before-tax Cost of Capital %

24.44 27.29 7.99 18.33

Equity Capital Preference Capital Debt Capital Retained Earnings

Ans:15.58%,13.39%