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Appendix B

COST OF CAPITAL
THE cost of capital of a firm is the minimum rate of return which the firm must
earn on its investments in order to satisfy the expectations of investors who
provide funds to the firm. It is the weighted average of the cost of various
sources of finance used by it. The method of computing the cost of capital is to
compute the cost of each type of capital and then find the weighted average of all
types of costs of capital. In other words, two steps are involved in determination
of cost of capital of a firm: (i) computation of cost of different sources of capital,
and (ii) determining overall cost of capital of the firm. For example, a company’s
capital structure is as follows:
14 per cent debentures of Rs. 10,00,000, 12 per cent Preference share capital
Rs. 5,00,000, Equity share capital Rs. 5,00,000. It is assumed that equity
shareholders of such companies expect 14 per cent dividend. Total capital Rs.
20,00,000. Income tax rate 30%. CDT 15%

Total cost = {(98,000 debenture interest taking tax saving at the rate of 30%) +
(69,000 preference dividend and corporate dividend tax) +( 80500 equity
dividend and corporate dividend tax)} = 2,47,500

2,47,500
Cost of capital = ———— × 100 = 12.375 %
20,00,000

This company should earn a minimum rate of return of 12.375 per cent on its
investments in various projects in order to satisfy the expectation of investors
who have provided funds to it. (Surcharge and education cess ignored)

Q .No.
.No. 1:
1: In considering the most desirable capital structure for a company, the
following estimates of cost of debt and equity capital (after tax) have been made
at various levels of debt-equity mix :

Debt as % of total Cost of Debt Cost of Equity

Capital Employed (%) (%)
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0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0
You are required to determine the optimal debt equity mix by calculating
composite cost of capital. Ignore corporate dividend tax.

Answer
Debt as % of total CE Overall cost of capital ( Ko) (%)
0 12.00
10 0.10(5.00) + 0.90(12.00) = 11.30
20 0.20(5.00) + 0.80(12.50) =11.00
30 0.30(5.50) + 0.70(13.00) = 10.75
40 0.40(6.00) + 0.60(14.00) = 10.80
50 0.50(6.50) + 0.50(16.00) = 11.25
60 0.60(7.00) + 0.40(20.00) = 12.20
RECOMMENDATION : DEBT : 30%

COMPUTATION OF COST OF DIFFERENT SOURCES OF CAPITAL

Cost of Debt
Cost of debt is that discounting rate at which present value of all future net cash
flows is equal to net cash inflow at the time of raising the debt.

EXAMPLE A

A company raised a debt of Rs.1,00,000 on 1.1.2001, issue expenses Rs.10,000,

interest rate 20 per cent, debt repayable in five equal installments with interest
issue expenses allowed out of taxable income of first year, interest allowed as
deduction out of taxable income of relevant year. Tax rate 50 per cent. Cash
flows are as follows:

01.01.2001 Rs.90,000 Inflow (Received Rs.1,00,000 as loan minus Issue

expenses Rs.10,000).
31.12.2001 Rs.25,000 Outflow (Repayment Rs.20,000 plus interest
Rs.20,000 minus tax saving on issued expenses Rs.5,000
minus tax savings on interest Rs.10,000).
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31.12.2002 Rs.28,000 Outflow (Repayment Rs.20,000 plus interest
Rs.16,000 minus tax savings on interest Rs.8,000).
1.12.2003 Rs.26,000 Outflow (Repayment plus interest minus tax
savings on it).
31.12.2004 Rs.24,000 Outflow – do –
31.12.2005 Rs.22,000 Outflow – do –
Here cost of capital is that discount rate at which present value of all future cash
outflows (Rs.25,000 of 31.12.2001, Rs.28,000 of 31.12.2002, Rs.26,000 of
31.12.2003, Rs.24,000 of 31.12.2004 and Rs.22,000 of 31.12.2005) would be
equal to Rs.90,000. Finding of this rate involves following steps:

(i) Find fake pay back period on the basis of average cash outflows. Average
cash flow = (25,000 + 28,000 + 26,000 + 24,000 + 22,000) divided by 5 =
Rs. 25,000. Fake pay back period =
90,000/25000 = 3.60
(ii) Locate the figure of fake pay back period in annuity table against loan
repayment period which is 5 years in this example. The corresponding rate
is 12 per cent.
(iii) Discount future cash flows at the rate locate under (ii). If the present value
of future cash flows is more than net cash inflow at the time of raising the
loan (i.e., Rs. 90,000 in this example), discount future cash flows at higher
rate than the rate located under (ii). If the present value of future cash
flows is less than net cash inflow at the time of raising the loan, discount
the future cash flows at a rate lower than the rate located under (ii) above.
Present value of future cash flows at 12 per cent.
25,000 × .893
28,000 × .797
26,000 × .712
24,000 × .636
22,000 × .567
——–
90,891
——–

As present value of future net cash outflows is more than net cash flow at the time of
raising the loan, we shall go for a higher rate. Let the rate be 17 per cent.
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25,000 × .855
28,000 × .731
26,000 × .624
24,000 × .534
22,000 × .456
——–
80915
——–
(iv) Cost of Debt
Lower rate NPV
= Lower rate + —————————————— × Diff. in rates
Lower rate NPV – Higher rate NPV

– 891
= 12 + —————— × 5 = 12.45 per cent
– 891 – 9085
There are three different situations regarding computation of cost of debt. (1)
Irredeemable debts, (2) Debts redeemable after certain period in lump sum, (3)
Debts redeemable in installments. The above explained method of calculation of
cost of debt is quite lengthy and complicated. It is unavoidable in third situation,
i.e., debts redeemable in installments. In first two situations, almost similar
results can be obtained by simple formula given below:
Irredeemable debt:
Annual interest (1 - Tax rate)
Cost of debt =————————————------× 100
Net proceeds of debt
Debt redeemable after certain period:
(RV – NP)
Annual Int. (I – T) + —————
N
Kd =————————————————————— × 100
NP + RV
———
2
Kd = Cost of debt T = Tax rate
RV = Redeemable value of debt
NP = Net proceeds of debt issue
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N = Term of debt, i.e., numbers of years for which debt would be
outstanding after issue.
Q. No. 2: A company has 10 per cent non-redeemable debentures of
Rs.5,00,000. Tax rate 40 per cent. Determine cost of capital if debt has been
issued: (i) at par, (ii) at 10 per cent discount, and (iii) at 20 per cent premium.

Answer :
(i) Kd [ 50,000(1-0.40)/ 5,00,000] x 100 = 6.00%
(ii) Kd [ 50,000(1-0.40)/ 4,50,000] x 100 = 6.67%
(iii) Kd [ 50,000(1-0.40)/ 6,00,000] x 100 = 5.00%

Q. No. 3: A company issued Rs.80,000 12 per cent debentures of Rs.100 each. Tax 40 per
cent, redeemable after 10 years. Floating cost 10 per cent of issue price. Find cost of capital if
issued at: (i) par, (ii) 10 per cent discount, and (iii) 10 per cent premium.

Answer
(i) [12(1 – 0.40)] + [(100 -90)/10]
Kd ---------------------------- x 100 = 8.63%
[ (100 + 90 ) / 2 ]
(ii) [12(1 – 0.40)] + [(100 -81)/10]
Kd ---------------------------- x 100 = 10.06%
[ (100 + 81 ) / 2 ]
(iii) [12(1 – 0.40)] + [(100 -99)/10]
Kd ---------------------------- x 100 = 7.34%
[ (100 + 99 ) / 2 ]

Q. No. 4: A company has issued 20 per cent debentures of Rs. 1,00,000. The
floating cost 10 per cent. The company has agreed to repay the debt in five equal
installments starting at the end of first year. Tax 50 per cent. Cost of capital?
Answer : See Answer to Example A
Cost of preference share capital: Calculated exactly in the same way in which
cost of debt capital is calculated with two changes: (i) No tax saving on payment
of preference dividend, and (ii) Payment of corporate dividend tax.

COST OF EQUITY SHARE CAPITAL

The computation of the cost of equity share capital is quite complex because
there are no fixed contractual payment for equity share capital as there are for
debt and preference share capital.
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It is taken as the rate of return expected by equity shareholders. Herein lies
the major difficulty in estimating this cost. How to estimate the expectations of
equity shareholders? Here market price of shares provides help to us. Market
price of share is function of the return that the shareholders expect and they are
likely to get Hence we estimate “the rate of return expected by equity
shareholder,” (i.e., cost of equity share capital) with the help of market price of
shares and what shareholders are likely to get. There are three methods
regarding estimating the cost of equity capital: (i) Dividend price ratio, (ii)
Dividend price ratio plus growth, and (iii) Earning price ratio. None of these three
methods is free from limitations, yet we use them to get reasonable estimate of
cost of equity capital.
Dividend Price Ratio
The theme of this method is that market price of equity share is equal to present
value of future infinite stream of dividends. Accordingly, cost of equity capital is
that discounting rate at which present value of all future dividends is equal to
current market price of share. Hence, given current market price of shares and
future stream of dividends, we can calculate cost of equity capital. This method
assumes that the company will not earn on its retained earnings and that the
retained earnings will results neither in appreciation of market price of share nor
an increase in dividends. In other words, the method assumes dividend per share
to be same year after year.
D D D
P = ———— + ————+ ———— + ..........................∞.
(1 + Ke )1 (1 + Ke )2 (1 + K )3
e

D
———
1 + Ke
P = ——————
1
1 – ———
1 + Ke

D D
P = —– Ke = —
Ke P

Ke = Cost of equity capital

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D = Dividend per share
F = Market price per share

Suppose market price of an equity share (face value Rs.100) is Rs.125 and
dividend per share is Rs.15, cost of equity capital

15
= —– = 0.12. = 12%
125
This method may be used when (i) pay out ratio is 100 per cent, and
(ii) business conditions are to remain stable, with the result that dividend per
share is likely to remain stable year after year.
Dividend Price Ratio plus Growth Method (Gordon-
(Gordon-Shapiro Model)
Model
While dividend price ratio method (discussed above) assumes constant amount of
dividend per share year after year, this method (D/P + growth) assumes dividend
per share to change year after year at constant rate. This rate of change of
dividend is estimated by adjusting “the average rate of change of dividend in the
past” by possible future variations.

D1 D1 (1 + g) D1 (1 + g)2
P = ———— + ————– + ————– + ...........................
(1 + Ke ) 1 (1 + Ke )2 (1 + K )3
e
D1 D1
P = ——– Ke = —– + g
Ke – g P

D1 = Dividend per share at the end of first year (after the date on which price
per share is given)
g = Growth rate of dividend
P = Current market price per share
Ke = Cost of equity capital
Q. No. 5: Dividend per share is expected to be Rs.1.20 at the end of year and is
expected to grow at 6 per cent per year perpetually. Determine cost of equity
capital if market price is Rs.24 per share.
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1.20
Answer Ke = ----------- + 0.06 = 11%
24
Q. No. 6: Mr. X has purchased equity shares of a company which paid a dividend
of Rs.5.00 per share last year. The dividends are expected to grow at 6 per cent
for ever. Find cost of equity capital of the company if Mr. X purchased shares at
the rate of Rs.88.33 per share.
5.30
Answer Ke = ----------- + 0.06 = 12%
88.33
Q. No. 7: A company paid a dividend of Rs.3 per share last year. Dividends are
expected to growth at 5 per cent per year for next 5 years and at 6 per cent per
year for ever after that. If required rate of return on equity shares is 10 per cent,
find market price of the shares . Suppose today is 1.4.2007. What will be the
market price on the following dates : 31.3.2008, 1.4.2008, 311.3.2009, 1.4.2009,
31.3.2010 and 1.4.2010.

Answer
P = [3.15(0.909) + 3.3075(0.826) + 3.4729 (0.751) + 3.6465(0.683) +
1 6 2 7
3.8288(0.621)] + 3.8288(1.06) /(1.10) +3.8288(1.06) /(1.10) +
3
3.8288(1.06) /(1.10)
8
…∞
+ …………………
=
6
3.8288(1.06)/(1.10) 2.289
[13.07] + -------------------- = 13.07 + ----------- = 76.03
1.06 0.03636
1 - -------------
1.10
Date Share Price
1.4.2007 76.0300 (Ex 2006-2007 dividend )
31.3.2008 83.6330 (cum 2007-2008 dividend)
1.4.2008 80.4830 (Ex 2007-2008 dividend )
31.3.2009 88.5313 (cum 2008-2009 dividend)
1.4.2009 85.2238 (Ex 2008-2009 dividend )
31.3.2010 93.7462 (Cum 2009-2010 dividend)
1.4.2010 90.2733 (Ex 2009 – 2010 dividend)
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Q No. 8: The MD of Smartdeal Ltd has just attended a meeting with an

investment analyst who has suggested that Smartdeal’s shares are overvalued by
10%. The data used by the investment analyst is shown as below;
Year Total dividend No. of shares Total earnings
2000 1,13,000 57,200 3.65,200
2001 1,22,680 57,200 4,26,400
2002 1,62,160 70,000 5,34,200
2003 2,00,140 80,000 5,72,400
Current share price of Smartdeal’ equity share is Rs.75. Ke. 12%. Are the shares
overvalued? (ICWA Dec. 2004)
Answer
Dividend per share ( 2000) = Rs.1.9755
Dividend per share ( 2003) = Rs.2.5018
g = (2.5018/1.9755)1/3 – 1
= AL[1/3(log2.5018 – log1.9755)] -1
= AL[1/3(0.3982 – 0.2958)] – 1 = 0.081 = 8.10 %
= 1.081 – 1 = 0.081 = 8.10%
2.50(1.081)
P = ------------------ = 69.29
0.12 – 0.081
% overvaluation = (5.71/67.50) x 100 = 8.46%
Q. No. 9 On the basis of the following information:
Current Dividend (D0) = Rs.2,50
Discount rate (k) = 10.50%
Growth rate (g) = 2%
Calculate the present value of stock of ABC Ltd. Is its stock overvalued if the
stock price is Rs.35, ROE =9% and EPS = Rs.2.25? Show the detailed
calculations. ( Nov.2007)
Answer
2.50(1.02)
Value of stock of ABC Ltd. = -------------- = Rs.30
0.1050 – 0.02
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Payout ratio = 2,50/2,25 = 1.1111
b= -0.1111
r = 0.09
g = -0.009999
2.50(1-.009999)
Value of stock: ---------------------- = 21.52
0.1050 – (-0.009999)
The stock is overpriced.
Q. No. 10:
10 A company is contemplating an issue of new equity shares. The
current market price is Rs.225 per share. The dividend per share for last five
years, has been as follows:

2000 Rs.10.70
2001 Rs.10.30
2002 Rs.13.20
2003 Rs.12.10
2004 Rs.14.03
The floating costs are expected to be 5 per cent of issue price which is
Rs.225.
Determine (a) growth rate in dividends, (b) cost of equity capital assuming
growth rate calculated by you, (c) cost of equity capital (new shares).
Teaching Note – not to be given in the exam. When a firm raises capital by
issuing new shares, it has to incur issue expenses. In this case, the rate of return
the firm should earn on net equity raised should be higher than the rate expected
by equity shareholders. The reason is quite simple. The net funds available to
the firm are less than what equity shareholders contribute. For example, if issue
expenses are 5 per cent and shareholders expected 19 per cent, the firm would
be earning on Rs.95 while shareholders would expect return on Rs.100.

Answer;
1/4
Growth rate of dividend = [14.03/10.70] = 7%
14.03(1.07)
Ke = ----------- + 0.07 = 13.67%
225
14.03(1.07)
Ke ( New Issue) = ----------- + 0.07 = 14.02%
225(1-0.05)

Earning Price Ratio

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As per this method, rate of return required by equity shareholders is equal to
E1 /P where E1 = EPS of first year and P = Market price per share. The
advocates of this approach opine that market price of share depends upon EPS
and is not influenced by dividend policy (i.e., payout ratio). If the payout ratio is
low, there would be lower amount of dividend per share in earlier years but it
will result in higher growth in EPS (low payout ratio means higher retained
earnings, which when invested will push up EPS), the consequence of which will
be higher dividend per share with same payout ratio. If payout ratio is higher,
there should be higher dividend per share in earlier years but its consequence
would be lower growth rate of dividend. In other words, lower payout ratio
results in lower dividends in earlier years but higher dividends in later years.
Higher payout ratio results in higher dividends in earlier year but lower growth
rate in dividends later years. Lower dividends of earlier years (in case of low
payout ratio) are compensated by higher dividends of later years. Higher
dividends of earlier years (in case of high payout ratio) get compensated by
lower growth rate of dividends in later year. Market price of the share is present
value of all future dividends (earlier years as well as later years). Hence it is not
influenced by dividend policy, i.e., pay out ratio. It is influenced by EPS. Hence,
under this method rate of return expected by shareholders is estimated with the
help of EPS and market price of share.

COST OF RETAINED EARNINGS

EARNINGS
Retained earnings belong to equity shareholders. Hence, cost of retained
earnings (Kr) is equal to cost of equity (Ke).

OVERALL COST OF CAPITAL

CAPITAL
The overall cost of capital of firm is determined by finding the weighted average
cost of different sources of capital. Weights may be based either on book values
of various components of capital or on present market values of various
components of capital. Book value weights are used to find the Ko of existing
capital. Market value weights are used to find the Ko of funds to be raised.

Q.No.11
Q.No.11:
11 Determine cost of capital using market value weights as well as book
value weights using following data:
Book value of capital structure: Rs.
Debenture (Rs. 1000 each) 16,00,000
Preference shares (Rs. 10 each) 4,00,000
Equity shares (Rs. 100 each) 20,00,000
Market price:
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Debentures Rs.1,100 each
Preference shares Rs.12 each
Equity shares Rs.200 each

Debentures carry 8 per cent interest. Issued at par. Redeemable at par

maturity period 10 years. Floatation cost 10 per cent.
Preference shares carry 10 per cent dividend rate. Issue and redemption at par.
Maturity period 10 years. Floatation cost 10 per cent.
Equity dividend expected at the end of year, i.e., Rs. 20 per share.
Anticipated growth rate in dividends is 5 per cent. Corporate tax 30 %. CDT 15%

Answer
Cost
Debentures [8(1 – 0.30)] + [(100 -90)/10]
---------------------------- x 100 = 6.95%
[ (100 + 90 ) / 2 ]
Preference [1(1 + 0.15)] + [(10 -9)/10]
shares ---------------------------- x 100 = 13.16%
[ (10 + 9 ) / 2 ]
Equity 20
shares ----------- + 0.05 = 15.00%
200

Computation of Overall cost of capital ( Book value weights)

Source of Finance Cost (X) Book Values (W) XW
Debentures 6.95 16L 111.20L
Preference shares 13.16 4L 52.54L
Equity shares 15.00 ( 1.15) 20L 345.00L
∑ W = 40L ∑ XW = 508.74L

Ko = ∑ XW /∑ W = 508.74L / 40L = 12.72%

Computation of Overall cost of capital ( Market value weights)
Source of Finance Cost (X) Book Values (W) XW
Debentures 6.95 17.60L 122.320L
Preference shares 13.16 4.80L 63.168L
Equity shares 15.00 ( 1.15) 40.00L 690.00L
∑ W = 62.40L ∑ XW = 875.488
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Ko = ∑ XW /∑ W = 875.488L / 62.40L = 14.03%

Q. No. 12 : The following items have been extracted from the liabilities side of
balance sheet of XYZ Ltd. as at 31st December 1986.
Paid-up capital: Rs.
4,00,000 equity shares of Rs.10 each 40,00,000
Reserve and surplus 60,00,000
Loans:
15% Non-convertible debentures 20,00,000
14% Loans 60,00,000
Other relevant information:
Year ended Dividend per EPS Market price per share in the
(31st Dec.) share (Rs.) (Rs) beginning of the year (Rs.)
1986 4.00 7.50 50
1985 3.00 6.00 40
1984 4.00 4.50 30
Find weighted average cost using book value weights and earning price ratio
method as basis of cost of equity.
Answer
1/2
Growth rate of EPS = (7.50/4.50) -1= 29.10%
1/2
Growth rate of Market Price = (50/30) -1= 29.10%
7.50(1.291)
Ke = ------------- x 100 = 15%
50(1.291)

Computation of Overall cost of capital ( Book value weights)

Source of Finance Cost (X) Book Values (W) XW
Debentures 10.50 20L 210L
Loan 9.80 60L 588L
Equity shares 15.00 100L 1500L
∑ W = 180L ∑ XW = 2298L

Ko = ∑ XW /∑ W = 2298L / 180L = 12.77%

Q. No. 13:
13 GREG Ltd. paid the following equity dividends over the last five years
:
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2000 20
2001 21
2002 29
2003 23
2004 28
Mr. Pinto is considering buying some shares in GREG as he believes that the
dividend will continue to grow. He requires a return of 17 per cent from this type
of investment. How much should he be prepared to pay if the 2004 dividend has
just been paid?
Answer
1/4
Growth rate of Dividend = (28/20) -1= 8.78%
D1 28(1.0878)
P = ---------- = ------------- = 370.54
Ke – g 0.17 – 0.0878

14 A Ltd. needs finance of Rs.10lakh for meeting its investment plans. It

Q. No. 14:
has Rs.2,10,000 in the form of retained earnings available for investment
purposes. The following are the further details:
1. Debt/equity mix 30%/70%
2. Cost of debt
Up to Rs. 1,80,000 10% (before tax)
Additional amount 16% (before tax)
3. Earnings per share Rs. 4
4. Dividend pay out 50% of earnings
5. Expected growth rate of dividend 10%
6. Current market price per share Rs. 44
7. Tax rate 30%
8. CDT 15%

Compute overall weighted average after tax cost of additional finance.

Answer
2.20
Ke = ------------- + 0.10 = 15%
44

Computation of Overall cost of capital

Source of Finance Cost (X) % Weights (W) XW
Debt 7.00 1.80L 12.600L
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Debt 11.20 1.20L 13.440L
Equity shares 15.00(1.15) 4.90L 84.525L
Retained earnings 15.00 2.10L 31.500L
∑ W = 10L ∑ XW = 142.065
(It is assumed that the return on retained earnings will be provided by issuing
Bonus shares and not by increasing the dividend.)

Ko = ∑ XW /∑ W = 142.065L / 10L = 14.2065%