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# Cost of capital

The rate of return that an organization must earn on its project investment to maintain its market value. Also known as - Cut-off rate - Target Rate - Required rate of return

## Cost of capital - Explicit or Implicit

Explicit Cost The explicit cost is the discount rate that equates present value of inflows with the present value of outflows (similar to IRR).

Implicit Cost Opportunity costs are technically referred to as implicit cost of capital. The rate of return associated with the best investment opportunity that would be forgone is implicit cost.

## Significance of the cost of capital

1)) Evaluating investment decisions and allocating the firms funds 2)) Designing a firms debt policy 3)) Appraising the financial performance of top management

Sources of funds
Equity Shares Preference Shares Term Loans, Debentures and Long term debt Reserves Each carries a cost denoted by K

Cost of Equity Capital (Ke):The cost of equity may be defined as the minimum rate of return that a company that a company must earn on equity shares capital.
Following Methods are used:

## A) Dividend yield method

Ke = D1 Po Where, Ke = cost of Equity Capital D1 = annual dividend per share on equity capital in period 1 (expected dividend) Po = current market price of equity share When the Equity shares are newly issued, the Cost of Capital can be calculated as follows: Ke = D1 NP Where NP = Net proceeds of issue (after deducting floating expenses and discount from Inflows) D1 = expected dividend per equity share

## Sums: Dividend Yield method

Q1) Rihanna ltd is expected to disburse a dividend of Rs.30 on each equity shares of Rs.10 each. The current market price of shares is Rs.80. Calculate the cost of Equity capital as per dividend yield method.

## Solution : D1/Po = 30/80*100 = 37.5%

Q2) Beyonce ltd issued 10,000 shares of Rs.10 each at a premium of Rs 2 each. The company has incurred issue expenses of Rs.5000. The equity shareholders expects the rate of dividend to 18% p.a. Calculate the cost of equity share capital.

## B) Dividend Growth Model

Ke = D1 + g Po Where, Ke = cost of Equity Capital D1 = expected dividend per share Po = CMP of equity share g = growth rate at which dividends are expected to grow per year When Equity shares are newly issued: Ke = D1 + g NP Where, NP = net proceeds

Example: R Ltd is expected to disburse a dividend of Rs.3 on each equity shares of Rs.10 each. The current market price of shares is Rs.8. Calculate the cost of Equity capital if g = 5%
Note: Sometimes the dividend growth model formula for calculation of cost of equity share capital is also written as follows, if the last declared dividend is known: Ke = Do*(1+g) + g Po Where, Ke = cost of Equity Capital Do = Recent/Last dividend paid per equity share g = constant annual growth rate of dividends Po = Current market price per share

Q3) Whitney ltd has its equity shares of Rs.10 each quoted in a stock exchange has market price of Rs.56. A constant expected annual growth rate of 6% and a dividend of Rs.3.60 per Share was paid for the current year. Calculate cost of capital. Solution: 3.60*(1+0.06) +0.06 = 12.81% 56 Q4) Shakira Ltd has its shares of Rs 10 each quoted on the stock exchange, the current market price per share is Rs.24. The gross dividend per share over the last four years have been Rs.1.20, Rs.1.32, Rs.1.45 and Rs.1.60. calculate Ke Solution: First lets find g G = 1.32-1.20/1.20, 1.45-1.32/1.32. etc. Approx 10% Ke = 1.60*(1+0.10) + 0.1 24 = 17.33%

Q5) Amy Lee ltd is an all equity financed company. The CMP of the share is Rs. 180. It has paid a dividend of Rs. 15 per share and expected future growth in dividend is 12%.

Solution:

## Price- earning model

Ke = E M E= current earnings per share { [NPAT-Pref. div] / no. of Equity shares]} M = market price per share

Q6) Celine Dion ltd has 50,000 equity shares of Rs.10 each and its current market value is Rs.45. The after tax profit of the company for the year ended 31st March,2011 is Rs. 9,60,000 . Calculate Cost of capital.
EPS = (960000-0)/50000 = 19.2 Ke = 19.2 / 45 * 100 = 42.67% MPS = 45

## Capital Asset Pricing Model Ke = Rf + i (Rm Rf)

Where,
Rf = risk free rate of return Rm= average market return i = beta of investment or firm

Q7) Janet Jackson ltd is planning to raise money from the capital markets which are expected to give a return (Rm) of 14%. The t-bill going rate is 8%. The beta of the firm is 0.9. Calculate the cost of equity based on CAPM model

## Cost of Preference Capital: Cost of Irredeemable Preference Shares (Perpetual Security)

Kp = Dp NP Where, Kp = Cost of preference share Dp = Expected preference dividend NP = Net proceeds received Issue price of Preference Share

Q8) Kylie Minogue ltd, issues 11% irredeemable preference shares of the face value of Rs. 100 each. Floatation costs are estimated at 5% of the expected sale price. What is the Kp, if preference shares are issued at (i) par value, (ii) 10% premium and (iii) 5% discount.

Solution:
(i) Issued at par: 11 / 100*(1-0.05) * 100 = 11.6 percent

(ii)

Kp =

## Dp + (RV SV) / n {(RV+SV) / 2}

* 100

Where, Kp = cost of preference share Dp = expected dividend at time t RV= Redemption value or Maturity value of preference share (when shares are redeemed/repaid) SV = Sales value or Net proceeds (at time of issue) n = Maturity period
Q9) Avril Lavigne ltd has Rs. 100 preference share redeemable at a premium of 10% with 15 years maturity. The coupon rate is 12%. Floatation cost is 5%. Sale price is Rs. 95 (net). calculate the cost of preference shares. Solution: Kp = 12 + (110-95)/15 (110+95)/2 Kp = ?

## Cost of Debt (Irredeemable / Redeemable)

Cost of Irredeemable debt Before tax cost of debt: Where, Kd = Before tax cost of debt Kd = I / SV I = Annual interest payment SV = Sales proceeds of bonds / debentures (Net proceeds, amount received at time of issue)

Tax adjusted cost of debt Kd = {I / SV} * ( 1- t ) Where, Kd = Tax adjusted cost of debt t = Tax rate

## SV = Sale proceeds of bonds / debentures

Q10 ) Madonna ltd has 10% perpetual debt of Rs.100,000. The tax rate is 35%. Determine the cost of capital (before tax as well as after tax) assuming the debt is issued at (i) par , (ii) 10% discount, and (iii) 10% premium Solution: (i) Debt issued at par: Before tax = 10,000/100,000*100 = 10%, After tax= 10% (1-0.35) = 6.5% (ii) Debt issued at discount: Before tax = 10,000/90,000*100 = 11.11%, After tax= 11.11% (1-0.35) = 7.22% (iii) Debt issued at premium: Before tax = 10,000/110,000*100 = 9.09%, After tax= 9.09% (1-0.35) = 5.91%

## Cost of Redeemable debt

Before tax Kd = I + {(RV SV) / n} (RV + SV) / 2 Where, I = Annual interest payment RV = Redemption value of debentures (amount payable on maturity of debentures) SV = Sale proceeds of debentures (amount received at time of issue) n = Number of years to maturity After tax Kd = I + {(RV SV) / n} x (1-t) (RV + SV) / 2 t = tax rate

Q11) Calculate the explicit cost of debt (after tax) for Annie Lenox limited in each of the following situations:

## (a) (b) (c) (d)

Debentures are sold at par and floatation costs are 5% Debentures are sold at premium of 10% and floatation costs are 5% of issue price Debentures are sold at discount of 5% and floatation costs are 5% of issue price. Assume Interest rate on debentures is 10%, face value is Rs. 100 maturity period is 10 years and tax rate is 35%

## Solution: (a) Kd = [10 + {(100-95)/10} ] / {(100+95)/2} * (1-t) = ?

(b) Kd = [10 + {(100-104.5#)/10} ] / {(100+104.5)/2} * (1-t) = ? [# 100+10%-5%of 110] (c) Kd = [10 + {(100-90.25#)/10} ] / {(100+90.25)/2} * (1-t) = ? [#100-5% - 5%of 95]

## Cost of Retained Earnings

Opportunity cost approach Kr = D (1- t) or Kr = Ke (normally used) Where, Kr = cost of retained earning

D = rate of dividend

## t = tax rate of dividend

Q12) Neely limited has paid dividend on equity share @ 24%. The tax rate is 35%. Calculate cost of retained earnings. Solution = 0.24 x (1-0.35) *100 = 15.6%

## Weighted Average Cost of Capital

CIMA defines WACC as the average cost of the company's finance (equity, preference and debt) weighted according to the proportion each element bears to the total pool of capital WACC = (Cost of equity x % of Equity) + (Cost of debt x % of debt) Ko = Kd (1-T) Wd + KeWe Ko = Kd (1-T)* D + Ke* E D+E D+E OR
Where, Ko = Weighted average cost of capital Kd (1-T) = After tax cost of debt Ke = Cost of Equity D = amount of debt E = amount of equity

Two approaches: Book Value based and Market value based Example: Q13 ) The required rate of return on equity is 16% and cost of debt is 12% . The firm has a capital structure mix of 60% equity and 40% debt. What is the overall rate of return the firm Gwen ltd should earn? Solution: WACC = (0.16*0.6)+(0.12*0.40) = 14.4%) Q14) Stefani ltd has a capital gearing ratio of 40%. Its cost of equity is 21% and cost of debt is 15%. Compute WACC Solution: WACC = (0.21 * 0.60) + (0.15 * 0.40)

Q15) Sheena Cements ltd has given you the following capital structure, Calculate WACC based on book values and market values. Cost of capital is net of tax.

## Sources Equity Preference Debentures

Market Values 80 30 40

## Book Values 120 20 40

Cost (%) 18 15 14

WACC based onMarket values Sources Market Values Equity Preference Debentures Total 80 30 40 150 0.533333 0.2 0.266667 1 Cost (%) 18 15 14 47 9.6 3 3.733333 WACC =16.333 WACC

WACC based onMarket values Sources Book Values Equity Preference Debentures Total 120 20 40 180 0.666667 0.111111 0.222222 1 Cost (%) 18 15 14 47 12 1.666667 3.111111 16.77778 WACC

WACC = 16.78%

Q16) Britney Spears limited is considering raising of funds of about Rs. 100 lakhs by one of the two alternative methods viz., 14% institutional term loan and 13% non-convertible debentures. The term loan option would attract no major incidental cost. The debentures would have to be issued at a discount of 2.5% and would involve a cost of issue of Rs. 1 lakh. You are to advise the company as to the better option based on the effective cost of capital in each case. Assume a tax rate of 50%. (CA Final 1991)
Solution: Evaluation of Raising Rs. 100 lakhs based on Effective cost of capital (Amount in Lakhs)

Particulars FV less: discount less: cost of issue Net amount raised Interest charges Less: savings in Interest `@ 50 % tax rate Net Interest cost Effective cost of capital

## 7 6.5 7 6.5 7% 6.74% `(7/100)*100) `(6.50/96.5)*100)

Recommendation: the cost of capital is lower i.e. 6.74%, if company raises 13% non-convertible debentures (NCDs) and hence it is suggested to issue NCDs and raise funds.

## See hand out for more sums..

Caselet: Aries limited wishes to raise additional finance of Rs. 10 lakhs for meeting its investment plans. It has Rs. 210,000 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 180,000, 10 percent (before tax); beyond 180,000. 12 percent (before tax) 3. EPS = Rs. 4 per share (paid) 4. Dividend payout, 50 percent of earnings 5. Expected growth rate in dividend, 10 per cent 6. CMP = Rs. 44 (on BSE). 7. Tax rate = 35% YOU are required to (a) determine the pattern for raising the additional finance, assuming the firm intends to maintain existing debt-equity mix (b) to determine post tax average cost of additional debt (c) to determine cost of retained earnings and cost of equity (d) compute overall cost of capital after tax of additional finance Solution: (a) Pattern for raising additional finance: Debt = 0.3*10L = Rs. 3 Lakh; Equity: 0.7*10 L = Rs. 7 Lakh Break up of Source of Funds: Retained Earnings 210,000 + Equity (b.f.) 490,000 = Total Equity Funds = Rs. 700,000 Debt funds (Rs 300,000): 10% debt = 180,000 + 12% debt 120,000 = Total = Rs. 300,000 (b) Kd = I / NP x (1-t) : (18000+14400)/300,000 (1-0.35) = 7.02% (c) Ke = Rs 4(50%) (1+0.10) + 0.10 = 15% Kr = Ke = 15% Rs. 44 (d) Overall cost (WACC)

Source Amount Proportion Post-tax cost Total cost Equity 490000 0.49 0.15 0.0735 Retained 210000 0.21 0.15 0.0315 Debt 300000 0.3 0.0702 0.02106 1000000 1 total cost = 0.12606

Practice Questions
Ques 1 A company issues 11% debentures of Rs.100 for an amount aggregating Rs.1,00,000 at 10% discount, redeemable at par after 5 years. The companys tax rate is 35%. Determine the cost of debt. Ques 2 Calculate the explicit cost of debt for each of the following situation: a) Debentures are sold at par and floatation costs are 5% of issue price. b) Debentures are sold at premium of 10% and floatation costs are 5% of issue price. c) Debentures are sold at discount of 5% and floatation costs are 5% of issue price. Note: Coupon rate of interest on debentures is 10% Face Value of debentures is Rs.100, Maturity period is 10 years Tax rate is 35% , Redemption at Par Ques 3 Compute the cost of Preference shares sold at Rs.100 with 9% dividend and a redemption price of Rs.110 if the company redeems it in 5 years.

Ques 4 Calculate the cost of an ordinary share selling at a current market price of Rs.120 and paying dividend of Rs.9 per share which is expected to grow at a rate of 8%.

Ques 5 From the following information, determine the cost of equity capital using the CAPM approach: a) Required rate of return on risk-free security is 8% b) Required rate of return on market portfolio of investment is 13% c) The firms beta is 1.6

Ques 6 Investors require a 12% rate of return on equity shares of company Y. What would be the market price of the shares if the dividend for the previous year was Rs.2 and investors expect dividends to grow at a constant rate of i) 4% , (ii) 0% (iii) -4% (iv) 11%
Ques 7 A mining companys iron ore reserves are being depleted and its cost of recovering a declining quantity of iron ore are rising each year. As a consequence, the companys earnings and dividends are declining at a rate of 8% per year. If the previous years dividend was Rs.10 and the required rate of return is 15%, what would be the current price of the equity share of the company? Ques 8 A company has on its books the following amounts and specific costs of each type of capital: Capital Book Value Market Value Specific Cost (%) Debt Rs.4,00,000 Rs.3,80,000 5 Preference 1,00,000 1,10,000 8 Equity 6,00,000 12,00,000 15 Retained Earnings 2,00,000 13 13,00,000 16,90,000 Determine the weighted average cost of capital using (i) Book value weights (ii) Market value weights Note: Market value is for Equity and Retained Earnings together.

Ques 9 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: 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 All these securities are traded in the capital markets. Recent market prices are: Debentures Rs.110 per debenture Preference share Rs.120 per share Equity shares Rs.22 per share Additional details: (i) Rs.100 per debenture redeemable at par; 10 year maturity, 11% interest rate, 4% floatation cost, sale price Rs.100 (ii) Rs.100 preference share redeemable at par; 10 year maturity, 12% dividend rate. 5% floatation cost, sale price Rs.100 (iii) Equity shares Rs. 2 per share is the floatation cost & issue price is 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% and the firm has the practice of paying all its earnings in the form of dividends. The corporate tax rate is 35%.

## Cost of Capital Practices in India

The most frequently used (67% cases) discount rate to evaluate capital budgeting decision is based on the overall cost (WACC) of the corporate.

Depending upon the risk characteristics of the project, multiple risk-adjusted discount rates are used by about 1/5th of corporate enterprises in India The CAPM model is most popular method of estimating the cost of equity (54% cos.) The Gordon`s dividend model is equally popular method to compute the cost of equity (52% cos.) As regards debt, the cost of debt, the most widely used method is the interest tax shield method