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Cost of Capital

Cost of Capital
The CoC of a firm is the minimum rate of return expected by its
investors.

Capital used by a firm may be in the form of Debt, preference capital,


retained earnings and equity shares.
Cost of Capital
A decision to invest in a particular project depends upon the cost of
capital (CoC) of the firm or the cut-off rate which is the minimum rate
of return expected by the investors.

To achieve the objective of wealth maximization, a firm must earn a


rate of return more than its CoC.
Cost of Capital
CoC is not a cost as such, in fact, it is the RoR that a firm requires to
earn from its projects.

K = r0 + b + f

K = Cost of capital
r0 = Normal rate of return at zero risk level
b = premium for business risk
f = premium for financial risk
Significance of Cost of Capital
1. As an acceptance criterion in capital budgeting: Present value of
expected returns is calculated by discounting the expected cash flows
at cut-off rate (i.e. CoC).
2. As a determinant of capital mix in capital structure decisions:
measurement of CoC is essential in planning the capital structure of
any firm.
3. As a basis for evaluating the financial performance: Comparison
actual profitability of the project with the projected CoC.
4. As a basis for taking other financial decisions: i.e. dividend policy,
working capital.
Cost of Capital
• Cost of loan/debt
• Cost of preference
• Cost of Equity
• Cost of retained earnings
Cost of Debt
• Irredeemable/Perpetual Debt: Debt that cannot be redeem.
Before-tax cost of debt
After-tax cost of debt

• Redeemable Debt
Before-tax cost of debt
After-tax cost of debt
Cost of Debt/Loan
Irredeemable
Before-tax cost of debt
Kd = Interest / Amount Received

After-tax cost of debt


Kd = Interest (1- tax rate) / Amount Received
Sum 1:
a) X ltd. Issues Rs. 50,000, 8% debentures at par. Compute the cost of
debt.

b) X ltd. Issues Rs. 50,000, 8% debentures at par. The tax rate


applicable to the company is 50%. Compute the cost of debt.
Sum 2:
Y ltd. Issues Rs. 50,000, 8% debentures at a premium of 10%. The tax
rate applicable to the company is 60%. Compute the cost of debt.
Sum 3:
A ltd. Issues Rs. 50,000, 8% debentures at a discount of 5%. The tax rate
applicable to the company is 50%. Compute the cost of debt.
Sum 4:
A ltd. Issues Rs. 1,00,000, 9% debentures at a premium of 10%. The
costs of floatation are 2%. The tax rate applicable to the company is
60%. Compute the cost of debt.
Cost of Debt/Loan

Redeemable
After-tax cost of debt
Kd =
Interest (1- tax rate) + Redeemable value – amount received/ no. of
years in redemption
-------------------------------------------------------------------------------------------
Amount received + redeemable value/ 2
Sum 5:
A company issues Rs. 10,00,000, 10% redeemable debentures at a
discount of 5%. The costs of floatation amount to Rs. 30,000. the
debentures are redeemable after 5 years. Calculate before-tax and
after tax cost of debt assuming a tax rate of 50%.
Sum 6:
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% p.a. and the debenture will
be redeemed at 5% premium on maturity. The firm’s tax rate is 40%.
Compute the after tax cost of debenture.
Sum 7:
Assuming that a firm pays tax at 50% rate, compute the after tax cost of
debt in the following cases:

1) A perpetual bond sold at par, coupon rate of interest being 7%.

2) A 10 year, 8% Rs. 1,000 per bond sold at Rs. 950 less 4%


underwriting commission.
Cost of Preference
Irredeemable

Kp = Preference dividend / amount received


Sum 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 capital if these
shares are issued at:

a) At par
b) At a premium of 10%, and
c) At a discount of 5%.
Cost of Preference

Redeemable

Preference dividend + Redeemable value – amount received/ no. of


years in redemption
-------------------------------------------------------------------------------------------
Amount received + redeemable value/ 2
Sum 2:
A company issues 10,000, 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 cost of preference capital.
Sum 3:
A company issues 1,000, 7% preference shares of Rs. 100 each at a
premium of 10% redeemable after 5 years at par. Calculate cost of
preference capital.
Cost of Equity
Expectations
• Without Growth
• With Growth
Cost of Equity
Without Growth

D1
P0

Ke = Expected dividend / current market price


Sum 1:
A company issues 1,000 equity shares of Rs. 100 each at a premium of
10%. The company has been paying 20% dividend to equity
shareholders for the past 5 years and expects to maintain the same in
the future also. Calculate cost of equity capital. Will it make any
difference if the market price of equity share is Rs. 160.
Cost of Equity
With Growth

= D1 / P0 + Growth

Ke= Expected dividend / current market price + Growth Rate


Sum 2:
a) A company plans to issue 1,000 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 in expected to be 5%. Calculate the cost of new issue
of equity shares.

b) If the current market price of an equity share is Rs. 150, calculate


the cost of existing equity share capital.
Sum 3:
The shares of a company are selling at Rs. 40 per share and it had paid
a dividend of Rs. 4 per share last year. The investor’s expects a
growth rate of 5% per year.

a) Compute the company’s equity cost of capital.


b) If the anticipated growth rate is 7% p.a., calculate the indicated
market price per share.
Cost of Retained Earnings

• Book Value Approach = same as cost of Equity shares

• Market Value Approach = N.A. (Because this is not any kind of share)
Cost of Retained Earnings

1. No taxes and brokerage fees


2. Taxes and brokerage fees
Cost of Retained Earnings
1. No taxes and brokerage fees

Kr = D1 / P0 + Growth

Kr= Expected dividend / Net Proceeds + Growth Rate


Cost of Retained Earnings
2. Taxes and brokerage fees

Kr = Ke (1- t) (1- b)
Where,
t = tax rate to shareholders
b = brokerage or commission to acquire new shares
Sum 1:
A firm 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?
Weighted Average Cost of
Capital
Composite cost of capital
OR
Overall cost of capital
OR
Average cost of capital
Weighted 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 to the specific cost of capital in proportion of the various
sources of funds of the total.

The weights may be given either by using the book value of the source
or market value of the source.

If there is a difference between Market value or book value weights,


the WACC would also differ.
Weighted Average Cost of
Capital

∑XW
Kw = ----------------
∑w

Kw = Weighted Average Cost of Capital


X = Cost of specific source of finance
W = Weight, proportion of specific source of finance
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