UNIT III

Cost of capital
 Outcomes

 Understand nature and significance of Cost of Capital.

 Know about components of cost of capital.

 Know about cost of debt and cost of preference capital.

 Understand cost of equity capital, weighted average

cost of capital and significance.
News of the Day
 Definition of Cost of Capital

According to Mittal and Agarwal “the cost of capital is the minimum

rate of return which a company is expected to earn from a proposed
project so as to make no reduction in the earning per share to equity
shareholders and its market price”.

According to Khan and Jain, cost of capital means “the minimum rate

of return that a firm must earn on its investment for the market value
of the firm to remain unchanged”.
 Cost of Capital depends upon

a) Demand and supply of capital

b) Expected rate of inflation

c) Various risk involved

d) Debt-equity ratio of the firm

 Significance of Cost of Capital 

1) Maximization of the Value of the Firm

2) Capital Budgeting Decisions

3) Management of Working Capital

4) Determination of Capital Structure

5) Evaluation of Financial Performance

 Components of Cost of Capital
The individual cost of each source of financing is called component of
cost of capital. Such components of cost of capital have been presented
below:

a) Cost of Debt

b) Cost of Preference capital

c) Cost of equity capital

d) Cost of retained earning

 Cost of Debt
A company may raise debt in variety of ways. It may borrow funds
from financial institutions or public either in the form of public
deposits or debentures (bonds) for a specified period of time at a
certain rate of interest. A debenture or bond may be issued at par
or at a discount or premium as compared to its face value.
 Debt Issued at Par
 
= (1 - T)R
Where: = Cost of debt, T = marginal tax rate, R = interest rate payable

Illustration

A company has issued 8% debentures and the tax rate is 50%, the after
tax cost of debt will be?
 Debt Issued at Premium or at Discount
 
= (1 - T)

Where: = Cost of debt, T = applicable tax rate, C = annual interest

payments, P = Net proceeds

Illustration:

A company issues 10% Debentures tor Rs. 2,00,000 Rate of tax is 55%.
Calculate the cost of debt (after tax) if the debentures are issued (i) at
par (ii) at a discount of 10% and (iii) at a premium of 10%.
 Solution
(i) Issued at Par
= Rs. 20,000/Rs. 2,00,000 (1 – .55)
=1/10 x .45
= 4.5%
(ii) Issued at a Discount of 10%
Rs. 20,000/Rs. 1,80,000 (1 – .55)
= 1/9 x .45
= 5 % 
(iii) Issued at Premium of 10%
Rs. 20,000/Rs. 2,20,000 (1 – .55)
= 1/11 x .45
= 4.1 %
News of the Day
 Cost of Preference Capital

The cost of preference capital is a function of the dividend

expected by investors. In the case of Preference capital,
payment of dividends is not legally binding on the firm and
even if the dividends are paid, it is not charge on earnings;
rather it is a distribution or appropriation of earnings to
preference shareholders.
 Irredeemable Preference Share
 
The preference share may be treated as a perpetual security if it
is irredeemable. Thus its cost is given by the following equation:

=
Where, is cost of preference share, is dividend on preference
share, is net proceeds from the issue of preference share.
 Illustration

A company issues 10% irredeemable preference share.

The face value per share is ₹ 100, but the issue price is ₹
95. What is the cost of a preference share? What is the
cost if the issue price is ₹ 105?
 Illustration

Find out the cost of 10,500 irredeemable preference

shares if issues at 2% premium of Rs.60 each. The dividend
paid by the company is Rs. 6 each. The flotation cost is Rs.
8 per share.
 Solution
 
Premium amount = 60*0.02 = 1.2
Issue price = 60 + 1.2 = 61.2
 Net proceeds = 61.2 - 8= 53.2
=
= 6 / 53.2
= 11.27%
 Redeemable Preference Share

These shares are issued for a particular period and at the expiry of that
period, they are redeemed and principal is paid back to the preference
shareholders. Formula for calculating cost of redeemable preference
shareholder

Kp = Dp+((RV-NP)/n )/ (RV+NP)/2

RV = Redemption value

N = Period of preference share

 Illustration

A preference share issues at 12% worth Rs 60,000 at 5%

discount and after 6 years it redeem at 10% premium. The
flotation cost is 5% and tax rate is 20%. Find out the cost of
preference share capital.
 Solution
Dividend on preference share (Dp) = 60,000*12/100 = Rs.7200
Discount = 60,000*5/100 = Rs.3000
Flotation Cost = 60,000*5/100 = Rs.3000
Net Proceeds (NP) = Rs. (60,000-3000-3000) = Rs. 54,000
Premium amount = 60,000*10/100 =Rs. 6000
Redemption Value = Rs. (60,000+6000) = Rs. 66,000
Kp = Dp+ ((RV-NP)/n)/ (RV+NP)/2
= 7200+ ((66,000-54,000)/6) / (66,000+54,000)/2
= 9200/60,000
= 15.33%
 Illustration
Company ABC a small company issued 50, 000 shares of 10 each and
pays Rs.8 per shares as dividend. Further issue 10, 000 debentures of Rs.
100 each and the interest pays by the company is 8%. Company wants to
expand its business by opening a new branch in different cities. It wants
to finance its expansion project through 6% preference shares. Find out:
• Cost of preference share if issues 100 of Rs. 80 each at 3% discount
and redeem at 5% premium after 8 years.
• Which one is good for the company redeemable preference share or
irredeemable preference share?
• Flotation cost Rs. 10 each.
 Solution
Discount= 80*0.03 = 2.4
Issue price= 80-2.4 = 77.6
Net proceeds = 77.6 – 2.4 = 75.2
Dividend = 0.06*80 = 4.8
Premium amount = 80*0.05 = 4
Redemption value = 80 + 4 = 84
Irredeemable Preference share:
Kp = Dp/NP
= 4.8 / 75.2
= 6.38%
 Redeemable Preference share:
Net proceeds = 80 – 2.4 - 10 = 67.6
Kp = Dp+ ((RV-NP)/n)/ (RV+NP)/2
= 4.8 + ((84-67.6)/8)/ (84+67.6)/2
= 4.8 + (2.05 / 75.8)
= 4.8 + 0.027
= 4.827%
The cost of redeemable preference shares is less than irredeemable
preference share by 1.55%. So, the redeemable preference share is
beneficial for the Company ABC.
 News of the Day
https://www.business-standard.com/article/pti-stories/pu
blic-sector-banks-turn-profitable-in-apr-sep-fy20-1191209
01299_1.html
 Cost of Equity Capital

Firms may raise equity capital internally by retaining earnings.

Alternatively, they could distribute the entire earnings to equity share
holders and raise equity capital externally by issuing new shares. In
both cases,, shareholders are providing funds to the firms to finance
their capital expenditure.

Hence, the equity shareholders’ required rate of return would be the

same whether they supply funds by purchasing new shares or by
foregoing dividends.
In practice, it is a formidable task to measure the cost of equity. The
difficulty derives from two factors:

1) Estimation of expected dividends

2) Future earnings and dividends are expected to grow over time.

External equity will cost more to the firm than the internal equity.
 Cost of Internal Equity: Dividend-growth
model

=  + g

Hence cost of equity equal to the expected dividend yield ( )

plus capital gain rate as reflected by expected growth in
dividends (g).
 Assumptions of the Dividend-growth
model
The market price of the ordinary  shares, is a function of expected
dividends.

The dividend, is positive (i.e., >0).

The dividend grow at a constant growth rate g, and the growth rate is
equal to the return on equity, ROE, times the retention ratio, b (i.e., g =
ROE*b).

The dividend pay-out ratio [i.e.,(1-b)] is constant.

 Illustration

Suppose that current market price of a company’s share is

₹ 90 and the expected dividend per share next year is ₹
4.50. If the dividends are expected to grow at a constant
rate of 8%, the shareholders’ required rate of return is?
 Solution
=  + g
= 4.50/90 + 0.08
= 0.13 or 13%

If the company intends to retain earnings, it should at least

earn a return of 13% on retained earnings to keep the
current market price unchanged.
 Cost of External Equity: Dividend-growth
model

=  + g

Where is the issue price of new equity. The cost of retained

earnings will be less than the cost of new issue of equity if >
 Illustration
The share of a company is currently  selling for ₹ 100. It wants to finance
its capital expenditure of ₹ 100 million either by retained earnings or
selling new shares, If the company sells new shares, the issue price will
be ₹ 95. The dividend per share next year, , is ₹ 4.75 and it is expected to
grow at 6%. Calculate:

1) The cost of internal equity (retained earnings)

2) The cost of external equity (new issue of shares)

 Solution

1. = 4.75/100
  + 0.06
= 0.1075 or 10.75%
= 4.75/95 + 0.006
= 0.11 or 11%

It is obvious that the cost of external equity is greater than

the cost of internal equity because of under pricing.
 Earning-Price ratio and Cost of Equity
= 
Illustration

A firm is currently earning ₹ 1,00,000 and its share is selling at a market

price of ₹ 80. The firm has 10,000 shares outstanding and has no debt.
The earnings of the firm are expected to remain stable, and it has a
payout ratio of 100%. What is the cost of equity? If the firms’ payout
ratio is assumed to be 60% and that it earns 15% rate of return on its
investment opportunities, then, what would be the firm’s cost of equity.
 Solution
  is zero, we can use expected
Case I, since expected growth rate
earnings-price ratio to compute the cost of equity. Thus:

= 10/80 = 0.125 or 12.5%

Case II, the EPS is 1,00,000/10,000 = ₹ 10. if the firm pays out 60% of
its earnings, the dividends per share will be: 10*0.6 = ₹ 6, and the
retention ratio will be 40%. If the expected return on internal
investment opportunities is 15%, then the firm’s expected growth is:
0.40*0.15 = 0.06 or 6%. The firm’s cost of equity will be:

= 6/80 + 0.06 = 0.135 or 13.5%

 Cost of Equity & The CAPM (Capital Asset Pricing
Model)

As per the CAPM, the required rate  of return on equity is given by the
following relationship:

= +(- )
= Risk free rate
( - ) = the market risk premium is the difference b/w the long term,
historical arithmetic averages of market return and the risk free rate.
β = is the systematic risk of an ordinary share in relation to the market.
 Illustration

The risk-free rate of return of the Purple Widget Company

is 5%, the return on the Dow Jones Industrials is 12%, and
the company’s beta is 1.5. The cost of equity is?
News of the Day
 Weighted Average Cost of Capital

A firm’s Weighted Average Cost of Capital (WACC)

represents its blended cost of capital across all sources,
including common shares, preferred shares, and debt.  The
cost of each type of capital is weighted by its percentage of
total capital and they are added together. 
The following steps are involved for calculating the form’s WACC:

 Calculate the cost of specific sources of funds.

 Multiply the cost of each source by its proportion in the capital

structure.

 Add the weighted component costs to get the WACC.

In financial decision making the cost of capital should be calculated

after tax basis. Hence the component costs should be the after tax
costs.
  
= (1-T) +

Where is the WACC, (1-T) and are respectively, the after

tax cost of debt and equity, D is the amount of debt and E
amount of equity.
 Illustration
The following information is available from the balance sheet of the
company:

Equity share capital ₹ 5,00,000

12% Preference share ₹ 5,00,000

10% Debenture ₹ 10,00,000

Determine the weighted average cost of capital of the company. It had

been paying dividends at a rate of ₹ 20 per share (g = 0), income tax 30%
and the current price of ₹ 100 share is ₹ 160.
 Illustration
Lohia Chemicals LTD has the following book value capital structure on
31 March 2014:
Source of Finance Amount (000) Prop(%)
Share capital 4,50,000 45
Reserves and surplus 1,50,000 15
Preference share capital 1,00,000 10
Debt 3,00,000 30
10,00,000 100

The expected after tax component costs of the various sources of

finance for Lohia Chemicals LTD are as follows:
Source of Finance Cost %
Share capital 18
Reserves and surplus 18
Preference share capital 11
Debt 8
Suppose Lohia Chemicals LTD has 45,000,000 equity shares outstanding and
the current market price per share is ₹ 20. Assume that the market values and
the book values of debt and preference share capital are the same. If the
component costs were the same as before, the market value weighted average
cost of capital would be?

Computation of WACC (Market value weights)?

Why do managers prefer the book value weights for calculating WACC?

1) Firms in practice set their target capital structure in terms of book

values.

2) The book value information can be easily derived from the published
sources.

3) The book value debt equity ratios are analyzed by investors to

evaluate the risk of the firms in the practice.
Market value weights are theoretically superior to book value weights.
They reflect economic values and are not influenced by accounting
policies. They are also consistent with market determined component
costs.

The difficulty in using market value weights is that the market prices of
securities fluctuate widely and frequently. A market value based target
capital structure means that the amounts of debt and equity are
continuously adjusted as the value of the firm changes.
News of the Day
 Capital Structure

Capital structure is the proportion of all types of capital viz.

equity, debt, preference etc. It is synonymously used
as financial leverage or financing mix. Capital structure is
also referred to as the degree of debts in the financing or
capital of a business firm.
 Optimal Capital Structure

E. F. Brigham defines “the optimum capital structure strikes that

balance between risk and return which maximizes the price of the
stock and simultaneously minimizes the firm’s overall cost of
capital.”

Generally a sound optimum capital structure is one which:

(i) Maximizes the worth or value of the firm

(ii) Minimizes the cost of capital

 Contd…..

(iii) Maximizes the benefit to the shareholders by giving

best earning per share and maximum market price of the
shares in the long-run

(iv) Is fair to employees, creditors and others.

 Features of an Optimum Capital Structure

1) Simplicity

2) Profitability

3) Solvency

4) Flexibility

5) Control
 Theories of Capital Structure

Capital Structure theories can be categorized as:

1) Theories of relevance

2) Theories of irrelevance
 The Net Income Approach

David Durand first suggested this approach in 1952, and he was a

proponent of financial leverage. He postulated that a change in
financial leverage results in a change in capital costs. In other words, if
there's an increase in the debt ratio, capital structure increases, and
the weighted average cost of capital (WACC) decreases, which results
in higher firm value.
 Contd….

This approach is based upon the following assumptions:

(i) The cost of debt is less than the cost of equity.

(ii) There are no taxes.

(iii) The risk perception of investors is not changed by the use of debt.
Contd….
 Contd……
a) The line of argument in favor of net income approach is that as the
proportion of debt financing in capital structure increase, the
proportion of a less expensive source of funds increases. This
results in the decrease in overall (weighted average) cost of capital
leading to an increase in the value of the firm.

b) The reasons for assuming cost of debt to be less than the cost of
equity are that interest rates are usually lower than dividend rates
due to element of risk and the benefit of tax as the interest is a
deductible expense.
 Illustration
(a) A company expects a net income of Rs. 80,000. It has Rs. 2,00,000,
8% Debentures. The equity capitalization rate of the company is 10%.
Calculate the value of the firm and overall capitalization rate according
to the Net Income Approach (ignoring income-tax).

(b) If the debenture debt is increased to Rs. 3,00,000, what shall be the
value of the firm and the overall capitalization rate?
Solution
 Net Operating Income Approach

This theory as suggested by Durand is another extreme of the effect of

leverage on the value of the firm. It is diametrically opposite to the net
income approach. According to this approach, change in the capital
structure of a company does not affect the market value of the firm and
the overall cost of capital remains constant irrespective of the method of
financing.
 Contd….
It implies that the overall cost of capital remains the same whether the
debt-equity mix is 50: 50 or 20:80 or 0:100. Thus, there is nothing as an
optimal capital structure and every capital structure is the optimum
capital structure.

Assumptions of NOI theory:

(i) The market capitalizes the value of the firm as a whole.

(ii) The business risk remains constant at every level of debt equity mix.

(iii) There are no corporate taxes.

Contd….
 Contd….

The reasons propounded for such assumptions are that the increased
use of debt increases the financial risk of the equity shareholders and
hence the cost of equity increases. On the other hand, the cost of debt
remains constant with the increasing proportion of debt as the financial
risk of the lenders is not affected.

Thus, the advantage of using the cheaper source of funds, i.e., debt is
exactly offset by the increased cost of equity.
The value of a firm on the basis of Net Operating Income Approach can be
determined as below:

V = EBIT/K0

Where, V = Value of a firm, EBIT = Net operating income or Earnings before interest
and tax, k0 = Overall cost of capital

The market value of equity, according to this approach is the residual value which is
determined by deducting the market value of debentures from the total market value
of the firm.

S=V–D

Where, S = Market value of equity shares, V = Total market value of a firm, D = Market
  
The cost of equity or equity capitalization rate can be calculated as
below:

Where is Cost of equity/Equity capitalization rate

=
 Illustration
H.B.P. Ltd. expects annual net operating income of Rs. 2,00,000. It has
Rs. 5,00,000 outstanding debt, cost of debt is 10%. If the overall
capitalization rate is 12.5% what would be the total value of the firm
and the equity capitalization rate according to the Net operating
Income approach.

(i) The firm increases the amount of debt from Rs. 5,00,000 to Rs.
7,50,000 and uses the proceeds of the debt to repurchase equity shares.

(ii) The firm redeems debt of Rs. 2,50,000 by issuing fresh equity shares
of the same amount.
Solution
Contd….
News of the Day
 Traditional Approach
The traditional approach/Intermediate approach, is a compromise
between the net income approach and net operating income approach.
According to this theory, the value of the firm can be increased initially
or the cost of capital can be decreased by using more debt as the debt
is a cheaper source of funds than equity.

Thus, optimum capital structure can be reached by a proper debt-

equity mix.
Contd….
Contd….
 Contd…..
Beyond a particular point, the cost of equity increases because
increased debt increases the financial risk of the equity shareholders.
The advantage of cheaper debt at this point of capital structure is
offset by increased cost of equity. After this there comes a stage, when
the increased cost of equity cannot be offset by the advantage of low-
cost debt.

The cost of debt may increase at this stage due to increased financial
risk.
 Illustration
ABB Ltd current net operating income (EBIT) is Rs. 8,00,000. The
company has Rs. 20 lakhs of 10% debt outstanding. Its equity
capitalization rate is 15%. The company is considering to increase its
debt by raising additional Rs. 10 lakhs and to utilize these funds to retire
the amount of equity. However, due to increased financial risk, the cost
of entire debt is likely to increase to 12% and the cost of equity it 18%.

Compute the market value of the company using traditional model and
also make recommendations regarding the proposal.
Solution
 Illustration
Compute the market value of the firm, value of shares and the average
cost of capital from the following information:

Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest

whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.
Solution
 Modigliani and Miller (MM)
Approach

M&M hypothesis is identical with the Net Operating

Income approach if taxes are ignored. However, when
corporate taxes are assumed to exist, their hypothesis is
similar to the Net Income Approach.
 (a) In the absence of taxes. (Theory of
Irrelevance)
In the opinion of Modigliani& Miller, two identical firms in all respects
except their capital structure cannot have different market values or cost of
capital because of arbitrage process.

In case two identical firms except for their capital structure have different
market values or cost of capital, arbitrage will take place and the investors
will engage in ‘personal leverage’ (i.e. they will buy equity of the other
company in preference to the company having lesser value) as against the
‘corporate leverage’ and this will again render the two firms to have the
same total value.
 Assumptions of M&M Approach
1) There are no corporate taxes.
2) There is a prefect market.
3) Investors act rationally.
4) The expected earnings of all the firms have identical risk
characteristics.
5) The cut-off point of investment in a firm is capitalization rate.
6) All earnings are distributed to the shareholders.
7) Risk of investors depends upon the random fluctuations of expected
earnings and the possibility that the actual value of the variables
may turn out to be different from their best estimates.
MM approach in the absence of corporate taxes, i.e., the theory of
irrelevance of financing mix has been presented in the following figure:
 Illustration
The following information is available regarding Mid Air Enterprises
1. Mid Air currently has no debt, it is an all equity company.
2. Expected EBIT ₹ 24 lakhs. EBIT is not expected to increase overnight, so
Mid Air is in no growth situation.
3. There are no taxes.
4. Mid Air pays out all its income as dividends.
5. If mid Air begins to use debt, it can borrow at the rate kd = 8 per cent. This
borrowing rate is constant and it is independent of the amount of debt.
Any money raised by selling debt would be used to retire common stock, so
Mid Air’s assets would remain constant.
6. The risk of Mid Air’s assets, and thus its EBIT, is such that its shareholders
require a rate of return ke = 12 per cent, if no debt is used.
Using MM Model without corporate taxes and assuming a debt of Rs. 1
crore, you are required to:

(a) Determine the firm’s total market value;

(b) Determine the firm’s value of equity;

(c) Determine the firm’s leverage cost of equity.

Solution
 (b) When the corporate taxes are assumed to exist
(Theory of Relevance)

Modigliani and Miller, in their article of 1963 have recognized that the
value of the firm will increase or the cost of capital will decrease with
the use of debt on account of deductibility of interest charges for tax
purpose. Thus, the optimum capital structure can be achieved by
maximizing the debt mix in the equity of a firm.
According to M & M approach value
  of Unlevered and Levered firm
calculated as:
= (1 - t)
= + tD
Where:
= value of unlevered firm
= value of levered firm
tD = discounted present value of the tax savings resulting from the tax
deductibility of the interest charges, t is the rate of tax and D the
quantum of debt used in the mix.
 Contd….
Value of levered and unlevered firm under the MM model (assuming
that corporate taxes exist) has been shown in the following figure.
 Illustration

There are two firms X and Y which are exactly identical except that X
does not use any debt in its financing, while Y has Rs. 1,00,000 5%
Debentures in its financing. Both the firms have earnings before
interest and tax of Rs. 25,000 and the equity capitalization rate is 10%.
Assuming the corporation tax of 50% calculate the value of the firm
using M & M approach.
Solution
News of the Day
 MCQs
Que 1. In weighted average cost of capital, a company can affect its
capital cost through?

A. policy of capital structure

B. policy of dividends

C. policy of investment

D. all of the above

Answer
d
Que 2. The weighted average cost of capital for a firm is the:

a. Discount rate which the firm should apply to all of the projects it
undertakes.

b. Rate of return a firm must earn on its existing assets to maintain the
current value of its stock.

c. Coupon rate the firm should expect to pay on its next bond issue.

d. Maximum rate which the firm should require on any projects it

undertakes.
Answer
b
Que 3. A single, overall cost of capital is often used to evaluate
projects because:
a. It avoids the problem of computing the required rate of return for
each investment proposal.
b. It is the only way to measure a firm's required return.
c. It acknowledges that most new investment projects have about the
same degree of risk.
d. It acknowledges that most new investment projects offer about the
same expected return.
Answer
a
Que 4. If the CAPM is used to estimate the cost of equity capital, the
expected excess market return is equal to the:
a. Return on the stock minus the risk-free rate.
b. Difference between the return on the market and the risk-free rate.
c. Beta times the market risk premium.
d. Beta times the risk-free rate.
Answer
b
Que 5. A firm with high operating leverage has:

a. low fixed costs in its production process.

b. high variable costs in its production process.

c. high fixed costs in its production process.

d. high price per unit.

Answer
c
Que 6. A firm with high operating leverage is characterized
by __________ while one with high financial leverage is
characterized by __________.
a. low fixed cost of production; low fixed financial costs
b. b. high variable cost of production; high variable financial costs
c. c. high fixed costs of production; high fixed financial costs
d. d. low costs of production; high fixed financial costs
Answer
c
Que 7. A critical assumption of the net operating income
(NOI) approach to valuation is:
a. That debt and equity levels remain unchanged.
b. That dividends increase at a constant rate.
c. That ko remains constant regardless of changes in leverage.
d. That interest expense and taxes are included in the
calculation.
Answer
c
Que 8. Two firms that are virtually identical except for their capital
structure are selling in the market at different values. According to
M&M
a. One will be at greater risk of bankruptcy.
b. The firm with greater financial leverage will have the higher value.
c. This proves that markets cannot be efficient.
d. This will not continue because arbitrage will eventually cause the
firms to sell at the same value.
Answer
d
Que 9. QWC Ltd. has cash of $100,000 that will be invested in an
equity investment that has a beta of 2.25. The current risk-free rate in
the market is 2.5%, and the market requires an 8% risk premium for
equity securities. What return should QWC Ltd. expect to earn?
a) $8,000
b) $18,000
c) $23,625
d) $20,500
Answer
d
Que 10. Cameron Industries is expected to pay an annual dividend of
$1.30 a share next month. The market price of the stock is $24.80 and
the growth rate is 3 percent. What is the firm's cost of equity?
a. 7.58 percent
b. 7.91 percent
c. 8.24 percent
d. 8.40 percent
Answer
c