COST OF CAPITAL

S.CLEMENT
 SOURCE OF FINANCE

 Debt
 Equity Retained  Debentures

 Preference  Earnings  Bonds

 Term Loans

 FC Loans
 Cost of capital
 Cost of capital is the rate at which a company
raises resources either in the form of capital
(dividends) or debt ( interest).
 Cost of capital also refers to the discount rate
which is used to determine the present values of
estimated future cash inflows.
 E.g. a company borrows at a interest rate of 12 %
which is a cost of capital. Rate of return on
investment should exceed cost of capital.
 Solomon Ezra, “ minimum required rate of return
or the cut-off rate for capital expenditure”
 Features
 It is not a cost – it is a rate of return
which required on the project
 Minimum rate of return required to
maintain to market price of shares
 Reward for risk – it relates to financial risk
in respect of capital structure.
 Implications
 Designing capital structure of a company different
sources at different cost which will have impact
on profitability.
 Capital budgeting decisions acceptance or
rejection of project depends on the cost of
capital.
 Comparative sources of financing. Source with
minimum cost (at what time). Retention of
management control to be decided.
 Evaluation of performance of top management.
 Financing and dividend decision.
 Classification of cost
 Historical and future – historical to decide past past
performance and evaluate future cost which is crucial for
future decisions.
 Specific and Composite – capital from one source will be
specific and from different sources is composite.
Decision criteria is based on single or composite.
 Average/marginal – marginal cost is more relevant
 Explicit / implicit –explicit arise when funds are raised
and implicit when they are used. Implicit means
opportunity cost of capital. E.g. retained earnings for
share holders
 Assumptions
 Cost can be explicit or implicit
 Marginal cost is more relevant
 Cost not to impact bottom line of the firm
 Cost should to be competitive
 Cost includes long & short term.
 Weighted average cost when funding at
different costs.
 Cost of debt capital
 Cost of debt contractual interest payable
over a period
 E.g. company issues debentures at par for
Re 100 lacs @ interest rate of 12%
 Company must earn at least 1.20 lac p.a.
to maintain same dividend to share
holders.
 Debentures can be issued at Par, Premium
& Discount.
 Computation of cost of capital
 Kd = R+(MV – NP) / n X 100

(MV+NP)
2
Kd= cost of capital
MV = maturity of value of debt
NP = net proceeds
n = number of years to maturity
R = annual interest payment
 Computation of cost of capital
debentures issued @ discount
 Debentures Re 500000
 Interest @ 12%
 Period 10 years
 Discount 4 %
 Other expenses 10000
 Computation of cost of capital
debentures issued @ discount
 60000+(500000 – 470000)
 10 *100
 (500000 +470000)
 2
 60000+3000/485000 *100
 63000/485000*100 = 13%
 Computation of cost of capital
debentures issued@ premium and
redeemed @ par
 Debentures Re 500000
 Interest @ 12%
 Period 10 years
 Premium 5 %
 Other expenses 10000
 Computation of cost of capital
debentures issued@ premium and
redeemed @ par
 60000+(500000 – 515000)
 10 *100
 (500000 +515000)
 2
 60000-1500/507500 *100
 58500/507500*100 = 11.53%
 ( proceeds 525 – exp. 0.10)
 Computation of cost of capital
debentures issued@ par and
redeemed @ premium
 Debentures Re 500000
 Interest @ 12%
 Period 10 years
 Redeemable @ Premium of 5 %
 Other expenses 10000
 Computation of cost of capital
debentures issued@ par and
redeemed @ premium
 60000+(525000 – 490000)
 10
*100
 (525000 +490000)
 2
 60000-3500/507500 *100
 63500/507500*100 = 12.51%
 (proceeds – exp – 5.00 -.10)
 Tax adjusted cost of debt
 Interest acts as tax shield since it is
admissible deduction for tax liability.
 To arrive at cost of debt, tax deduction to
be factored in.
 Kd after tax=Kd (before tax)*(1-T)
 E.g.12%(1-.30) = 8.4 %
 Tax adjusted cost of debt
 A company issued 15%, Re 100 debenture
for 7 years at a discount of 2.25% and it
will be redeemed at a premium of 5%. Tax
rate @ 50%.
 Calculate cost of tax adjusted debt.
 Tax adjusted cost of debt
 15 + 7.25/7 X 100
 ( 97.75+105)
 2
 15 + 1.04 X 100
 101.38
 15.82 %
 15.82 ( 1 -.50) = 7.91%
 Cost of preference
 Preference shares are fixed cost bearing
securities.
 Dividend fixed by the company is the cost
of capital for the company.
 No tax rebate for dividend payments
unlike debt obligations.
 Formula for Kp = DPS/NP *100
 DPS – Dividend per PS.NP –net proceeds.
 Cost of preference
 Preference sharesof Re 100 each issued at
11 %.Issue expenses is Re 2 per share.
 Kp = 11/100-2*100 =11.22%
 Cost of preference
 Preference issue -1000,9% preference
shares of Re 100 each. Issue expenses @
3%.
 Calculate the cost
 If share is issued at par
 Issued at discount of Re 5 per share
 Issued at premium of Re 6 per share.
 Cost of preference
 Issued at par
 9/97 *100 = 9.278%
 Issued at discount of Re 5
 9/100-5-3*100 = 9.783.
 Issued at premium of Re 6
 9/100+6-3 *100 = 8.737 %.
 Cost of preference shares
 X ltd issued 9%, 10,000 preference shares
of Re 100 each. Underwriting commision @
2%. Brokerage 1%. Other issue expenses
@ Re 10,000. tax rate @ 50%.
 Find out cost of capital.
 Cost of preference shares
 9/96 X 100 = 9.37
 9.37/0.5 = 18.75%.
 Working notes
 100 – ( 2% +1% +1% ) = 96
 Cost of equity share capital
 Cost of equity is the minimum rate of return that a company
should earn to have positive impact on share prices.
 At the time of new issuance, it should not impact earnings of
existing share holders (EPS) and share price.
 It is treated as variable dividend securities
 Computation of cost of equity is comparatively difficult since
there is no legal obligation to pay and rate is not predetermined.
 No or lower dividend has its impact on share price and
reputation.
 Expectation of share holders – consistent and risingdividend and
maximization of shareholders wealth.

 Various methods to calculate

 Dividend Yield method
 Ke = DPS/MP *100
 Ke = cost of equity
 DPS = current cash dividend per share
 MP = current market price share
 E.g. 3000 ES of Re 10 each. Market price
Re 15 per share. Dividend Re 1.20. per
share
 Ke = 1.20/15*100 = 8%
 Earnings Yield method
 Based on the principle that equity holders will
get all the earnings after meeting the expenses.
 Measured through Earnings / Price ratio.
 Ke = EPS/MP *100.
 Ke –cost of equity capital.EPS- earnings per
share. MP – market price.
 This method relates total earnings to MP of the
share
 It is better than dividend to MP
 Earnings Yield method
 Company issued 500000 equity shares of
Re 10 each. Profit @ 6,00,000. MP Re 16
 EPS = 600000/500000 = 1.20
 KE = 1.20/16 *100 = 7.5%
 Limitations
 All the earnings are not distributed
 Un stability of market price
 EPS is not constant.
 Dividend + growth in Dividend method
 Pre supposes growth in earnings will increase in
dividend rate. This is based on the concept that of share
holders expectations i.e. consistent and increasing
dividend.
 Ke = (DPS/MP) x 100 + G
 E.g. MP Re 60.Dividend per share Re 4.50. 7% growth
in dividend expected.
 Ke = 4.50/60*100+7 = 14.5%
 Solomon Ezra advocated this method as it ensures
accurate estimate of capital budgeting decisions.
 Difficult to estimate the rate of growth in price
appreciation expected by share holders
 Cost of Equity capital
 ABC ltd issued 2000 equity shares of Re
100 each as fully paid. Profit after tax Re
20000.Market price Re 160 per share.
Dividend RE 8 per share.
 Find out
 A) dividend Yield method
 B) Earrings Yield method
 Cost of Equity capital
 Dividend yield method DPS/MP *100
 8/160*100 = 5%
 Earnings yield method – EPS/MP*100
 10/160*100 =6.25%
 Capital Asset Pricing model

In 1952,Harry Markowitz, showed exactly how an

investor can reduce standard deviation of portfolio
returns by choosing stock that do not move
exactly together.
This theory explains the relationship between risk
and return.
In mid 1960s, three economist William Sharpe,John
Lintner & Jack Treynor have propounded the
theory of CAPM and answered the the basic
questions posed by Markowitz.
 CAPM
 Securities are risky since returns are
variable
 SD measures the variance
 Risk of security arises from market and
unique risk
 Portfolio diversification can eliminate
unique but not market risk
 Contribution of a security to the portfolio
risk is measured by beta
CAPM – Assumptions
All investors aim to maximize their returns
All operate on common single period
planning horizon
All are rational and always look at risk and
return
All investors are price takers, i.e. no
investor can influence market price by his
scale of operations
Dividends and capital gains are taxed at
the same rate.
All securities are highly divisible i.e. can be
traded in small parcels
 CAPM
CAPM is an equilibrium model which describes the
pricing of assets, as well as derivatives.
Expected return of an asset equals the risk less return
+ risk premium.
Expected security return=
Risk less return+ beta x (expected risk premium)
In short, CAPM describes relationship between risk and
expected return and that is used in the pricing of risky
securities.
Beta is used to measure additional risk (systematic)
faced by the investor.
 Capital Asset Pricing Model
(CAPM)
 Systemic risk and un systemic factor in portfolio of
investments.
 investors expectations - Higher the risk higher the
return.
 Beta factor - each has company has a beta factor. A
company’s beta factor is that company’s risk compared
to the risk of over all market.
 If a company has a beta factor of 3.0 , it is said to be 3
times more risky than the over all market.
 Investor investing in such company , expectation of
return will be higher.
 Capital Asset Pricing Model
(CAPM)
 Model that links the notions of risk
and return
 Helps investors define the required return
on an investment
 As beta increases, the required return for
a given investment increases
 Security market line

β1
C
β>1
B
BB
C

AA A BB
AA
β<1
 Security market line
Rate of
return
C
17.5
BB
15.0
AA
12.5

Rf=10

05 1.0 1.5 2.0

Beta
 Capital Asset Pricing Model
(CAPM)
 Ks = Krf +β (Km – Krf)
 Ks – required rate of return
 Krf = Risk free rate (rate of return on risk
free investment. E.g. GOVT.securities
 β = beta
 Km – expected return on the over all stock
market
 Capital Asset Pricing Model
(CAPM)
 E.g. Risk free rate @ 5%.Stokck market rate of
return @ 12.5 % next year. Beta factor of XYZ
company @ 1.7. Expected rate of return ?
 Ks =Krf + β ( Km – Krf)
 Ks = 5% +1.7(12.5% - 5%)
 Ks = 5% +1.7(7.5%)
 Ks = 5% + 12.75%
 Ks = 17.5%
 Decision – if XYZ is not giving 17.5%, investor
will think of investing in other share.
 CAPM – Empirical Evidence

 It is difficult to measure expected return since actual

return may or may not match with expected return.
 It relies more on historical data.
 To test the model , portfolio should comprise all risky
investments including stocks, bonds, real estate etc.
Most market indexes contain only common stocks.
 It assumes that that beta is the only reason that
expected returns differ. But average return on smaller
stocks has been substantially larger than predicted by
CAPM.
 It assumes T.Bills are risk free. But it does not take in
to account the real return after factoring inflation.
 Cost of retained earnings
 Company does not distribute entire earnings and
only part is distributed as dividends.
 Share holders fore go opportunity cost of capital
due to retained earnings.
 Income fore gone is the cost of retained earnings
which share holders expect.
 It implies that company should earn on the
retained earnings at least equal to the rate at
which would have been earned by share holders.
In other words it shuld match with opportunity
cost of capital for share holders.
 Cost of retained earnings to be adjusted for tax
and flotation cost.
 Cost of retained earnings
 Formula –
 Kr =Ke (1 –Td) (1-B)
 Kr – cost of retained earnings
 Ke – cost of equity
 Td – income tax on income distributed as
dividends
 B – brokerage (flotation cost)
 Cost of retained earnings
 E.g cost of capital 12%. Tax rate 30%
Flotation cost 3%.
 Cost of retained earnings will be
 Kr(1- Td) (1 –B)
 12% (1-30%) (1-3%)
 0.12 (1-.0.30 ) (1 -.003)
 0.12*0 .70 *0.97
 8.15%
 Cost of retained earnings
 Calculate the cost of retained earnings.
 Current MP Re 140
 Floatation cost (brokerage) per share 3%
 Growth in expected dividend 5%
 Expected dividend per share Re 14
 Tax 30%
 Cost of retained earnings
 Kr = DPS/MP*100 +G) (1-Td) (1-B)
 = (14/140*100+5%) (1-0.30)91-0.03)
 = (10%+5%) (0.70) (0.97)
 = 15% *.070 *.097
 = 10.19 %
 Valuation of retained earnings
 According to Gitman, retained earnings are treated
as equity capital for the purpose of valuation.
 E.g. –company has capital structure of 40,000
equity shares of Re 10 each and retained earnings
Re 1,00,000.Market value of share is Re 18.
 MV of equity is
 (40000 X 18) 720000 X 400000/500000 = 576000
 MV of Retained earnings 720000*100000/500000
=144000
 Weighted average cost of capital
 WACC arises when fund are raised from
different sources at different cost and
invested in different projects.
 So, WACC is over all or average cost.
 Assignment of weights – on basis of
proportion of each item. E. g. Equity is Re
25 lacs of Re 10 lacs as capital structure,
weight to be assigned is 25%.
 Weighted average cost of capital
 Weights can be book value or market
value weights.
 Book value can be ascertained from
balance sheet and market value from
market price.
 Market value for certain is difficult to
arrive at. E.g. Retained earnings.
 For valuation of retained earnings, Gitman
model can be followed.
 Weighted average cost of capital
 Proportion of Equity @50 ,Preference @10
& Debt 40%.
 Cost – Equity @ 16, Preference @ 12 &
Debt @ 8%
 WACC =
 (0.5)(16)+(0.10)(12)+(0.4) (80) = 12.4%
 CACULATE WACC

Source of funds Amount After tax cost of

capital
Equity 350000 .12

Retained earnings 200000 .10

Preference 150000 .13

Debentures 300000 .09

Source Amount Weights After tax Weighted
cost cost
1 2 3 4 5(3*4)

Equity 350000 .35 .12 .0420

R.Earning 200000 .20 .10 .0200

Preferenc 150000 .15 .13 .0195

Debenture 300000 .30 .09 .0270

Weighted Average cost of capital = .10850 or 10.85%

Source Amount After tax cost

Equity(100000*10) 10,00,000 11%

Preference(25000*10) 2,50,000 8%

Retained earnings 5,00,000 11%

Debentures 9% 7,50,000 4.5%

DEBENTURES TRADED AT 94%. PREFERENCE @ par & EQUITY AT 13.

FIND OUT WACC
 MARKET VALUE OF EQUITY
100000*13=1300000
PORPORTION OF EQUITY
1300000*2/3 = 866667
PROPORTION OF RETAINED EARNINGS
1300000*1/3 = 433333

MV PREFERENCE @ 25000*10 = 2500000

MV OF DEBENTURES 7500000 *94% = 7050000

Source Market value After tax cost cost
(rate) (Amount)
1 2 3 4 =(2*3)

Equity 866667 .110 95333

Retained 433333 .110 47667

earning
Preference 250000 .080 20000

9% debenture 705000 .045 31725

Total 2255000 194725
WACC 194725/2255000*100 = 8.63%
 Exercise
 MP @ Re 20 per share. Dividend @ RE
1.Investors expect a growth rate of 5%.
 Compute
 A) company’s cost of capital
 B) if anticipated growth rate is 6%,what will be
the MP per share
 C) if the cost of capital is 8% and anticipated
growth is 5%, what will be the MP if dividend of
Re 1 per share is maintained.
 Exercise
 A) Ke = DPS/MP*100 +G
 1/20*100+5 = 10%
 B) G=6%,DPS =Re 1,Ke = 10%
 Ke = DPS/MP+G
 10%= Re 1/MP+ 6%
 1/MP=10% -6% =4%
 MP=1/4% or Re 25
 Exercise
 C) Ke = DPS/MP+G
 8% = 1/MP+5%

 1/MP= 8% -5% =3%

 MP =1/3% OR Re 33.33


 Industry View
 ALUMINUM – We equate cost of capital with
effective rate of interest on incremental
borrowing necessary to finance capital
expenditure. The specific type of borrowing
determines cost of capital.
 PHARMA – it is average rate of return for the
last 5 years.
 TOOTHPASTE – our rate of return is very high
and thus it is not necessary to calculate cost of
capital.