Cost of Capital

Cost of capital
Cost of capital is the rate return the firm requires from

investment in order to increase the value of the firm in the
market place.
Hampton :The sources of capital of a firm must be in the form
of preference shares, equity shares, debt and retained earnings.
In simple cost of capital of a firm is the weighted average cost
of their different sources of financing.
Components Of Cost Of Capital
A firm’s cost of capital include :
1) Return at zero risk level :- It relates to the expected rate of return when a
project involves no financial or business risk.
2) Business risk premium :- Business risk premium is determined by the
capital budgeting decisions for investment proposals. If the firm selects a
project which has more than the normal risk, the suppliers of the funds for
the project will expect a higher rate of return than the normal rate. Thus
the cost of capital increases.
3) Financial risk premium :- Financial risk relates to the pattern of capital
structure of the firm. A firm which has higher debt content in its capital
structure should have more risk than a firm which has comparatively low
debt content.
Classification Of Cost Of Capital
Historical cost and Future cost
Specific cost and Composite cost
Average cost and Marginal cost
Explicit cost and Implicit cost
IMPORTANCE OF COST OF
CAPITAL
Helpful in Capital Budgeting Decision: Capital budget decision largely depends on the cost of
capital of each source. According to net present value method, present value of cash inflow must be
more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting
decision.
Helpful in Structure Decision: Capital structure is the mix or proportion of the different kinds of
long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence,
cost of capital helps to take decision regarding structure.
Helpful in Evolution of Financial Performance :Cost of capital is one of the important determine
which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to
evaluate the financial performance of the firm.
Helpful in comparative analysis of various sources of finance: Cost of capital is help in

comparative analysis of various sources of finance
Helpful in Other Financial Decisions: Apart from the above points, cost of capital is also used in
some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a
major part in the financial management.
THE CONCEPT OF THE OPPORTUNITY COST OF
CAPITAL
The opportunity cost is the rate of return foregone on the next

best alternative investment opportunity of comparable risk.
Risk-return relationships of various securities

Computation Of Cost Of Capital
I. Computation of specific costs.
II. Computation of composite cost.
Computation of specific costs of
capital
A. Cost of Debt
B. Cost of Preference Shares
C. Cost of Equity Shares
D. Cost of Retained Earnings
Cost of Debt
It is the rate of return which is expected by lenders.
Cost of debt is cheaper than other sources as interest paid on debt capital is tax deductible.
Cost of Debt(K d) = Interest/Net proceedsx100
When debt is issued at par: NP = Face value-Issued expenses
When debt issued at premium: NP = Face value + Premium – Issue expenses
When debt issued at discount: NP = Face value – Discount – Issue expenses
Cost of debt(after tax) = K d (before tax) × (1-Tax rate)
Case-Z ltd issue 5000 9% debenture of 100/- at 10% premium and repayable after 5 year at 5 % discount for
which the company will be required to incur following expense along with 30% tax rate.
Underwriting commission -5%
Brokerage-.5%, calculate the cost of debenture before and after tax.
SOL: Kd=9+95-104.50/5÷95+104.50/2X100
9-1.90/99.50
Compare
Cost of Perpetual and Redeemable Debt
case. A company issue 1000 10% debenture of 500/- for which the company will be required to incur following
expense along with 40% tax rate.
•Underwriting commission -2%
•Brokerage-.5%
•Printing-1500
•Issue at 10% discount and redeemable at 5% premium after 5 year.
Cost of Non-redeemable Preference share
Fixed rate of dividend is payable on preference shares. But in the practical sense preference dividend is
regularly paid by the companies when they earn sufficient of profit.
The dividend paid preference shares is not deducted from tax, as dividend is an appropriate of profit and
not considered as an expense.
Kp(after tax)=Dividend/Net Proceed X100
Kp (before tax)=Kp(after tax)/1-tax rate
Case: A company issues 10% preference shares of the face value of 50 each at par. Flotation costs are
estimated at 10% of sale price. Calculate cost of Kp before tax when tax rate is 30%.
Kp(before tax)=5/45(1-.30)x100=15.87%
D=10% 0n 50=5
NP=50-10% 0n 50=45
Case: ABC ltd issues 9% preference shares of 100 each at par redeemable at 10% premium after 10 years.
Kp(after tax)=D+(RV-NP)/N÷RV+NP/2X100
=9+110-100/10÷110+100/2x100=9.52%
Kp(before tax)=9.52/1-.50=19.4%
Cost of equity share
Ke is different in comparison to debt and preference share capital.
Because the equity shareholders do not get fixed dividend, its depending upon
the profit earned by an organization.
Dividend approach
An investor invest in equity shares with expectations of a certain
return(dividend)
Ke=(Dividend per share/Market price per share)x100
Case: Issue 1000 share of 100/- at premium of 10%. The company has been
paying 25% dividend for the past 5 year and expect to maintain the same in
future. Compute the Ke if MV of equity is 175.
Ke(after tax)=25/175x100=14.28%
MV=Equity capital+ Retained Earning/No.share of equity
Dividend plus growth approach: Investors not only expect dividend but
regular growth in the rate of dividend.
Ke=(D/MV)+Gx100
Where, D= Dividend per share

G=Growth rate in expected dividends
Case: R company’s share market price currently is 60. it pays a dividend of
2 per share and investors expect a growth rate of 10% per year.
Ke(after tax)=2/60+.10x100=13%.
Earning approach
Ke=E/MVx100
Where, E= earning per share
Case: A firm is considering an expenditure of 75 lakhs for expanding its
operation
No. of existing share=10 lakhs
MV=100/-
Net earning=100 lakhs /10 lakhs=10
Assuming that new share will be issued at 92/- and cost will be 2/-
Ke=E/MVx100
=10/100x100=10%
Cost of Retained Earning
The profits retained by a company for future development, business use
and expansion is called retained earnings
If earnings are not retained in that case they are distributed to the equity shareholders who in
turn, invest that money in new equity shares and earn a return on it.
The cost of retained earnings is the same as cost of equity.
But the cost of Kr would be adjusted by the personal tax rate and applicable brokerage,
commission etc if any.
Kr(after tax)=Ke(1-T)(1-F) or D/MV(1-T)(1-F)x100
T=tax for shareholder, f= floatation cost
Case: The cost equity of a company is 15%, tax rate of the shareholders is 40% and expenses
in the form of commission is 3% of the investment in share. The company proposes to utilize
its retained earnings to the extent of 300000. find out the cost of retained earnings.
Kr=.15(1-.4)(1-.03)x100=8.73%
Weighted average cost of capital
Sources Amount Rate( W WX
x)
Equity share capital 350000 12 3.5 42
Preference share 150000 10 1.5 15

capital
Debenture 300000 13 3 39
Retained Earning 200000 10 2 20
Total 10,00,000 ΣW=10 ΣWX=116
Calculate the WACC.

WACC=ΣWX/ ΣWx100
=116/10=11.6
The capital structure of Raman ltd is as follows:
Equity share capital(4000 shares) 400000

9% preference share capital 100/- 250000
7% debenture of 100/- 250000
Retained Earning 100000
The company has earned 20/- on equity capital. the corporate tax rate is 50% and the
shareholders personal tax is 25%. Calculate the WACC.
Kd=7/100x100=7%(1-.50)=3.50
Kp=9/100x100=9%
Ke=20/125x100=16%
MV=400000+100000/4000=125
Kr=16(1-.25)x100=12%
Sources Amount Rate(x) W WX
Equity share capital 400000 16 4 64
Preference share 250000 9 2.5 22.5

capital
Debenture 250000 3.50 2.5 8.75
Retained Earning 100000 12 1 12
Total ΣW=10 ΣWX=107.25
Calculate the WACC.

WACC=ΣWX/ ΣWx100
WACC=107.25/10=10.7
Composite Cost(WACC)

Cost of Capital

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Cost of capital

Cost of capital is the rate return the firm requires from

Helpful in comparative analysis of various sources of finance: Cost of capital is help in

The opportunity cost is the rate of return foregone on the next

Risk-return relationships of various securities

Kp(after tax)=Dividend/Net Proceed X100

Kp (before tax)=Kp(after tax)/1-tax rate

Where, D= Dividend per share

Preference share 150000 10 1.5 15

Retained Earning 200000 10 2 20

Total 10,00,000 ΣW=10 ΣWX=116

Calculate the WACC.

Equity share capital(4000 shares) 400000

Preference share 250000 9 2.5 22.5

Calculate the WACC.

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