COST OF CAPITAL

Cost of capital – meaning – significance – classification of cost –

determination – problems – computation of cost of specific sources
of finance (cost of Debt, Equity& Preference shares, Retained
earnings) – Computation of weighted average cost of capital,
Marginal cost of capital
Cost of Capital:
It can also be stated as the opportunity cost of an
investment, i.e. the rate of return that a company would
otherwise be able to earn at the same risk level as the
investment that has been selected.
The cost of capital of a Company is the minimum rate of return
expected by its investors. It is the weighted average cost of various
sources of finance used by a firm. The capital used by a firm may be
in the form of debt, preference capital, retained earnings and equity
shares. The concept of cost of capital is very important in the
financial management. A decision to invest in a particular project
depends upon the cost of capital of the firm or the cut off rate which
is the minimum rate of return expected by the investors.
 It is a cut-off rate for the allocation of capital to investments of
projects.
 In other words, Cost of capital is the minimum required rate of
earning.

(Decision-making is a process of choosing among alternatives. In the

investment decisions, an individual or a manager encounters
innumerable competing investment opportunities to choose from. For
example, you may invest your savings of Rs.1,000 either in 7 per
cent, 3 year postal certificates or in 6.5per cent, 3 year fixed deposit
in a nationalized bank. In both the cases, the government assures
the payment, so the investment opportunities reflect equivalent risk.
You decide to deposit your savings in the bank. By this action, you
have foregone the opportunity of investing in the postal certificates.
You have, thus, incurred an opportunity cost equal to the return on
the foregone investment opportunity. It is 7 per cent in case of your
investment. The opportunity cost is the rate of return
foregone on the next best alternative investment
opportunity of comparable risk. Thus, the required rate of return
on an investment project is an opportunity cost. (- FM by
I.M.Pandey)

COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL:

Weighted average cost of capital is the average cost of the costs of

various sources of Financing. Weighted average cost of capital is also
known as composite cost of capital, overall cost of capital. Once the
specific cost of individual sources of finance (such as Equity shares,
Preference shares, Debentures, Long Term funds and Retained
earnings) is determined, we can compute the weighted average cost
of capital by putting weights to the specific costs of capital in
proportion of the various sources of funds to the total.
MARGINAL COST OF CAPITAL

Sometimes, we may be required to calculate the cost of additional

funds to be raised, called the marginal cost of capital. The marginal
cost of capital is the weighted average cost of new capital calculated
by using the marginal weights. The marginal weights represent the
proportion of various sources of funds to be employed in raising
additional funds. In case, a firm employs the existing proportion of
capital structure and the component costs remain the same the
marginal cost of capital shall be equal to the weighted average cost of
capital.

MEASUREMENT OF COST OF CAPITAL

The term cost of capital is an overall cost. This is the

combination cost of the specific cost associated with specific source
of financing. The computation of cost capital therefore, involves two
steps: The computation of the different elements of the cost in term
of the cost of the different source of finance.
 The calculation of the overall cost by combining the specific
cost into a composite cost. From the view point of capital budgeting
decisions the long-term sources of fund are relevant as the
constitute the major source of financing of fixed cost. In calculating
the cost of capital, therefore, the focus is to be on the long-term
funds.
In other words the specific cost has to be calculated for: 1)
Long term debt 2) Preference Shares 3) Equity Shares 4) Retained
earnings

COST OF DEBT: A bond is a long term debt instrument or security.

Bonds issued by the government do not have any risk of default. The
government honour obligations on its bonds. Bonds of the public
sector companies in India are generally secured, but they are not
free from the risk of default. The private sector companies also issue
bonds, which are also called debentures in India. A company in India
can issue secured or unsecured debentures. In the case of a bond or
debenture, the rate of interest is generally fixed and known to
investors. The principal of a redeemable bond or bond with a
maturity is payable after a specified period, called maturity period.
The chief characteristics of a bond or debenture are as follows:
Face value:
Face value is also referred to as the par value. A bond or debenture
is generally issued at a par value of Rs. 100 or Rs. 1,000, and
interest is paid on face value.
Interest Rate and frequency of payments: The Interest should
be considered net of tax (of the Company). While considering the
cost of debt, the interest rate should be taken after the tax effect
only (i.e., after considering the tax savings). Suppose if the rate of
interest is 15% and the Tax rate of the Company is 30%, cost of the
debt should be taken as equivalent to 15% minus (15% x
30%)=10.5% only. This is due to the fact that the Interest on the
 Long-term Debt and debentures are allowable as expenditure for
finding out the taxable profit.
Maturity: The period after which the debt or debenture is going to
be repaid is the Maturity period.
Redemption Value: The Debentures, especially may be redeemed
(repaid by the company itself) at par or at a premium or at a
discount.
Market value: A bond or debenture may be traded in a stock
exchange. The price at which it is currently sold or bought is called
the market value of the bond or debenture. Market value may be
different from par value or redemption value.
Problem:
 Suppose a company issues 1,000, 15% debentures of the face value
of Rs. 100 each at a discount of Rs.5.
 Suppose further that the under-writing and other costs are Rs.
5,000/- for the total issue. Thus Rs. 90,000 is actually realised, i.e.,
Rs. 1,00,000 minus Rs. 5,000 as discount and Rs. 5,000 as under-
writing and other expenses.
 The interest per annum of Rs. 15,000 is therefore the cost of Rs.
90,000, actually received by the company. This is because interest is
a charge on profit and every year the company will save Rs. 6,000 as
tax, assuming that the income tax rate is 40%.
 Hence the Interest Net of Tax (after tax cost of the procured fund) of
Rs. 90,000 is Rs. 9,000 which comes to =9000/90000= 10%.
 Tutorial Note:
 An Underwriter assures the company at the time of issue of shares or
debentures to the public that they will subscribe for or contribute
towards a certain number of Shares or Debentures, if the public don’t
subscribe for the same. They will charge commission for the
underwritten shares or debentures.

(Tutorial Note: Concept of Own Debentures – when surplus

funds are available with a Company and is not further
required till the time the debentures are going to be
redeemed and the income that can be earned by investing
the surplus is lower than the Interest payable on
debentures, it is advisable to invest in own debentures, i.e.,
buy back of debentures )
Cost of Perpetual or Irredeemable debentures:

Debenture may be issued at par (i.e., at the face value) or at

a discount or at a premium. Similarly, the Debenture may be
redeemed at par or at a discount (which has remote
possibility) or at a premium. We have to compute the
amount realized taking in to account the discount or the
premium also.

Always, the interest has to be computed at the face value.

The same has to be reduced by the amount of tax savings it
is going to bring in. The net of tax interest is the annual cost
of the debt. Besides, the discount if any given at the time of
the issue has to be spread over the life of the Debenture
equally and considered along with the Interest (net of tax)
as the annual cost of the debt. If the Debenture has to be
redeemed at a premium, we have to spread the premium
also over the life of the Debenture and included in the
annual cost of the debt. The total of these will be used in the
numerator while computing the Cost of the debt.

In the denominator, we should take in to account, the

average investment i.e., (Net Amount realized + Redemption
value)/2.

(Tutorial Note: Concept of Own Debentures – when surplus

funds are available with a Company and is not further
required till the time the debentures are going to be
redeemed and the income that can be earned by investing
the surplus is lower than the Interest payable on
debentures, it is advisable to invest in own debentures, i.e.,
buy back of debentures )
Cost of Redeemable Debentures:
If the debentures are redeemable after the expiry of a fixed period,
the cost of debentures would be:
Cost = [Interest x (1-t)]+[(RV-NP)/N]
[RV+NP]/2
Where, I = Annual interest payment, NP = Net proceeds of
debentures, RV = Redemption value of debentures, t = Tax rate and
N = Life of debentures.
Amortization of a Bond or a Debenture:
Problem 2:
Reserve Bank of India is proposing to sell a 5-year bond of Rs. 5,000
at 8 per cent rate of interest per annum. The bond amount will be
amortised equally over its life. What is the bond’s present value for
an investor if he expects a minimum rate of return of 6 per cent?

COST OF CONVERTIBLE DEBENTURES:

See the problem in the EXCEL Workbook. Debentures which are

issued with an option to exchange the same for equity
shares at the maturity of the debentures are called
“Convertible debentures”. Instead of redeeming the loan
debenture fund, shares will be issued at an agreed rate. The value of
shares issued on maturity of the debentures shall be the redemption
value. Other than this, all other features of a redeemable debenture
are applicable in this case. The Short cut method and the YTM
method discussed in the Excel Workbook are applicable for these
debentures also for computing the Cost of the debt.

Deep Discount Bonds:

A deep-discount bond is a bond that sells at a significantly

lesser value than its par value. In particular, these bonds sell at a
discount of 20% or more to par and has a yield that is significantly
higher than the prevailing rates of fixed-income securities with a
similar profile. In this case, instead of the Interest rate,
Maturity value of the Bond will be given as the Face value of
the Bond, whereas the issue price shall be much less than
the face value. In these type of bonds, Total Interest paid =
Face Value minus Issue price.
YTM or Trial and error method has to be applied in respect of
these bonds for finding out the Cost of Capital.

DIVIDEND IS NOT A DEDUCTIBLE EXPENSE FOR INCOME

TAX PURPOSES AND HENCE THERE IS NO QUESTION OF TAX
SAVINGS IN THE PAYMENT OF DIVIDEND
Cost of Irredeemable Preference Shares:
= AD / NP
Where,
AD = Annual Preference Dividend
NP = Net proceeds of the Issue of Pref Shares

Problem 1: (Irredeemable Preference shares)

If Reliance Energy is issuing preference shares at Rs.100 per share,
with a dividend rate of Rs.12, and a (issue) floatation cost of 3%
then, what is the cost of preference share ? (Hint: 12/97 = 12.37%)

Problem 2:
XYZ & Co. issues 2,000 10% preference shares of Rs. 100 each at
Rs. 95 each. Calculate the cost of preference shares. (10/95 =
10.53%)
Illustration of the Cost of Redeemable Preference shares:
Problem 3:
Referring to the earlier question but taking into consideration that if
the company proposes to redeem the preference shares at the end
of 10th year from the date of issue. Calculate the cost of preference
share?
 COST OF EQUITY

COST OF EQUITY (Internal or External)

(Internal Equity refers to the Retained earnings and External Equity
refers to issue of Share Capital)
It may prima facie appear that equity capital does not carry any
cost. But this is not true. The market share price is a function of
return that equity shareholders expect and get. If the company
does not meet their requirements, it will have an adverse effect
on the market share price. Also, it is relatively the highest cost of
capital. Since expectations of equity holders are high, higher cost
is associated with it.

cost of equity is
Just like any other source of finance,
expectation of equity shareholders. We know
that the value is performance divided by expectations. If we know
the value and performance, then we can calculate expectation as a
balancing figure.
Here, performance means the amount paid by the company to
investors, like interest, dividend, redemption price etc. In case of
debentures and preference shares, amount of interest or dividend is
fixed but in case of equity shares it is uncertain.
Therefore, there is not a single method to calculate cost of equity but
different methods which depends on various factors like:
 If dividend is expected to be constant, then dividend price
approach should be used.
 If earning per share is expected to be constant, then earning
price approach should be used.
 If dividend and earning are expected to grow at a constant
rate, then growth approach (Gordon’s model) should be used.
 If it is difficult to forecast future, then realized yield approach
(or IRR model) should be used, which looks into past.
 When the cost of equity or expectation of investors is dependent
on risk i.e., Higher the risk, higher the expectations and vice versa,
then Capital asset pricing model (CAPM) should be used,
 which is based on risk.

Dividend Price Approach:

 The cost of equity in the case of the no-growth firms is equal to the
expected E/P ratio.
 Here, cost of equity capital is computed by dividing the current
dividend by average market price per share.
 This dividend price ratio expresses the cost of equity capital in
relation to what yield the company should pay to attract investors.
 However, this method cannot be used to calculate cost of equity of
units suffering losses.
This is also known as Dividend Valuation Model. This model
makes an assumption that the dividend per share is
expected to remain constant forever. Here, cost of equity
capital is computed by dividing the expected dividend by market
price per share as follows:
Cost of Equity = E/P
Where E= Expected Dividend and P=Market price (Ex-
dividend)

Tutorial Note:
 Ex-dividend value = Share value without considering the dividend
 Cum-dividend value = Share value after considering (i.e., including)
the dividend which will be received by the buyer of shares

To determine whether you should get a dividend, you need to look at

two important dates. They are the "record date" or "date of record"
and the "ex-dividend date" or "ex-date."

When a company declares a dividend, it sets a record date when you

must be on the company's books as a shareholder to receive the
dividend. Companies also use this date to determine who is sent
proxy statements, financial reports, and other information.
Once the company sets the record date, the ex-dividend date is set
based on stock exchange rules. The ex-dividend date for stocks is
usually set one business day before the record date. If you
purchase a stock on its ex-dividend date or after, you will not receive
the next dividend payment. If you purchase before the ex-dividend
date, you get the dividend.

Here is an example:

Declaration Ex-Dividend Record Date Payable Date

Date Date

Friday, 8th Friday, 15th Monday, 18th Tuesday, 3rd

Sept.,2017 Sept.,2017 Sept.,2017 Oct.,2017

On September 8, 2017, Company XYZ declares a dividend payable on

October 3, 2017 to its shareholders. XYZ also announces that
shareholders on record of the company's books on or before
September 18, 2017 are entitled to the dividend. The stock would
then go ex-dividend one business day before the record date.

In this example, the record date falls on a Monday. Excluding

weekends and holidays, the ex-dividend is set one business day
before the record date or the opening of the market—in this case on
the preceding Friday. This means anyone who bought the stock on
Friday or after would not get the dividend. At the same time, those
who purchase before the ex-dividend date on Friday will receive the
dividend.

With a significant dividend, the price of a stock may fall by that

amount on the ex-dividend date.
If the dividend is 25% or more of the stock value, special rules apply
to the determination of the ex-dividend date.  In these cases, the ex-
dividend date will be deferred until one business day after the
dividend is paid.  In the above example, the ex-dividend date for a
stock that’s paying a dividend equal to 25% or more of its value, is
October 4, 2017.
A stock is cum dividend, which means "with dividend," when a
company has
declared that there will be a dividend in the future but has not yet
paid it
out. A stock will trade cum dividend until the ex-dividend date. ...
When the
buyer receives the next dividend scheduled for distribution,
the share is cum
dividend.

Earnings Price Approach

The advocates of this approach co-relate the earnings of the
company with the market price of its share. Accordingly, the cost of
equity share capital would be based upon the expected rate of
earnings of a company. The argument is that each investor
expects a certain amount of earnings, whether distributed
or not from the company in whose shares he invests. Thus, if
an investor expects that the company in which he is going to
subscribe for shares should have at least a 20% rate of earning,
the cost of equity share capital can be construed on this basis.
Suppose the company is expected to earn 30% the investor will
be prepared to pay Rs.150 for a share of Rs.100 [i.e., (30/20)x100].
Cost of Capital under this approach = E/P
Where E= Earnings Per Share and P=Market price per share
This approach assumes that the earnings per share will remain
constant forever. The Earning Price Approach is similar to the
dividend price approach; only it seeks to nullify the effect of
changes in the dividend policy.
Growth Approach / Gordon’s Model
As per this approach, the rate of dividend growth remains
constant. Where, earnings, dividends and equity share price all
grow at the same rate, the cost of equity capital may be computed
as follows
Cost of Equity = (D/P)+G
Where,
D= Next Expected dividend
P= Market price per share
G=Constant Growth Rate of Dividend
In case of newly issued equity shares where floatation cost is
incurred, the cost of equity share with an estimation of constant
dividend growth is calculated as below:
Cost of Equity = [(D/(P-F))+G]
Where,
D= Next Expected dividend
P= Market price per share
G=Constant Growth Rate of Dividend
F = Flotation cost per share

Problem:
The share of a company is currently selling for Rs.100. It
wants to finance its capital expenditures of Rs.100 million
either by retaining earnings or selling new shares. If the
company sells new shares, the issue price will be Rs.95. The
dividend per share next year, DIV1, is Rs.4.75 and it is
expected to grow at 6 per cent on face value. Calculate (i)
the cost of internal equity (retained earnings) and (ii) the
cost of external equity (new issue of shares).
(Hint: For Retained earnings: Cost of Retained
Earning=(4.75/100)+6%=10.75%
For the shares to be issued: Cost of
E.Shares=(4.75/95)+6%=11%)
Problem:
A company has paid dividend of Re.1 per share (of face value
of Rs.10 each) last year and it is expected to grow @ 10% of
the dividend every year. CALCULATE the cost of equity if the
market price of share is Rs.55.
Solution:
Expected dividend= Rs.1.10 which is =11%
Expected Growth rate is 10% of the dividend or Re.0.10 or
1%
Therefor cost of capital = 11% + 1% =12%
Growth rate:
Average Model: (Trend analysis)
The growth rate in this method is found out by taking the
average growth in dividend of the earlier years. For example,
if the Dividend has grown from Rs.10.50 to Rs.13.50 over a
period of six years (For a share of Rs.100, whose market
value is Rs.150), the average is taken by dividing the
increase in Dividend by the number of years it takes to grow
to the present level, i.e, Rs.3.00 divided by 6 years. The
resulting growth is 4.8% in the dividend.
If the expected dividend in the next year is Rs.18/-, the cost
of capital shall be (Rs.18/Rs.150)+4.8%=12%
+4.8%=16.8%.
Gordon’s Growth Model:
Unlike the Average method, Gordon’s growth model
attempts to derive a future growth rate. As per this model,
increase in the level of investment will give rise to an
increase in future dividends. This model takes Earnings
retention rate (ERR) and rate of return on investments (ROI)
into account to estimate the future growth rate. It can be
calculated as follows:
Growth (g) = ERR × ROI
In other words, the retained earnings only will increase the
investment level and the increased investment shall bring in
the return on additional investment which can be expected
as the growth.
This shall be discussed again in detail in the chapter
“Dividend” (Module 4).

Realised Yield Approach:

Mr. Mehra had purchased a share of Alpha Limited for R s . 1,000.
He received dividend for a period of five years at the rate of 10
percent. At the end of the fifth year, he sold the share of Alpha
Limited for Rs.1,128. You are required to COMPUTE the cost of
equity as per realised yield approach.
[Hint: Cash outflow at t(0) =Rs.1000. Cash inflow every year
Rs.100 … thereafter at the end of the fifth year Rs.1128 is
going to be realised]
[Ans:12%]
Capital Asset Pricing Model: (CAPM)
CAPM model describes the risk-return trade-
off for securities. It describes the linear
relationship between risk and return of
securities.
The risk to which a security is exposed, can be
classified into two groups:
(i) Unsystematic Risk: This is also called
company specific risk as the risk is
related with the company’s performance.
This type of risk can be reduced or
eliminated by diversification of the
securities portfolio. This is also known as
diversifiable risk.
(ii) Systematic Risk: It is the macro-
economic or market specific risk
under which a company operates. This
type of risk cannot be eliminated by the
diversification hence, it is non-
diversifiable. The examples are inflation,
Government policy, interest rate, price
fluctuations etc.
As diversifiable risk can be eliminated by an
investor through diversification, the non-
diversifiable risk is the risk which cannot be
eliminated; therefore, a business should be
concerned as per CAPM method, solely
with non-diversifiable risk.

The non-diversifiable risks are assessed in

terms of beta coefficient (b or β)
(standardized weights) through fitting
regression equation between return of a
security and the return on a market
portfolio.

Thus, the cost of equity capital can be calculated under

this approach as:

Cost of Equity (Ke)= Rf + ß (Rm −

Rf)
Where,
 Ke = Cost of equity capital
Rf = Risk free rate of return
ß = Beta coefficient (The measurement of
the volatility (i.e. systematic risk) of a
security compared to the broader market)
Rm = Rate of return on market portfolio
Rm-Rf=Market Risk Premium

PROBLEM:
CALCULATE the cost of equity capital of H
Ltd., whose risk-free rate of return equals
10%. The firm’s beta equals 1.75 and the
return on the market portfolio equals to
15%.
Cost of Equity Capital (CAPM) = 0.10 + 1.75 (0.15
− 0.10)
= 0.10 + 1.75 (0.05) = 0.1875 or 18.75%

Therefore, Required rate of return = Risk free rate +

Risk premium
 The idea behind CAPM is that the
investors need to be compensated in two
ways - (i) Time value of money and (ii)
Risk.
 The time value of money is represented
by the risk-free rate in the formula and
compensates the investors for placing
money in any investment over a period
of time.
 The other half of the formula represents
risk and calculates the amount of
compensation the investor needs for
taking on additional risk. This is
 calculated by taking a risk measure
(beta).
The CAPM says that the expected return of
a security or a portfolio equals the rate on
a risk-free security plus risk premium. If this
expected return does not meet or beat the
required return, then the investment should
not be undertaken.
The shortcomings of this approach are:
(a) Realistic estimation of beta with historical data is
not easy; and
(b) Market imperfections may lead investors to
unsystematic risk.
Despite these shortcomings, the CAPM is
useful in calculating cost of equity, even
when the firm is suffering losses.
The basic factor behind determining the cost
of equity share capital is to measure the
expectation of investors from the equity
shares of that particular company.
Therefore, the whole question of
determining the cost of equity shares
hinges upon the factors which go into the
expectations of particular group of investors
in a company of a particular risk class.