1. Cost of Capital

Cost of Capital
1. Cost of Capital
It is the weighted average of cost of various sources from which capital is raised.
It is the minimum return to be earned by the company to meet the expectations of the capital providers.
Cost of Capital
(Ko)
Cost of Debt Cost of Equity Cost of Retained

Cost of PSC (Kp)
(Kd) (Ke) Earnings (Kr)
Cost of Capital
I = Interest rate
T = Tax Rate
RV = Redeemable value
N = No. of years to maturity
PD = Preference dividend
NP = P0 = Net Proceeds / Market Value/ Face value
Flotation cost to be considered on issue price if question is silent.
Redeemable value to be taken at par value if question is silent.
Cost of Capital
2. Cost of Irredeemable Debt
!(#$%)
Kd = ×100
'(
3. Cost of Redeemable Debt – Approximation Method
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! #$% ) &
Kd = $%'!" ×100
(
Cost of Capital
4. Cost of Redeemable Debt – YTM Method
Option - 1
Find Kd using approximation method say x.y%
Find NPV at x% and (x + 1)%
NPV = PVCI – PVCO = [Int.(1 – t) ´ PVAF(r,n)] + [RV ´ PVF(r,n)] – Cost today
We require one +ve NPV and one -ve NPV.
!"#$% %&'$ ()*
Kd = IRR = Lower rate + ×(𝐻𝑖𝑔ℎ 𝑅𝑎𝑡𝑒 − 𝑙𝑜𝑤 𝑅𝑎𝑡𝑒)
(!"#$% %&'$ ()*,-./0$% 1&'$ ()*)
Option – 2
Find NPV at rates given in question.
NPV = PVCI – PVCO = [Int.(1 – t) ´ PVAF(r,n)] + [RV ´ PVF(r,n)] – Cost today
We require one +ve NPV and one -ve NPV.
!"#$% %&'$ ()*
(!"#$% %&'$ ()*,-./0$% 1&'$ ()*)
Cost of Capital
5. Cost of Redeemable Debt in instalment
Use YTM method to calculate the cost of debt.
Calculate cash flows of each year
Cash flow = [Interest ´ (1 – t)] + Amortized maturity amount p.a.
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(!"#$% %&'$ ()*,-./0$% 1&'$ ()*)
Cost of Capital
6. YTM vs Intrinsic Value
If we find rate for
a given issue YTM
price
Rate
If we find issue
price for a given Intrinsic Value
rate
Intrinsic Value (IV) = Present value of all future cash inflows

IV of bond/debenture = PV of interest + PV of redemption value
7. Decision on basis of Intrinsic value (IV)

(A) If IV > Current price – Recommend to buy or Under-priced
(B) If IV < Current price – Not recommend to buy or Over-priced
Cost of Capital
8. Convertible Debentures
Redeemable value = Higher of either cash or equity value
Value of one equity share = P0 ´ (1 + g)n
Cost of Capital
9. Cost of Irredeemable Preference Shares
)3
Kp = ×100
()
10. Cost of Redeemable Preference Shares – Approximation Method
!"#$%
)34 &
Kp = $%'!" ×100
(
11. Cost of Redeemable Preference Shares – YTM Method

!"#$% %&'$ ()*
Kp = IRR = Lower rate + ×(𝐻𝑖𝑔ℎ 𝑅𝑎𝑡𝑒 − 𝑙𝑜𝑤 𝑅𝑎𝑡𝑒)
(!"#$% %&'$ ()*,-./0$% 1&'$ ()*)
Cost of Capital
12. Cost of Equity – Dividend Approach [Constant DPS]
3
Ke = ×100
)5
13. Cost of Equity – Earning Approach [Constant EPS]

6
Ke = ×100
)5
14. Cost of Equity – Dividend Growth Approach or Constant Growth Approach or Gordon Model
37
Ke = + 𝑔
)5
15. Cost of Equity – Earning Growth Approach

67
Ke = + 𝑔
)5
Cost of Capital
16. Cost of Equity – Capital Assets Pricing Model
Ke = Rf + (Rm – Rf)(β)
17. Cost of Equity – Realized Yield Approach

8.9.8$:84;&<.'&= >&.:
Return of one year =
?:9$@'A$:'
374)7
(1 + r1) =
)5
3B4)B
(1 + r2) =
)7
&
Ke = 1 + 𝑟1 × 1 + 𝑟2 × 1 + 𝑟3 … … … . (1 + 𝑟𝑛) − 1
Or If year wise price data is not given than use YTM method
Cost of Capital
D = Dividend per share = E ´ DP Ratio
E = Earning per share
D1 = Expected dividend per share = D0(1 + g) = E1 ´ DP Ratio
E1 = Expected earning per share = E0(1 + g)
3)C
DP Ratio = Dividend payout ratio = ×100
6)C
P0 = Net Proceeds / Market value / Face value
G = Growth rate
Option – 1 – g = (b)(r)
& 3:
Option – 2 – g = − 1
35
Rf = Risk Free Return
Rm = Market rate of return
Rm – Rf = Market risk premium
Β = Beta coefficient
Cost of Capital
18. Cost of Retained Earnings

Kr = Ke; If there is no flotation cost i.e. NP can’t be computed
Kr = Ke; If there is flotation cost i.e. NP can be computed
In case if personal tax is given than

Kr = Ke(1 – tp)(1 – B)
tp = Personal tax rate
B = Brokerage on income
Cost of Capital
19. Weighted Average Cost of Capital (WACC = Ko)
- It is the weighted average of cost of all sources taken together.
- Ko = (Ke)(We) + (Kr)(Wr) + (Kp)(Wp) + (Ke)(Wd)
- Weights can be either book value or market value.
- Prefer to use MV weights if question is silent, provided MV of all sources can be computed
Cost of Capital
20. Points to Remember (PTRs)

- Flotation cost are not to be considered for calculating market value weights.
- Term loan doesn’t have any market value. If market value is required than consider its book value to be its
market value.
- We always require ex-dividend or ex-interest values.
- Ex-dividend value = Cum-dividend value – Dividend amount
- Ex-interest value = Cum-interest value – Interest amount
- Market value of an equity share represents value towards face value and reserve & surplus.
- If Kr ≠ Ke then distribute the total market value between face value and reserve and surplus in the ratio of their
book value.
Cost of Capital
21. Weighted Marginal Cost of Capital
- It is the cost of raising additional rupee of capital.
- In this case only the additional capital raised should be considered for calculating Ko.

1. Cost of Capital

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1. Cost of Capital

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Cost of Capital

Cost of Debt Cost of Equity Cost of Retained

3. Cost of Redeemable Debt – Approximation Method

Intrinsic Value (IV) = Present value of all future cash inflows

7. Decision on basis of Intrinsic value (IV)

10. Cost of Redeemable Preference Shares – Approximation Method

11. Cost of Redeemable Preference Shares – YTM Method

13. Cost of Equity – Earning Approach [Constant EPS]

15. Cost of Equity – Earning Growth Approach

17. Cost of Equity – Realized Yield Approach

18. Cost of Retained Earnings

Kr = Ke; If there is flotation cost i.e. NP can be computed

In case if personal tax is given than

20. Points to Remember (PTRs)

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