FINANCIAL MANAGEMENT

CHAPTER 6

COST OF CAPITAL

Learning Objectives
After reading this unit, you will be able to:
·State the meaning of cost of capital.
·Specify the significance of cost of capital.
·Calculate cost of equity preference debenture loan capital and
weighted average cost of capital (WACC).

Structure
6.1 Introduction
6.2 Meaning of Cost of Capital
6.3 Significance of Cost of Capital
6.4 Cost of Equity Shares
6.5 Cost of Preference Shares
6.6 Cost of Debenture
6.7 Cost Of Long Term Loans (KL)
6.8 Weighted Average Cost Of Capital (W.A.C.C.)
6.9 Summary

6.1 Introduction

Business procures funds from different sources. Every source has different
cost either in the form of dividend or in the form of interest. Business must earn
returns, which are sufficient to pay the cost of the funds.
Cost of capital is the minimum returns, which must be earned by business from
funds invested in business, which is weighted average cost of capital (WACC)
of various sources of funds used in business.

6.2 Meaning Of Cost Of Capital

It is the minimum rate of return that company must try to earn on the funds
invested in various projects of the company.
Minimum rate consists of risk free rate of return + premium for risk associated
with particular business.
Risk free rate of return is available on government securities where there is no
risk of default.
Premium is added for two types of risks associated with business viz. Business
Risk that arises when there is volatility in earnings of a company due to
changes in demand, supply, economic environment, business conditions etc.
Financial risk arises when firm depends on debt funds, since payment of
principal and interest must be made as per loan obligation.

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6.3 Significance Of Cost Of Capital

Management must invest funds in those projects, which would bring returns
more than cost of capital; then only share holders are benefited. Cost of capital
is the weighted average cost of capital (WACC) of various sources of funds
used in capital structure. Thus, returns from the project must be more than
WACC. In capital budgeting, decision methods used for evaluation of project
are based on WACC of project. While locating various sources of finance and
designing capital structure, management must ensure that WACC is kept at
minimum.

6.4 Cost Of Equity Shares

Cost of Equity Capital (Ke)

(1) Dividend-Yield Method

Formula:
Ke = D/ P
D= Dividend per share
P= Market price per share

Features:
(i) Future expected dividend is assumed to be constant.
(ii) Does not allow for any growth rate
(iii) In re ality, shareholders expect growth.

Illustration 1:
ABC Ltd. has declared dividend of 15% on share of Rs. 10, which will remain
constant. What is cost of equity if market price of share is Rs. 30?

Solution: Ke = D x 100

P
Ke = 1.5 x 100
30

= 5%

D = 15% = Rs. 1.50

P = Rs. 30
(2) Dividend-growth Method
Formula : Ke = (D1/ P) + g
D 1= Do (1+g)
g = Growth rate of dividend
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Features:
(I) Based on assumption that shareholders expect dividend to grow year after
year.
(ii) Allowance for future growth in dividend is added to current dividend
yield.
(iii) It is recognized that current market price of a share reflects expected future
dividends.

Illustration 2:
Company has declared dividend of 20% last year, which is expected to
increase at a constant rate of 6%.What is cost of equity if market price share is
Rs. 18?

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Features:
(i) Based on assumption that investors capitalize the stream of future earnings
of the share
(ii) Even if earnings are not distributed and kept as retained earnings, it causes
further growth in earnings of company and market price of share
Illustration 3:
Aditya Ind. Ltd. has just paid dividend of 35%, which is expected to grow at a
constant rate of 5%. What is cost of equity if market price of share is Rs. 30?
Solution:
Ke = D1 + g D1 = Rs. 3.50
P P = Rs. 30
g =5%
= 3.5 + 5%
30
= 11.67%+ 5%
= 16.67%.
Illustration 4:
EBIT of company is Rs. 28 Crore. Interest paid by company is Rs. 3 crore. Tax
rate is 40%. Preference capital (10%) is Rs. 10 crore and equity capital (Rs. 5)
is Rs. 30 Crore. Debentures (10%) Rs. 50 Crore and Loan (12%) Rs. 25 Crore.
Decide cost of equity if market price of share is Rs. 20.
Solution:
Ke = ___________E.P.S.______________
Market Value per Share (M.V.P.S.)
Now EPS = EBIT - Int. – Tax – Pref. Dividend
No. of Equity Shares.
EBIT = Rs. 28 crore
Int. = Rs. 3 crore
Tax. = 40% [28 – 3] = Rs. 10 crore
Pref. Div. = 10% [10] = Rs. 1 crore
No. of equity shares = Equity Capital = 30 Cr. = 6 Cr. Shares
Price per share 5
Hence,
E.P.S. = 28 - 3 - 10 - 1
6
= 14
6
and Ke= 2.33 x 100
20 = 11.65%
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(4) Capital Asset Pricing Model (CAPM) Method

Formula: Ke = Rf +β (Rm - Rf )
Rf = Risk free rate of return Risk free rate
Rm=Market return
Β=Beta of investment
Features:
(i) CAPM divides cost of capital in two components Risk free rate of return and
risk premium for a particular investment, which depends on market returns
and risk factor β.
Illustration 5:
Returns available on Govt. T-bills is 3%. Returns available in market are 18%.
Beta for the share is 1.2. Decide cost of equity using C.A.P.M. method.
Solution:
Ke = Rs + β [Rm - Rf]
Rf= 3%Rm = 18%β = 1.2
Hence,
Ke = 3% + 1.2 [18% - 3%]
= 3% + 18%

6.5 Cost Of Preference Shares

Cost of Redeemable Pref. Shares (Kp)
The cost of redeemable preference share can be calculated by
using the following formula:
Where, DP = Preference dividend,
n = Period of preference share,
RV= Redeemable value of preference share, and
NP = Net proceeds from issue of preference shares.
Example 4.3:
Baibhav Ltd., issued 10,000, 12% preference shares of Rs 100 each at a
premium of 6%); the floatation cost being 2.5% on issue price. The shares are
to be redeemed after 5 years at a premium of 5%. Compute the cost of
preference share capital.
Solution:
We know that the cost of preference shares may be calculated as
Where I= Interest =2,00,000 x 12/100 =Rs 24,000
NP = Net proceeds = Rs. 2,00,000
T =Tax Rate = 30% i.e 0.3
Kd = 24,000 (1-0.3) = 0.84 or 8.4 %
2,00,000

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6.6 Cost Of Debenture

Cost of Redeemable Debentures (Kd) For redeemable debentures, the
maturity date is fixed initially. so we take the averages of sale value and
redeemable value while calculating the cost of redeemable debentures.
1. Cost of redeemable debt, before tax : Cost of redeemable debt, a before
tax issued at par can be expressed as follows:
Kd = I + (P- NP)/n
(P+ NP)/2
Where,
Kd = Cost of debt
I = Interest /Fixed charge per annum
P/RV = Face value of debenture/ Redeemable value
NP = Net proceed /Price at which the debenture or the bond is sold
T = Tax rate
n= No of years
Illustration 1:
A firm issues debentures of Rs 1,00,000 and realizes Rs 98000 after allowing
2% commission to brokers.The debenture carry an interest rate of 10% . The
debenture are due for maturity at the end of the 10th year. You are required to
calculate the effective cost of debt before tax.
Solution:
Kd = I + (P- NP)/n
(P+ NP)/2
10,000 + (1,00,000 -98,000)/10
(1,00,000 +98000)/2
= 10, 000 + 200
99,000
=.103 or 10.30%
2. Cost of redeemable Debt,after
A debenture or a bond may be issued at a discount tax or a premium.It is
redeemable after the expiry of a given period(n).Its price differs from its face
value .The cost of redeemable debt issued at a discount or premium is
calculated as follows:
Kd = [I + 1/n (P- NP)](1-t)
1/2 (P+ NP)
Kd = cost of debt
I = Fixed charge per annum
P/RV = Face value of debenture /redeemable value
NP= price at which the debenture or the bond is sold/net proceed
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T = tax rate
n = No. of years
Illustration 2
MV Ltd issues 10 years debentures of the face value of Rs 100 at a discount of
10% . The coupon rate of interest is 8% .Assuming 50% tax rate, calculate
after-tax cost of the debt.
Solution:
The after –tax cost of debt will be:
Kd = [I + 1/n (P- NP)](1-t)
1/2 (P+ NP)
[Rs8 + 1/10 (Rs 100-90)] (1- 0.50)
½ (100+90)
= 0.0474 or 4.74
6.7 Cost Of Long Term Loans (kL)
KL= Interest (1-t)
Loan
Illustration 1:
Company took loan = 100 processing charges = 2%. Rate of interest 13%.
Tax rate 35%What is cost by Loan?
Solution:
KL = Interest ( 1 – t ) x 100
Net loan proceed
= 13 Cr. ( 1 – 0.35) x 100
( 100 - 2 ) Cr.
= 8.2 %
6.8 Weighted Average Cost Of Capital (w.a.c.c.)
Weighted Average Cost of Capital (WACC):
WACC is the weighted average of cost of various sources of finance, weight
being book value or market value of each source.
Capital available for any project of company is coming from various sources.
Hence cost of capital is WACC.
For proper evaluation of project, WACC is considered as minimum rate of
return required from project. The relative worth of a project is determined using
this rate as discounting rate.
W.A.C.C. Ke x Equity Kp x Pref. cap Kd x Debenture KL x Loan
= ---------------- + ---------------- + ------------------- + -------------
Total capital Total capital Total capital Total capital
Kdand KL are post tax costs
Total capital = Equity +Pref. + Debentures + Loan taken
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Illustration 1:
Total capital of Co. = Rs. 150 crore
Composition is as under
Source Amount ( Rs. crore) Cost
Equity 20 18%
Preference shares 10 8%
Debentures 100 7% (Post – Tax )
Loan 20 8.5% (Post – Tax )
What is W.A.C.C.?

Solution:

WACC = E x Ke + P x Kp+ D Kd__ + L x Kl_

E+P+D+L E+P+D+L E + P + D +L E+P+D+L

Given : E = 20, P = 10, D = 100, L = 20

Ke = 18% Kp = 8% Kd = 7% KL = 8.5%

Hence WACC = 20 x 18% + 10 x8% + 100 x 7% + 20 x 8.5%

150 150 150 150

= 1 [ 20 x 18 + 10 x 8 + 100 x 7 + 20 x 8.5 ] %
150

= 8.73%

Illustration 2:

Company has total capital Rs. 100 Cr. With following composition ( tax rate
= 40%)
Source Amt. (Rs. Crore.) Cost
Equity 10 20%
Preference 20 8%
Debentures 60 12% ( Pre - tax )
Loan 10 14% ( Pre - tax )

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Solution:
WACC = E Ke + P Kp+ D Kd_(1-E)_+ L x KL ( 1- t)
E+P+D+L E+P+D+L E + P + D +L E+P+D+L

E = 10, P = 20, D = 60, L = 10

Ke = 20% Kp = 8% Kd = 12% KL = 14%

Hence WACC = 10 x 20% + 20 x 8% + 60 x 12%(1-0.4) + 10 x 14% (1-

0.4)
100 100 100 100

= 1 [10 x 20 + 20 x 8 + 60 x 12 x 0.6 + 10 x 14 x 0.6 ] %

100
= 8.76%
6.9 Summary

· Cost of capital is the minimum rate of return that must be earned by business
on the funds invested in business.
· Shareholders are benefited when management invests funds in projects,
which bring returns more than cost of capital.
· There are different formulae and methods to find out cost of equity shares,
preference shares, debentures, and loans.
· WACC is the weighted average of cost of various sources of finance.
Generally, cost of capital of company is WACC.

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