COST OF CAPITAL

Cost of Capital is the minimum return expected by he contributors of capital. The

contributors may be equity share holders, debenture holders and preference share holders who
invest in equity shares, debentures and preference shares respectively of a company.
Simply the company has to earn a minimum amount (return) on the money contributed by
Re turn
x100
Investment
outsiders (Investment) i.e. return of Investment (ROI) =
The ROI is a charge on the company in real sense and so it is treated as Cost. It is usually
represented as % on the capital contributed.
The company usually uses cost of capital as a hurdle rate (or) interest rate (or) discount rate in
order to take a decision regarding investment in a project (or) Business.
There are various sources available for raising capital and these various sources have varied
levels of risk and return. If there is only one source of finance then the cost of that source of
finance will be the cost of capital. But the availability of finance from a single source is not
unlimited (i.e. limited) and not practical too.
So, the combined cost of all the sources of finance which the company uses is the cost of capital
of the company. (Dont add up all the costs its is wrong).
The combined cost can be arrived by making weighted average of specific cost of capital.
Specific cost in the sense cost of each source.

(i) Cost of debentures: The cost of debentures is denoted by K d. Kd is usually the interest rate
that the company has to pay on the capital raised in the form of debentures.
i.e. Kd = Interest rate
But the advantage of raising debentures (or) debt capital is that interest is deductible
expenditure for tax purpose (Sec. 36 of Income tax Act).

What is the use of this advantage for the company while arriving at cost?

The answer to this question can be best explained with the help of an illustration.
Suppose that there are two companies A and B. Company A is an all equity company where
as company B raises capital with a mix of debt and equity. The capital structure is as follows.

Company A Company B
Equity share capital 5,00,000 3,00,000
12% debentures --- 2,00,000
Total capital 5,00,000 5,00,000

The two companies are related to the same risk class and have the same Earnings (EBIT)

Company A Company B

1
 EBIT 1,00,000 1,00,000
Less: Interest N.A 24,000
EBT 1,00,000 76,000
Less: Tax @ 35% 35,000 26,600
EAT 65,000 49,400

Both the companies are earning the same income, but the return to equity share holders
vary.

65,000
x 100 = 13%
5,00,000
Return on Equity (ROE) for company A is for company B
49,400
x 100 = 16.46%
3,00,000

The difference in return is only due to interest and its tax advantage .company B is
paying return (i.e. Interest) to debenture holders as well as more return to equity holders as
compared to company A.

Company A pays 65,000 to its contributors of capital. Company B pays (24,000 + 49,400)
= 73,400 to its contributors.

Difference in return = 8,400. Thus the tax advantage is interest x tax rate = 24,000 x 35%
= 8,400.

The net cost of debentures to the company will be interest (-) interest x tax rate = interest
(1 tax rate)
Kd = Interest (1 - tax rate)

Usually expenses will be incurred by the company in raising capital and these
expenses are termed as flotation (or) floating costs.
If there are floatation costs then cost of debt will be as follows:
Intereste (1 - Tax rate)
Kd
Net sale proceeds

Net sale proceeds = capital raised (-) Flotation costs

Debentures are redeemable at par, at premium, at discount. If they are redeemed at

premium then that premium should be apportioned over the maturity period of debenture.

So, the cost of redeemable debentures is

2
 RV-NSP
Intereste (1 - Tax rate) +
Kd N
RV NSP
2

Rv = Redeemable value; NSP = Net sale proceeds

N = Maturity period

(ii) Cost of Preference Shares: Dividend payable on preference shares is not a charge on profit
and hence not deductible for tax purposes:
Kp = preference dividend
The preference dividend is inclusive of dividend distribution tax.
If there are flotation costs, then
Pr ef. dividend
Kp
Net sale proceeds

The cost of redeemable preference shares

RV - NSP
Pr ef. dividend +
Kp N
RV + NSP
2

RV = Redeemable value of preference share

NSP = Net sale proceeds

(iii) Cost of loans:

KL = Interest (1 Tax rate)

(iv) Cost of equity:

In the case of preference shares and debt (debentures & loan), the rate of return payable
by the company is available on the face of it. But in the case of equity shares, it is not available.

Though there is no compulsion on payment of dividend (or) return to equity share

holders, but if the company fails to give them return, they will shift their investment elsewhere.
The return may be in the form of dividends (or) capital appreciations.
There are various methods (or) approaches available in order to arrive at cost of equity.
They are as follows:

Computation of Cost of Equity (Ke) under various approaches:

Price Approach
1. Dividend price Approach
Dividend per share (DPS)
Ke x100
Market price per share (MPS)

(or)
Total dividend
x100
Market value of equity

3
2. Earnings Price Approach
Earnings per share (EPS)
Ke x100
MPS

(or)
Total earnings
x100
MV of equity

Growth Approach
1. Gordons Dividend Growth Approach
D1
Ke g
P0

2. Earnings Growth Approach

EPS
Ke g
P0

D1 = Expected dividend per share i.e. D0 (1+g)

D0= Dividend paid by the company.
P0 = Market price of share
g = growth rate

Computation of growth rate

The earnings after paying dividends will be treated as Reserves and transferred to
balance sheet which will be used as capital to generate earnings. So, growth rate is the rate of
return on retained earnings.

g = Retention ratio x Return on Investment (ROI)

Dividend per share (DPS)

Dividend Payout ratio = x100
Earnings per share (EPS)

Dividend payout ratio means so much of the earnings paid as dividend and the balance
of earnings is treated as retained earnings. So,

Retention Ratio = 1 Dividend payout ratio

DPS
x100
EPS
= 1
EPS DPS Retained earnings
x100 x100
EPS Total earnings
=

4
Realized yield approach
D PE PB
Ke
PB

D = Dividend
PE = Price at end
PB = Price at beginning
PE PB = Capital appreciation.

Capital assets Pricing model (CAPM)

Ke = Rf + (RM RF)
RF = Risk free rate
= Beta
RM = Market return
(RM RF) = risk premium

Beta
Beta is the measure of risk. When an investor invests in a company he will expect a
minimum return i.e., the return paid by a bank where he takes no risk i.e., risk free rate (R f)
plus premium for taking risk.
The premium is times the market return more than Risk free rate of return
= Rf + premium for taking risk
= Rf + (Rm Rf)

v. Cost of Reserves
Reserves are created out of profits and are shareholders funds. So, the cost of reserves is
nothing but cost of equity except that there are no flotation costs.

Kr = Ke (except flotation cost)

Weighted average cost of capital (WACC)

WACC (or) overall cost of capital Ko is the weighted average of each cost of specific
source.
K o WE x K E + WD x K D WP x K P

WE = weight of equity WD = weight of Debt weights are the proportions i.e. simply
Equity Capital
WE
Total Capital

The proportions (or) weights may be Book value weights (or) market value weights. But
the latter are more appropriate then the former.

5
Problem 1
A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The company has
been paying 25% dividend to equity shareholders for the past five years and expects to maintain
the same in the future also. Compute the cost of equity capital. Will it make any difference if the
market price of equity share is Rs. 175?

Problem 2
(a) A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are
expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share initially
and growth in dividends is expected to be 5%.
Compute the cost of new issue of equity shares.
(b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity
share capital

Problem 3
The current market price of the shares of A Ltd. is Rs. 95. The floatation costs are Rs. 5 per share
amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are required to calculate the
cost of equity share capital.

Problem 4
A firm is considering an expenditure of Rs. 75 lakhs for expanding its operations.
The relevant information is as follows :
Number of existing equity shares =10 lakhs
Market value of existing share =Rs.100
Net earnings =Rs.100 lakhs
Compute the cost of existing equity share capital and of new equity capital assuming that new
shares will be issued at a price of Rs. 92 per share and the costs of new issue will be Rs. 2 per
share.

Problem 5
(a) A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate applicable to the company is
50%. Compute the cost of debt capital.
(b) B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate applicable to
the company is 60%. Compute the cost of debt capital.
(c) A Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute
the cost of debt capital.
(d) B Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of floatation are
2%. The tax rate applicable is 50%. Compute the cost of debt-capital.
In all cases, we have computed the after-tax cost of debt as the firm saves on account of tax by
using debt as a source of finance.

Problem 6
A company issues Rs. 20,00,000, 10% redeemable debentures at a discount of 5%. The costs of
floatation amount to Rs. 50,000. The debentures are redeemable after 8 years. Calculate before
tax and after tax. Cost of debt assuring a tax rate of 55%.

Problem 7
XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per share.
Calculate cost of preference share capital if these shares are issued (a) at par, (b) at a premium of
10% and (c) of a debentures of 6%.

6
Problem 8
ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Redeemable after 8 years at a
premium of 10%. The cost of issue is Rs. 2 per share. Calculate the cost of preference share
capital.

Problem 9
Calculate the cost of capital in the following cases:
i) X Ltd. issues 12% Debentures of face value Rs. 100 each and realizes Rs. 95 per
Debenture. The Debentures are redeemable after 10 years at a premium of 10%.
ii) Y. Ltd. issues 14% preference shares of face value Rs. 100 each Rs. 92 per share. The
shares are repayable after 12 years at par.

Note: Both companies are paying income tax at 50%.

Problem 10
a) A company raised preference share capital of Rs. 1,00,000 by the issue of 10% preference share of
Rs. 10 each. Find out the cost of preference share capital when it is issued at (i) 10% premium, and
(ii) 10% discount.
b) A company has 10% redeemable preference share which are redeemable at 6the end of 10 th year
from the date of issue. The underwriting expenses are expected to 2%. Find out the effective cost of
preference share capital.
c) The entire share capital of a company consist of 1,00,000 equity share of Rs. 100 each. Its current
earnings are Rs. 10,00,000 p.a. The company wants to raise additional funds of Rs. 25,00,000 by
issuing new shares. The flotation cost is expected to be 10% of the face value. Find out the cost of
equity capital given that the earnings are expected to remain same for coming years.

Problem 11
A company is considering raising of funds of about Rs. 100 lakhs by one of two alternative method,
viz., 14% institutional term loan or 13% non-convertible debentures. The term loan option would
attract no major incidental cost. The debentures would have to be issued at a discount of 2.5% and
would involve cost of issue of Rs. 1,00,000.
Advise the company as to the better option based on the effective cost of capital in each case.
Assume a tax rate of 50%.

Problem 12
The following information has been extracted from the balance sheet of Fashions Ltd. as on 31-12-
1998:
Rs. in Lacs
Equity share capital 400
12% debentures 400
18% term loan 1,200
a) Determine the weighted average cost of capital of the company. It had been paying dividends at a
Consistent rate of 20% per annum.
b) What difference will it make if the current price of the Rs. 100 share is Rs. 160?
c) Determine the effect of Income Tax on the cost of capital under both premises (Tax rate 40%).

Problem 13

7
Problem 14
ABC Ltd. has the following capital structure.
Rs.
Equity (expected dividend 12%) 10,00,000
10% preference 5,00,000
8% loan 15,00,000
You are required to calculate the weighted average cost of capital, assuming 50%
as the rate of income-tax, before and after tax

Problem 15
The following information is available from the Balance Sheet of a company
Equity share capital 20,000 shares of Rs. 10 each Rs. 2,00,000
Reserves and Surplus Rs. 1,30,000
8% Debentures Rs. 1,70,000
The rate of tax for the company is 50%. Current level of Equity Dividend is 12%. Calculate the
weighted average cost of capital using the above figures.

Problem 16
A Limited has the following capital structure:
Equity share capital (2,00,000 shares) Rs. 40,00,000
6% preference shares Rs. 10,00,000
8% Debentures Rs. 30,00,000
The market price of the companys equity share is Rs. 20. It is expected that company will pay a
dividend of Rs. 2 per share at the end of current year, which will grow at 7 per cent for ever. The tax
rate may be presumed at 50 per cent. You are required to compute the following:
a) A weighted average cost of capital based on existing capital structure.
b) The new weighted average cost of capital if the company raises an additional Rs. 20,00,000 debt
by issuing 10 per cent debentures. The would result in increasing the expected dividend to Rs. 3 and
leave the growth rate unchanged but the price of share will fall to Rs. 15 per share.
c) The cost of capital if in (b) above, growth rate increases to 10 per cent.

Problem 17
The ABC Company has the total capital structure of Rs. 80, 00,000 consisting of:
Ordinary shares (2, 00,000 shares) 50.0%
10% preference shares 12.5%
14% debentures 37.5%

8
The shares of the company sell for Rs. 20. It is expected that company will pay next year a dividend
of Rs. 2 per share which will grow at 7% forever. Assume a 50% tax rate. You are required to:
a) Computed a weighted average cost of capital structure.
b) Compute the new weighted average cost of capital if the company raises an additional Rs.
20,00,000 debt by issuing 15% debenture. This would result in increasing the expected dividend to
Rs. 3 and leave the growth rate unchanged, but the price of share will fall to Rs. 15 per share.
c) Compute the cost of capital if in (b) above, growth rate increases to 10%.

Problem 18
ABC Ltd. has the following capital structure
4,000 Equity shares of Rs. 100 each Rs. 4, 00,000
10% preference shares Rs. 1, 00,000
11% Debentures Rs. 5, 00,000
The current market price of the share is Rs. 102. The company is expected to declare a dividend of
Rs. 10 at the end of the current year, with an expected growth rate of 10%. The applicable tax rate is
50%.
i) Find out the cost of equity capital and the WACC, and
ii) Assuming that the company can raise Rs. 3, 00,000 12% Debentures, find our the new
WACC if
(a) Dividend rate is increased from 10 to 12%,
(b) Growth rate is reduced from 10 to 8% and
(c) Market price is reduced to Rs. 98.

Problem 19
An electric equipment manufacturing company wishes to determine the weighted average cost of
capital for evaluating capital budgeting projects. You have been supplied with the following
information:
BALANCE SHEET

Additional Information:
i) 20 years 14% debentures of Rs. 2,500 face value, redeemable at 5% premium can be sold at par,
2% flotation costs.
ii) 15% preference shares: Sale price Rs. 100 per share, 2% flotation costs
iii) equity shares: Sale price Rs. 115 per share, flotation costs, Rs. 5 per share
The corporate tax rate is 55% and the expected growth in equity dividend is 8% per year. The
expected dividend at the end of the current financial year is Rs. 11 per share. Assume that the
company is satisfied with its present capital structure and intends to maintain it.