Aravali Institute of Management

Presentation
On
Cost of Capital

Presented to Presented By
Dr. Asha Group No 5
Sharma
 COST OF CAPITAL

st of capital to a company is the minimum required rate of return that

n its investments in order to satisfy the various categories of investors
made investments in the form of shares, debentures & term loans.

SOURCE OF FINANCE:

1. Equity share capital; Preference share capital; Debt amount

if it is new organization.
2. In case of existing organization in addition to above Reserve
& Surplus also the one source.
 COMPUTATION OF COST OF
DEBT {Kd}
DE
BT

IRREDEMABLE REEDEMABLE
DEBT DEBT
 IRREDEMABLE DEBT

FORMULA
1. Kd, before tax = I
------------
NP/Mpo
2. Kd, after tax = I [ 1- T ]
------------
NP
Were: Kd = Cost of debt, I = Interest Amount, T = Tax Rate,

Rv = Redemption value, Np = Net Proceedings [ issue price-flotation cost ]

N = No of years, Mpo = Current Market Price.
ple:
1. A 10% debentures, face value of Rs 100 each issued at
[a] 100; [b] 90; [c] 110
mpute cost of debt, before tax @ 50%
h tax rate (2) with out tax rate ?

Solution: With tax rate

With out tax rate
Formula Kd = I Kd = I (1-T)
-------- ------------
NP NP
1. Kd = 10/100 = 10% Kd = 10 (1-0.5)/100 = 5%
2. Kd = 10/90 = 11.11% Kd = 10 (1-0.5)/90 = 5.5%
3. Kd = 10/110 = 9.09% Kd = 10 (1-0.5)/110 = 4.54%

ote:- Tax shield on interest = Interest

Tax Rate
Net interest = Interest – Tax shield on interest
 e:- 2 10% debentures, face value of Rs 100 each issued at 100 but
years with Rs 10 assume tax rate 40%. Compute cost of debt ?
REEDEMABLE PREFERENCE SHARE
Formula

Solution: Kd = I (1-T) + Rv-NP/n I = Interest amount = 10

----------------------------- T = Tax rate = 40%
Rv + Np/2 Rv = Redemption value = 11
= 10 (1-40%) + (110-100)/5 Np = Net proceeds = 100
----------------------------------- = n = No of years = 5
7.6%
110+100/2
If FV, IP, RV =Were:-
100 FV = Face Value
Then Kd = CR(1-T) IP = Issue Price
RV = Redemption Value
CR = Coupon Rate
[ OR ]Kd = Cost of Debt
 By using Internal Rate of Return [ IRR ] method
YEAR CASH DISFAC DIS CASH DIS CASH DIS CASH
FLOW @ 8% FLOW 9% FLOW FLOW
12%
0 (100) 1 (100) 1 (100) 1 (100)

1-5 10 3.99 39.9 3.88 38.8 3.60 36

5 110 0.68 74.8 0.649 71.39 0.567 62.37

NPV 14.7 10.19 (1.63)

nternal Rate of Return [ IRR ], Formula

= 8 + 14.7
RR = Li + NPVLi -------------- 4
--------------------------- Di 16.33
NPVLi - NPVHi
= 8 + 3.6 = 11.60
:- IRR = INTERNAL RATE OF RETURN
Li = LOWER INDEX
NPVLi = NET PRESENT VALUE OF LOWER INDEX
NPVHi = NET PRESENT VALUE OF HIGHER INDEX
Di = DIFFERENCE IN INTEREST RATE
PREFERENCE SHARE CAPITAL [ Kp ]

IRREDEMABLE PREFERENCE SHARE

REEDEMABLE PREFERENCE SHARE

 IRREDEMABLE PREFERENCE SHARE

FORMULA
Kp = Pd
-------------
NP/MPo

REEDEMABLE PREFERENCE SHARE

FORMULA
Kp = Pd + [ Rv – Np ]
------------
n
---------------------------
Were: Rv+Np/2

Cost of preference share

Preference Dividend
Mpo = Current market value
Redemption value
n = No of years
 e:
1. 10% preference share face value of Rs 100 each issue
90 & 110 ?
Solution: Kp = Pd/NP

1. Kp = 10/100 = 10%
2. Kp = 10/90 = 11.11%
3. Kp = 10/110 = 9.09%
preference share of Rs 100 each issued at 100 but redeemab
er 5 years @ 120 Rs ? Compute KP ?
Solutio
n: KP = Pd + [ Rv – Np ] = 10 + [ 120-100 ]
-------------- ---------------
n 5
------------------------------
--------------------------
Rv + Np/2 120 + 100/2
0+ 4
--------- = Kp = 12.72% ; This formula gives only approximate ans
 By Using IRR Method

YEAR CASH DIS FAC DCF DIS FAC DCF

FLOW 13% 14%

0 (100) 1 (100) 1 (100)

1–5 10 3.517 35.17 3.433 34.33
5 120 0.542 65.04 0.519 62.28
NPV 0.12 (3.39)

nternal Rate of Return [ IRR ], Formula

= 13 + 0.21
---------------- 1
RR = Li + NPVLi 0.21 + 3.39
--------------------------- Di
NPVLi - NPVHi = 13 + 0.058 = 13.058%
At IRR = NET PRESENT VALUE OF = TOTAL PRESENT VAL
CASH IN FLOW OUT FLOW

. At IRR ------- NET PRESENT VALUE { NPV } = 0

 COST OF EQUITY [ Ke ]
Formula’s

1. Dividend Yield Model = Ke = D/MPo

st of Equity; D = Dividend Per Share; MPo = Current Market Value
2. Dividend Yield + Growth Model = Ke = d1
------- + g
MPo Were: E = EARNINGS

= d0 ( 1+g ) D = DIVIDENDS
-------------- + g
MPo
CE = CAPITAL
EMPLOYED
d1 = Dividend at the end of current year; MPo = Current Market Value;
g = Growth Rate in Dividend; b = Retention Rate = E – D/D
r = Required Rate of Return = E/CE
 3. Dividend Net Worth Model = Ke = D
-------------------------
Average Net Worth

D = Dividend Per Share

Avg Net Worth = Opening + Closing Net Worth/2

4. Price Earning Approach [ PEA ], Ke = 1 1

EPS
------------- =
--------------- ---------
PER
MPS/EPS MPS
Price
PEREarning
= Price+ Earning
Growth Model,
Ratio Ke = EPS
EPS = Earning Per Share ---------- + PER
g = MPS/EPS
MPS = Market Price Per Share MPS
= Growth in Earning Per Share
 6 . CAPITAL ASSET PRICING MODEL [ CAPM ]

1. Ke = Rf + β [ Rm – Rf ]

1. Rp = Rm - Rf

Were: Rf = Risk free rate of return

Rm = Return on market Portfolio
β = Beta Factor
Rp = Risk Premium
floatation cost was given in problem then reduce floatation c
arket price. { Mpo – Floatation cost }

ssue price differs with market price use issue price rather th
ce in the formula.
 COST OF RETAINED EARNINGS
[ Kr ]
{ Opportunity Cost Approach }

Kr = Ke

f there is involvement of floatation cost, cost of retained ear

are slighter cheaper than cost of equity.
 WEIGHTED AVERAGE COST OF CAPITAL [ WACC / Ko ]

mpany cost of capital is nothing but the weighted arithmetic average

ost of various sources of finances that have been used by it.

WACC / Ko = [ Ko is also known as overall cost of capital ]

e of Cost of Weighted Av
Amount Weights Capital Cost of Cap
------------------------------------------------------------------------------------------

Capital 50 0.50 15% 7.5%

ence Capital 25 0.25 14% 3.5%

25 0.25 8% 2%
----------- ----------- ---------
100 1 WACC 13
----------- { OR }
----------- ---------
WACC / Ko = Kd D + Kp P + Ke E
------ ------ -----
V V V

= 8% {25/100} + 14% {25/100} + 15% {50/100}

= 2% + 3.5% + 7.5%

= 13%