Cost of capital, its significance and its computation

Under guidance of Dr Abhijeet singh

Prepared by Prashant Kiran Roll No. 20 MBA

Cost of Capital
The cost of capital of a firm is the minimum rate of return expected by its investors. Cost of capital for a firm may be defined as the cost of obtaining funds i.e. the average rate of return that the investors in a firm would expect for supplying funds to the firm. According to Solomon Ezra, cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditures.

Symbolically, cost of capital may be represented as:

K=r0+b+f

Where, K=Cost of capital ro=Normal rate of return at zero risk level b=premium for business risk f=premium for financial risk

Significance of the cost of capital

As an Acceptance Criterion in capital budgeting 2. As a Determinant of capital mix in capital structure Decisions 3. As a Basis for Evaluating the financial performance
1.

Determination of cost of capital

The cost of capital can be computed as Computation of cost of specific source of finance 2. Computation of weighted average cost of capital
1.

1. Computation of specific source of finance

Computation of each specific source of finance, viz, debt, preference share capital, equity share capital and retained earnings are as follows

(a) Cost of Debt

The cost of debt is the rate of interest payable on debt. It is given as

(i) The cost of debt before tax is Kdb=I/p Where, Kdb=Before tax cost of debt I =interest p =principal

In the case when the debt is raised in premium or discount,P is consider as the amount of net proceeds received from the issue and not the face value of securities. The formula may be changed to
Kdb=I/NP where, NP=Net proceeds

(ii)

Further when the debt is used as a source of finance, the firm saves a considerable amount in payment oif tax as interest is allowed as a deductable expences in computation of tax which reduces the effective cost of debt. The after tax cost of debt

(iii) Kda=Kdb(1-t) where, Kda=After tax cost of debt t = Rate of tax

Cost of redeemable debt When the debt is issued as a redeemable i.e. it is redeemed after a certain period of time then
(iv) Before tax cost of redeemable debt,
(RV-NP)
I +

Kdb=

n RV+NP

2 Where, I =Annual interest n=Number of years in which debt is to be reedemed RV=Redeemable value of debt NP=Net proceeds of debentures

(v) After tax cost of redeemable debt

(RV-NP) I(1-t)+

Kda=
2

(RV+NP)

problem
(a)

Y itd. Issues Rs 50000,8% debentures at a premium of 10%.The tax rate applicable to the company is 60%.Compute cost of debt capital.

X ltd issues Rs. 50,000 ,8% debentures at par. The tax rate applicable to the company is 50%.Compute the cost of debt capital. (c) A ltd issues Rs 50000,8% debentures at a discount of 5%.The tax rate is 50%.Compute the cost of debt capital. (d) B ltd issues Rs 100000,9% debenture at a premium of 10%.The cost of flotation are 2%.The tax rate applicable is 60%.Compute cost of debt capital.
(b)

Cost of debt Redeemable in Installments

A company may also issue a bond or debentures to be reedemed periodically. In such case principal amount is repaid each period instead of lump sum amount at maturity and hence cash outflow each period include interest and principal. It is given as
Vd=
I1+P1

I2 + P2

1+Kd

(I+Kd)2

Vd=present value of bond or debt I=Annual interest in period 1,2,and so on P=periodic payment of principal Kd=cost of debt or required rate of return

Cost of existing Debt

If a firm wants to compute the current cost of existing debt, the current market yield of the debt is take into consideration Problem Suppose a firm has 10% debentures of Rs 100 each outstanding on Jan1,1999 to be redeemed on December 31,2005 and the new debentures could be issued at a net realisable price of Rs 90 in the beginning of 2001,the current cost of existing debt will be

Kdb=

10 + (100-90) 5 100+90 2

=12.63%

Cost of preference capital The cost of preference capital which is perpetual can be calculated as
D

Kp=
P

where, Kp=cost of preference capital D=Annual preference dividend P=Preference share capital

If preference share are issued at premium or Discount or when costs of floatation are incurred to issue preference shares, then the cost of preference capital can be computed with the following formula: Kp=
D NP

It has to be noted that as dividends are not allowed to be deducted in computation of tax, no adjustments are required for taxes. For reedeemable preference shares, the cost can be calculated as:
MV-NP D+ n Kpr= MV+NP 2

A company issues 10000, 10% preference shares of Rs 100 each. Cost of issue is Rs 2 per share.Calculate cost of preference capital if these shares are issued (a) At par (b) At a premium of 10% (c) At a discount of 5%

1.

2. 3.

Cost of equity share capital The cost of equity is the maximum rate of return that the company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock. Payment of dividend is not legal binding. It may or may not be paid. The cost of equity share capital can be computed in the following ways: (a) Dividend yield method or Dividend/Price ratio method (b) Dividend yield plus growth in dividend method (c) Earning yield method

(a) Dividend yield method

In this method the cost of equity capital is the discount rate that equates the present value of expected future dividends per share with the net proceeds (or current market price) of a share. Symbolically,
D Ke = or NP MP D

where, Ke=cost of equity capital D=Expected dividend per share NP=Net proceeds per share MP=Market price per share

A company issues 1000 equity shares of Rs 100 each at a premium of 10%.The company has been paying 20% dividend to equity share holders 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 160?

(b)Dividend yield plus growth in dividend method

When the dividends of the firm are expected to grow at a constant rate and the dividend pay out ratio is constant this method is used. According to it Where Ke=Cost of equity capital D1=Expected dividend per share at the end of the year NP=Net proceeds per share G=Rate of growth in dividend D0=Previous years dividend
D1
Do + NP G= NP (1+g) +G

Ke=

(a) A company plans to issue 1000 new shares of Rs 100 each at par.The flotation costs are expected to be at 5%. The company pays a dividend of Rs 10 per share initially and the growth in dividend 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 150, calculate the cost of existing equity share capital.

(c) Earning yield Method

According to this method ,the cost of equity capital is the discount rate that equates the present value of expected earning per share with the net proceeds(or current market price) of a share. Symbollically,
Earning per share

Ke =
Net proceeds

EPS NP

Where the cost of existing capital is calculated

=
=

Earnings per share

Market price per share

EPS MP

1.

2.
3.

4.

This method of computing cost of equity capital may be employed in the following cases: When the earning per share is expected to remain constant When the dividend pay out ratio is 1005 or when the retention ratio is zero When a firm is expected to earn an amount on new equity shares capital which is equal to the current rate of earnings The market price of the share is influenced only by earning per share.

Cost of retained earning

It can be computed with the help of following formula
D1 + G Or MP

Kr=

D1 NP

+G

Where,
Kr=cost of retained earning D =Expected earning at the end of the year NP=Net proceeds of share issue G =Rate of growth MP=Market price per share

Computation of weighted Average cost of capital

Weighted average cost of capital is the average cost of the costs of various source of financing . Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. It can be calculate4d as follows Kw=
Summation of XW Summation of W

Where, Kw=Weighted average cost of capital X=Cost of specific source of finance W=weight, proportion of specific source of finance