Cost of capital It is the minimum rate of return that a firm must earn on its investments for the market value of the firm to remain unchanged. It is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return or standard return.
Types of cost
Assumptions to measure cost of capital
Business risk will remain same.
Financial risk will remain same.
Specific cost of capital
Cost of debt
Cost of preference capital
Cost of equity capital
Cost of retained earnings
Cost of Debt
Cost of perpetual debt:
Ki= Interest payment
A company has 10 percent perpetual debt of Rs. 1 lac. The tax rate is 35 percent. Determine the cost of capital (before tax as well as after tax) assuming the debt is issued at (1) par, (2) 10 percent discount, and (3) 10 percent premium.
Cost of redeemable debt
Short cut method
Kd= I+ (f + d + Pr - Pi)/Nm
A company issues 11 percent debentures of Rs. 100 for an amount aggregating Rs. 1 lac at 10 percent premium, redeemable at par after five years. The company’s tax rate is 35 percent. Determine the cost of using method.
Cost of preference of shares
Dp is dividend on preference shares
Sale proceeds is equal to sale proceeds minus floatation cost
Redeemable preference capital
ABC Ltd. has issued 11 percent preference shares of the face value of Rs. 100 each to be redeemed after 10 years. Flotation cost is expected to be 5 percent. Determine the cost of preference shares.
Cost of Equity Capital
(1) Constant growth model
Suppose that dividend per share of a firm is expected to be Rs. 1 per share next year and is expected to grow at 6 percent per year perpetually. Determine the cost of equity capital assuming the market price per share is Rs. 25.
Answer = 10%
Z ltd. Is forseeing a growth rate of 12 percent per annum in the next 2 years. The growth rate is likely to fall to 10 percent for the third year and the fourth year. After that, the growth rate is expected to stabilize at 8 percent per annum. If the last dividend was Rs. 1.5 per share and the investors required rate of return is 16 percent, find out the intrinsic value per share of Z ltd. as of date.
Capital Asset Pricing model approach:
It describes the relationship between the required return or cost of equity capital and the non diversifiable risk of a firm measured by beta coefficient, b.
Ke= Rf + b (Km-Rf)
Cost of Retained Earnings
Overall cost of Capital
It is weighted average of the cost of each specific type of fund.
Where w is the proportion of specific capital in the capital structure ki is specific cost of capital
Assignment of weights
Historical weights/Marginal weights
Book value/market value weights
A firm’s after tax cost of capital of the specific sources is as follows:
Cost of debt 8%
Cost of preference shares 14%
Cost of equity 17%
The following is the capital structure:
Source book value Market value
Debt 3 lac 270000
Preference capital 2 lac 230000
Equity capital 5 lac 750000
Calculate the weighted average cost of capital using weights.