Lecture 13. cost of capital

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1
Amity Business School
, Semester II
FINANCIAL MANAGEMENT
Cost of Capital

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Cost of Capital

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Meaning
• Cost of Capital means cost of obtaining funds
i.e. average rate of return that the investors in
a firm would expect for supplying funds to
the firm.
OR
It is the minimum rate of return which a firm,
must and is expected to earn on its
investments so as to maintain the market
value of its shares

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Significance of Cost of capital
• Helpful in capital Budgeting
• Helpful in capital structure decisions
• Helpful in evaluating the financial
performance
• Basis for other financial decisions like
dividend policy, working capital decisions etc.

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Classification of Cost of capital
• Historical cost and Future cost
• Specific cost and composite cost
• Explicit cost and Implicit cost
• Average cost and Marginal cost

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Computation of Cost
• Cost of Specific Source of finance
• Composite Cost of Capital

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Cost of Specific source of Finance
1. Cost of Debt
2. Cost of Preference Capital
3. Cost of Equity Capital
1. Cost of Debt
Debt may be in the form of debenture, bond and term loan from
the financial Institutions. On Debt, Interest is paid to the Investors
& payment of interest is a Fixed obligation.

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Cost of Debt
In case of Irredeemable debt
Kd = I(1-t)
NP
I = Interest
Where NP= Net proceeds
Q1. Rayon Steel ltd. has issued 30000 irredeemable 14% debentures of Rs.150 each.
The cost of floating of Debenture is Rs.5 per debenture
The company’s taxation rate is 40%. Calculate the cost of Debt.

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Cost of Redeemable debt
Kd = I (1-t)+ 1/n (RV-NP)
½ (RV+NP)
Q2. Surya Industries has raised fund through issue of 10,000 debenture
of Rs. 150 each at a discount of Rs 10 per debenture with 10 years
maturity. The coupon rate is 16%.The floatation cost is Rs.5 per
debenture. The Debenture are redeemable with 10% premium.
Corporate tax is 40%.Calculate the cost of Debt.

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Q3. A company recently made an issue of Non convertible debenture for Rs.400 Lakhs
The terms of the issue are as follows;
Each Debenture has a face Value of Rs.100 and carries a rate of Interest of 14%.
the debenture is redeemable at a premium of 5% after 10 yrs.
if the company realized Rs.97 per debenture and the corporate tax rate is 50%
What is cost of Debt?
Q4. Z steels Ltd has issued 50,000 irredeemable 15% debenture of Rs.100 each.
The cost of floatation of debenture is Rs.5 per share
The company’s taxation rate is 50%. Calculate the cost of debt.
Q5. N ltd has raised a term loan of Rs.2 Crores from a commercial bank on a prime
Lending rate plus 4%. The prime lending rate of the bank is 12%. The company’s
Corporate rate of tax is 40%. Calculate cost of debt raised from the bank.

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Cost of Preference Capital
Kp = D/P
Where D = Annual Preference dividend
P = preference Share Capital
(Proceeds)
Kp = D/NP
Redeemable Preference Shares
Kpr = D+1/n( RV-NP) (MP or NP)
1/2 (RV+NP)
Where MV = Maturity value of Preference shares

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Cost Of Preference Share
Q6. Green field Ltd has issued 10,00,000 irredeemable preference shares of Rs 150 each
At a coupon rate of 14%. The issue expenses are Rs.15 per share. Calculate the cost of
Preference share.
Q7. The term of the Preference share is made by Cola Ltd are as follows;
Each preference share has a face Value of Rs.100 and carries a rate of Dividend of
14%. The share is redeemable after 12 yrs at par. If the net amount realized per share
Is Rs.95, what is cost of preference shares.
Q8. Dell Ltd has Rs 100 preference share redeemable at a premium of 10% with 15 yrs
Maturity. The coupon rate is 12%. Floatation cost is Rs.5. Sales price is Rs. 95.
Calculate the Cost of Preference share
Q9. A firm has issued preference shares of the face value of $100 with the promised
Dividend of $12 per annum after incurring a floating cost of 2%. What is the cost of
Preference share to the company.

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Q10.Excel Co. Ltd has preference share having face value of $100 per share.
The rate of preference dividend is 14 per cent p.a. Shares are redeemable
after 12 years at par. The net amount realized per share is $95. Determine
the cost of preference share capital.