Cost of capital is the minimum rate of return a firm requires to increase its value. It is a weighted average of the costs of a firm's various sources of financing such as debt, preferred stock, common stock, and retained earnings. A firm's cost of capital includes three components: the risk-free rate, the business risk premium, and the financial risk premium. The cost of capital is used to evaluate investment decisions, design a firm's debt policy, and appraise financial performance. It is calculated by determining the specific costs of each financing source and computing a composite weighted average cost of capital.

1. COST OF
CAPITAL
BY:
MS. SHWETA
GOEL

2. COST OF CAPITAL
 Cost of capital is the minimum rate of return the
firm requires from the investment in order to
increase the value of the firm.
 The sources of capital of a firm must be in the
form of preference shares, equity shares, debt and
retained earnings.
 In simple cost of capital of a firm is the weighted
average cost of their different sources of financing.
6/19/2023
FM/ MS. SHWETA GOEL 2

3. COMPONENTS OF COST OF
CAPITAL
A firm’s cost of capital include 3 components :
1) Risk-free interest rate :- It relates to the expected rate of
return when a project involves no financial or business risk.
2) Business risk premium :- Generally business risk premium
is determined by the capital budgeting decisions for
investment proposals. If the firm selects a project which
has more than the normal risk, the suppliers of the funds
for the project will naturally expect a higher rate of return
than the normal rate. Thus, the cost of capital increases.
6/19/2023
FM/ MS. SHWETA GOEL 3

4. 3) FINANCIAL RISK PREMIUM :- FINANCIAL RISK RELATES
TO THE PATTERN OF CAPITAL STRUCTURE OF THE FIRM.
A FIRM WHICH HAS HIGHER DEBT CONTENT IN ITS
CAPITAL STRUCTURE SHOULD HAVE MORE RISK THAN
A FIRM WHICH HAS COMPARATIVELY LOW DEBT
CONTENT.
6/19/2023
FM/ MS. SHWETA GOEL 4

5. The above 3 components of cost of capital may be
written in the form of the following equation.
K=rf+ b + f
Where,
K= cost of capital
rf = risk-free interest rate
b= business risk premium
f= financial risk premium
6/19/2023
FM/ MS. SHWETA GOEL 5

6. SIGNIFICANCE OF COST OF CAPITAL
FM/ MS. SHWETA GOEL 6/19/2023 6
Evaluating
Investment
Decisions
1
Designing o
firm’s debt policy
2
Appraising the
financial
performance of
top management
3

7. CLASSIFICATION OF COST OF
CAPITAL
1) Historical cost and Future cost
2) Specific cost and Composite cost
3) Average cost and Marginal cost
4) Explicit cost and Implicit cost
6/19/2023
FM/ MS. SHWETA GOEL 7

8. COMPUTATION OF COST OF
CAPITAL
Computation of the Cost of Capital involves;
I. Computation of specific costs.
II. Computation of composite cost.
6/19/2023
FM/ MS. SHWETA GOEL 8

9. SPECIFIC COST OF CAPITAL
FM/ MS. SHWETA GOEL 6/19/2023 9
Computation of Specific
Cost includes;
• Cost of Debt
• Cost of Preference Shares
• Cost of Equity Shares
• Cost of Retained Earnings

10. COMPUTATION OF
SPECIFIC COST
A. Cost of Debt :-It is the rate of return which is
required by the lenders.
Cost of Debt(Kd) =
𝐼
B0
Where,
Kd = Cost of Debt
I = Interest
B0= Net proceeds/ Issue price of the bond
I= Face value of debt* Interest rate
6/19/2023
FM/ MS. SHWETA GOEL 10

11. B0 = FV+ Pm – D – F
B0= Net proceeds
FV= Face value of debt
Pm= Premium charged on the issue of debt
D= Discount on issue of debentures
F= Flotation cost
If taxes are also given:
Kd= Kd (without tax)(1-t)
6/19/2023
FM/ MS. SHWETA GOEL 11

12. COST OF REDEEMABLE
DEBT(BEFORE TAX)
Redeemable debt refers to the debt which is to be
redeemed or repayable after the expiry of a fixed period
of time.
B0 = 𝒊=𝟎
𝒏 𝑰𝒊(𝟏−𝒕)
(𝟏+Kd)i
+
𝑩𝒏
𝟏+𝒌𝒅 𝒏
Illustration:
12.5% debentures of face value 100 each
Discount=5%, Flotation cost= 1%, Tax=40%
Cost of capital of debentures= 12.5(1-0.40)/94= 7.9%
6/19/2023
FM/ MS. SHWETA GOEL 12

13.  B0 = 𝒊=𝟎
𝒏 𝑰𝒊(𝟏−𝒕)
(𝟏+Kd)i
+
𝑩𝒏
𝟏+𝒌𝒅 𝒏
 B0 =
𝟏𝟐.𝟓(𝟏−𝟎.𝟒𝟎)
(𝟏+Kd)1
+
𝟏𝟐.𝟓(𝟏−𝟎.𝟒𝟎)
(𝟏+Kd)2
+
𝟏𝟐.𝟓 𝟏−𝟎.𝟒𝟎
(𝟏+Kd)3
+
⋯ . +
𝟏𝟐.𝟓 𝟏−𝟎.𝟒𝟎
(𝟏+Kd)n
+
𝑩𝒏
𝟏+𝒌𝒅 𝒏
 94= 7.50(Pvaf(r,n))+100(PVF(r,n))
6/19/2023
FM/ MS. SHWETA GOEL 13

14. 6/19/2023
FM/ MS. SHWETA GOEL 14
 Kd=
𝐼 1−𝑡 +(𝑅𝑉−B0)/n
(𝑅𝑉+𝐵𝑜)/2
 Kd=
12.5 1−𝑡 +(𝑅𝑉−B0)/n
(𝑅𝑉+𝐵𝑜)/2

Where,
I = Annual Interest Payment
RV = Redemption Value Of Debentures
Bo= Net Proceeds Of Debentures
T= Tax rate
n= No. Of Years To Maturity

15. ILLUSTRATION
 Ques: A 7year, ₹100 debenture of a firm can be sold for
a net price of ₹97.75. The rate of interest is 15% per
year and bond will be redeemed at 5% premium on
maturity. The firm’s tax rate is 35%. Compute the
after-tax cost of debenture.
 Ans. Kd=
𝐼 1−𝑡 +(𝑅𝑉−B0)/n
(𝑅𝑉+𝐵𝑜)/2
= =
15 1−0.35 +(105−97.75)/7
(105+97.75)/2
 = 10.785/101.375= 10.63%
6/19/2023
FM/ MS. SHWETA GOEL 15

16. ILLUSTRATION
The Elu Ltd is contemplating a debenture issue on the following
terms:
Face value: Rs 100 per debenture
Term of maturity :7 years Yearly coupon rate of interest
Years 1 - 2: 9 per cent
3 - 4 : 10 per cent
5 - 7 : 11per cent
The current market rate on similar debenturs is 11 per cent per
annum. The company proposes to price the issue so as to yield a
(compounded) return of 12 per cent per annum to the investors.
Determine the issue price. Assume redemption at a premium of 5 per
cent on face value
6/19/2023
FM/ MS. SHWETA GOEL 16

17. SOLUTION
Years Cash
outflows
PVIF at
12%
Total PV
1 Rs 9 0.893 Rs 8.037
2 9 0.797 7.173
3 10 0.712 7.120
4 10 0.636 6.360
5 11 0.567 6.237
6 11 0.507 5.577
7 116*
(11+105)
0.452 52.432
92.936
6/19/2023
FM/ MS. SHWETA GOEL 17

18. B. COST OF PREFERENCE
SHARE CAPITAL
Normally a fixed rate of dividend is payable on
preference shares.
1) Cost of irredeemable preference share capital
KP=
𝑷𝑫
𝑷𝟎
Where,
KP =Cost of pref.share capital
PD=Fixed preference dividend
𝑷𝟎 =Net proceeds of pref. shares
6/19/2023
FM/ MS. SHWETA GOEL
18

19. ILLUSTRATION
 A ltd issues 15% preference shares of the face value of
₹100 each at a flotation cost of 4%. Find out the cost of
capital of preference share if:
 (a) Issued at par
 (b) Issued at a premium of 10%
SOLUTION:
(a) KP=
𝑷𝑫
𝑷𝟎
=
𝟏𝟓
𝟗𝟔 = 15.36%
(b) KP=
𝑷𝑫
𝑷𝟎
=
𝟏𝟓
𝟏𝟎𝟔 = 14.15%
6/19/2023 19

20. 2)COST OF REDEEMABLE PREFERENCE
SHARES
 Redeemable preference shares are those which are to be redeemed after the
expiry of specified period of time.
 P0 = 𝒊=𝟎
𝒏 𝑷𝑫𝒊
(𝟏+Kp)i
+
𝑷𝒏
𝟏+𝒌𝒑 𝒏
PD= annual dividend
P0 = Net proceeds from the issue of preference shares
n= no . of years to maturity
Kp= Cost of preference share
6/19/2023
FM/ MS. SHWETA GOEL 20

21.  Kp=
𝑷𝑫+(𝑷𝒏−P0)÷n
(𝑷𝒏 +P0)÷𝟐
PD= annual dividend
P0 = Net proceeds from the issue of preference shares
𝑷𝒏= Redemption price
n= no . of years to maturity
Kp= Cost of preference share
6/19/2023
FM/ MS. SHWETA GOEL 21

22. ILLUSTRATION
A ltd issues 15% preference shares of the face value of
₹100 each at a flotation cost of 4%. Find out the cost
of capital of preference share if shares are
redeemable after 10 years at a premium of 10%
6/19/2023
FM/ MS. SHWETA GOEL 22

23. SOLUTION
 Kp=
𝑷𝑫+(𝑷𝒏−P0)÷n
(𝑷𝒏 +P0)÷𝟐
 Kp=
𝟏𝟓+(𝟏𝟏𝟎−96)÷10
(110+96)÷𝟐
 = 15.9%
6/19/2023
FM/ MS. SHWETA GOEL 23

24. C. COST OF EQUITY
CAPITAL
The rate of discount at which the expected dividends
are discounted to determine present value is known as
the cost of equity share capital.
1) Zero-Growth Dividends
Ke =
𝑫𝟏
𝑷𝟎
Where,
Ke =Cost of equity capital
𝑫𝟏 =Expected dividend per share at the end of year 1
𝑷0=Net proceeds per share
6/19/2023
FM/ MS. SHWETA GOEL
24

25. 2)CONSTANT GROWTH IN
DIVIDEND
In this method, dividends are assumed to grow at a
constant rate (g%) per annum
Dn = D0(1+g)n
Ke =
𝑫𝟏
𝑷𝟎
+g
𝑷𝟎 =
𝑫𝟏
𝑘𝑒−𝑔
Where,
D0 = Dividend of the current year
Ke =Cost of equity capital
𝑫𝟏 =Expected dividend per share at the end of year 1
𝑷0=Current market price of share
g=Growth rate in dividends
6/19/2023 25

26. 6/19/2023
FM/ MS. SHWETA GOEL 26
 𝑷𝟎 =
𝐷0
(1+𝑔)
1+𝑘𝑒 1 +
𝐷0
1+𝑔 2
1+𝑘𝑒 2 +
𝐷0
1+𝑔 3
1+𝑘𝑒 3 +------+
𝐷0
1+𝑔 𝑛
1+𝑘𝑒 ∞
ILLUSTRATION
 Ques: ABC ltd. has just declared and paid a
dividend at the rate of 15% on the equity share of
Rs100 each. The expected future growth rate in
dividends is 12%. Find out the cost of equity shares
given that the present market value is Rs168.

27. SOLUTION
Ke =
𝑫𝟏
𝑷𝟎
+g
Ke =
𝟏𝟔.𝟖
𝟏𝟔𝟖
+0.12 = 22%
6/19/2023
FM/ MS. SHWETA GOEL 27

28. C3)EARNING PRICE
APPROACH
ke=
𝐷𝐼𝑉1
𝑃0
+ 𝑔
=
𝐸𝑃𝑆1(1−𝑏)
𝑃0
+ 𝑏𝑟 (br=g)
=
𝐸𝑃𝑆1
𝑃0
(without growth)
Where,
K e=Cost of equity capital
EPS=Earning per share
𝑃0 =Net proceeds
B= retention ratio
R= return on investment
6/19/2023 28

29. COST OF EQUITY AND CAPM
Ke= Rf + (Rm-Rf)𝜷
Ques: The risk- free rate is 4% and the return on
broad market index is expected as 14%. Presently
company has beta of 1.2 but it is expected to
increase to 1.5 due to some changes in
managerial policies. Find out the cost of equity as
per CAPM before and after the change in
managerial policies
0.04+(0.14-0.04)1.2 6/19/2023
FM/ MS. SHWETA GOEL 29

30. D. COST OF RETAINED
EARNINGS
It refers to that portion of the profit retained by the
company for future development, business use and
expansion is known as retained earnings. Cost of
retained earnings is same as cost of equity except that
here we don’t consider flotation cost, underwriting
commission etc.
Ke =
𝑫𝟏
𝑷𝟎
+g
6/19/2023
FM/ MS. SHWETA GOEL 30

31. ILLUSTRATION
The equity share of A ltd is quoted in the market for
Rs700 per share. A constant annual growth rate of 5% is
expected and the company paid a dividend of Rs24 per
share last year. Compute the cost of equity.
Solution Ke =
𝑫𝟏
𝑷𝟎
+g
Ke =
𝟐𝟓.𝟐
𝟕𝟎𝟎
+0.05= 8.6%
6/19/2023
FM/ MS. SHWETA GOEL 31

32. COMPUTATION OF
COMPOSITE COST
Weighted Average Cost of Capital(WACC)
It refers to the weighted average cost of different sources of
finance. It is very important in financial decision making. Steps
involved in computation of WACC;
• Calculate the cost of each of the sources of finance .
• Assigning weights to specific costs.
• Multiplying the cost of each sources by the
appropriate weights.
• Dividing the total weighted cost by the total
weights. 6/19/2023
FM/ MS. SHWETA GOEL 32

33. WEIGHTED AVERAGE COST OF CAPITAL CAN
BE COMPUTED THE FOLLOWING FORMULA.
WACC=W𝑒 × 𝐾𝑒 + 𝑊𝑝 × 𝐾𝑝 + 𝑊𝑑 × 𝐾𝑑
Weights can be assigned on the following basis
 Historical weights- 1.Book value weights
2.Market value weights
 Marginal weights
 Target weights
6/19/2023
FM/ MS. SHWETA GOEL 33

34. ILLUSTRATION
The cost of capital (after tax) of a company is the specific sources is as
follows:
Cost of Debt 10%
Cost of Preference shares 12%
Cost of Equity Capital 15%
6/19/2023
FM/ MS. SHWETA GOEL 34
Particulars Book value Market value
Equity share
capital(45000shares@10 each)
450000 1050000
12% preference
shares(1000shares@100 each)
100000 250000
Reserves and surplus 250000 ----
10% debentures(2500 debentures
@100 each)
250000 240000

35. SOLUTION:
COMPUTATION OF WEIGHTED AVERAGE
FM/ MS. SHWETA GOEL 6/19/2023 35
Particulars Book value Book
value
weights
Market
value
Market
value
weights
Equity share
capital(including
reserves and
surplus)
700000
(450000+250000
)
0.67 1050000 0.68
Preference share
capital
100000 0.09 250000 0.16
Debentures 250000 0.24 240000 0.16
Total 1050000 1.0 1540000 1.0

36. SOLUTION
Particulars BVW Cost of
capital
K*weights MVW K*MVW
Equity share
capital(includi
ng reserves
and surplus)
0.67 0.15 0.1005 0.68 0.102
Preference
share capital
0.09 0.12 0.0108 0.16 0.0192
Debentures 0.24 0.10 0.024 0.16 0.016
WACC 0.1353=13.53% 0.1372=13.72
%
6/19/2023
FM/ MS. SHWETA GOEL 36

37. ILLUSTRATION
The capital structure of HTH ltd.as on 31st March 2019 is as follows:
Equity share capital (20 lacs shares of Rs10 each) Rs200lakhs
Reserves and surplus Rs 40 lakhs
10% Debentures of Rs100 each Rs60 lakhs
For the year ended 31stmarch 2019 the company paid dividend of 20% and
are expected to grow by 6% every year. The current market price per share is
Rs60 and tax rate is 30%
Calculate
Cost of equity and debt
Weighted average cost of capital using book value weights
The company plans to raise a further capital of 50lakhs by loan @12%. Due to
this market price of equity falls to Rs40 per share. Calculate new WACC
6/19/2023
FM/ MS. SHWETA GOEL 37

38. 6/19/2023
FM/ MS. SHWETA GOEL 38