1. Cost of Capital

2. Definition of Cost of Capital
 Weighted arithmetic average of various sources
of capital
 Say, for a company having the ratio of debt:
equity = 2 : 1, capital base of Rs. 300 Crores
and post-tax cost of debt being 6% and that of
equity being 15%
 [(200/300) x 0.06] + [(100/300) x 0.15] = 0.09 or 9 %
is the Weighted Average Cost of Capital

3. Cost of Debentures - Concept
 Discount rate that equates the net proceeds from issue
of debentures to the present value of future cash
outflows in form of interest payments and principal
repayments
 P= ∑ [I x(1-T)/(1+kd)t] + [F/(1+kd)n]
 P= Net amount realised per debenture
 F= Redemption price per debenture & n= maturity period
 Kd= post-tax cost of debenture capital
 T= Corporate tax rate
 I= Annual interest rate payment per debenture
 kd = [(I x(1-T)) + (F-P)/n]/ [(F+P)/2]

4. Cost of Debentures – Problem 2
 F= Rs. 500  Solution calculations
 I = 0.12x500= Rs 60  kd = [(I x(1-t)) + (F-P)/n]/
 Maturity n=6 yrs. [(F+P)/2]
 Issue Price = 500 –  Kd= [(60x (1-0.4))+ (500-
Discount @3% of 500 = 470)/6]/ [(500+470)/2] =
Rs 485 [36+5]/ [485] = 0.0845 or
 Net realisation= Issue 8.45 %
price – Mktg. cost @3%
of 500= 485 – 15= 470
 Tax = 40 %

5. Cost of Term Loans
 Interest rates x (1 – T)  XYZ Ltd., has taken
 Interest paid on term term loan of Rs. 12
loans is tax deductible lakhs @ 15 %. If the
U/s. 37 of I T Act. tax rate is 40 %, the
cost of term loan is
 15/ 100 x (1 – 0.40)
= 0.15 x 0.60
= 0.09 or 9 %

6. Cost of Preference Capital
 P= ∑ [D/(1+kp)t] + [F/(1+kp)n]
 P= Net amount realised per preference share
 F= Redemption price per share
 n= maturity period
 kp= post-tax cost of preference capital
 D= Annual preference dividend per share
 kp = [D + (F-P)/n]/ [(F+P)/2]

7. Cost of Preference Capital –
Problem 3
 F = Rs 100  Solution calculations
 D = Dividend @ 8 %  kp = [D + (F-P)/n]/
or Rs 8 [(F+P)/2]
 Net realisation,  kp = [8 + (100-95)/6]/
P= Rs 95 [(100+95)/2]
 Maturity n = 6 years = [8 + (5/6)]/[195/2]
 [8.833]/ 97.5 = 0.0906
or 9.06 %

8. Cost of Equity Capital - 1
 Dividend Forecast  Cost of equity from
Approach company’s point of view
 Pe = ∑ Dt / (1 + ke)t, where
is the rate at which the
 Pe = Price per equity
intrinsic value market
share price of the share is equal
 Dt = Expected
to discounted value of
dividend per share at
end of year ‘t’ future dividends
 Ke = Rate of return
required by equity
share holders

9. Cost of Equity Capital - 2
 Dividend Forecast  Numerical
Approach:  Let D1 = Rs 5, and
 P0 = ∑ Dt / (1 + ke)t can P0 = Rs 25, and
be simplified as: P0 = g = 7 %, hence
Dt / (ke- g) ke = (5/25) + 0.07
 Or by solving for ke we = 0.20 + 0.07
get, ke = (Dt / P0) = 0.27 or 27 %
+g

10. Cost of Equity Capital – 3
 Realised Yield Approach  Realised Return
 Assumptions =3√ (W1 x W2 x W3) – 1, where,
 Actual returns have Wt = (Dt + Pt)/
been in line with Pt-1
expected returns  Dt = Dividend per share
 Investors will continue payable at the end of
have same year
expectations  Pt = Market price at the
end of the year
 Pt-1 = Market price at the
beginning of the year

11. Cost of Equity Capital – 4
Capital Asset Price Model Bond Yield Approach
Approach  Logic: Return required is
 ki = Rf + βt (Rm- Rf) based directly on risk
 ki = Required rate of return profile of the company,
on security “i” which is reflected in
 Rf = Risk-free rate of return return earned by
 Rm= Rate of return on bondholders.
market portfolio  Return = Yield on LT
 βt = Beta of security “i” Bond + Risk premium

12. Cost of Equity Capital – 5
 Earnings Price Ratio Approach
 Cost of Equity = E1 / P, where
 E1 = Expected Earnings Per Share next year
= Current EPS x (1 + g)
 P = Current market price of the share
 Two parameters need to be analysed further
 Dividend pay-out ration
 Rate of return on the retained earnings the firm is capable of
handling
 Results from this approach are accurate if all earnings are
paid out as dividends.

13. Cost of Retained Earnings
 Cost of External Equity  No particular method
 Ke = [(D1/ P0(1 - f)) + g] available for calculating “f”,
 ke = Cost of external equity the floatation costs
 D1 = Dividend expected at the  Ke = ke/ (1 – f) can be
end of year 1 approximation in such
 P0 = Current market price of cases, where ke is Expected
share Rate of Return on Equity
 f = floatation costs as % of  Example:
current market price Retained Earning = 100 L
 g = Constant growth rate for Ext. Equity = 100 L
dividends ke = 18 %
f=5%
 Ke = 0.18/ (1 – 0.05)= 0.1895
OR 18.95 %

14. Capital Structure
Importance of Capital Structure Decisions
 Objective: Mix the permanent sources of
funds that will maximise market price of
company’s shares thereby minimise the
cost of capital
 Usually planned at the time of company’s
formation and also when additional capital
is needed

15. Capital Structure
Decision Process
Capital Budgeting Decision
Need for LT Sources of Finance
Capital Structure Decision
Existing Capital Structure Debt-Equity Mix Dividend Decision
Effect on EPS Effect on Risks to Inv
Effect on Cost of Capital
Value of the Company