This document discusses the concept of cost of capital and how to measure it. It defines cost of capital as the minimum rate of return a company must earn on invested funds to prevent a decrease in shareholder value. The document then discusses how to calculate the cost of various components of capital structure including: - Preference share capital - Debt capital - Equity share capital - Retained earnings It provides formulas and examples for calculating the cost of each component based on factors like dividend/interest rates, issue price, tax rates, redemption value, and growth rates. The weighted average cost of capital is also introduced as a way to incorporate different costs of all components of a firm's capital structure.

1. COST OF CAPITAL AND ITS
MEASUREMENTS
Dr. RICHA SINGHAL
ASSOCIATE PROFESSOR
DEPTT.OF EAFM
S.S.JAIN SUBODH PG COLLEGE
1
DR. SHAILESH MATHUR
ASSOCIATE PROFESSOR
DEPTT.OF ABST
.S.JAIN SUBODH PG COLLEGE

2. CONTENT
DEFINITION
SIGNIFICANCE
COST OF PREFERENCE SHARE CAPITAL
COST OF DEBT CAPITAL
COST OF EQUITY SHARE CAPITAL
COST OF RETAINED EARNINGS
WEIGHTED AVERAGE COST OF CAPITAL
2

3. WHAT IS COST OF CAPITAL?
An investor provides long-term funds
(i.e., Equity shares, Preference
Shares, Retained earnings,
Debentures etc.) to a company and
quite naturally he expects a good
return on his investment. In order to
satisfy the investor’s expectations
the company should be able to earn
enough revenue.
The cost of capital is the minimum
rate of return which a company is
expected to earn from a proposed
project so as to make no reduction in
the earning per share to equity
shareholders and its market price
3

4. 1. Maximization of the Value of the Firm
2. Capital Budgeting Decisions
3. Decisions Regarding Leasing
4. Management of Working Capital
5. Dividend Decisions
6. Determination of Capital Structure
7. Evaluation of Financial Performance
4
SIGNIFICANCE OF COST OF CAPITAL

5. MEASUREMENT OF COST OF CAPITAL
Cost of capital is measured for
different sources of capital
structure of a firm. It includes;-
Cost of preference share capital
Cost of debt capital
Cost of equity share capital
Cost of retained earnings etc.
5

6. NET
PROCEEDS
At Par = PerValue- Floatation
cost
At Premium = Per value+
Premium – Floatation Cost
At Discount = Per value-
Discount- Floatation Cost
6

7. COST OF
PREFERENCE
SHARE
CAPITAL
For preference shares, the
dividend rate can be
considered as its cost,
since it is this amount
which the company wants
to pay against the
preference shares. Like
debentures, the issue
expenses or the
discount/premium on
issue/redemption are also
to be taken into account.
7

8. COST OF PREFERENCE SHARE CAPITAL
The cost of preference share capital is calculated in the following
ways:
A. When Preference shares are irredeemable:
Kp(before tax) = Kp(after tax) / 1 –T
Where, Kp = Cost of preference share capital; D = Dividend;
NP = Net Proceed = Issue price – Issue expenses
Kp (after tax) =
D
x 100
NP
Where, Kp = Cost of preference share capital ;T = Tax rate

9. Example 3:
XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate cost of preference share capital if these shares are issued (a) at par, (b)
at a premium of 10% and (c) at discount of 6%.
Solution:
Where, Kp = Cost of preference share capital; D (Dividend per share) = Rs. 8;
NP (Net Proceed per share) = Issued price – Issue expenses
(a) If issue at par = 100 – 2 = Rs. 98
(b) If issue at 10% premium = 100 + 10 – 2 = Rs. 108
(c) If issue at 6% discount = 100 – 6 – 2 = Rs. 92
Kp (If issue at par) = (D / NP) x 100 = (8 / 98) x 100 = 8.16%
Kp (If issue at premium) = (8 / 108) x 100 = 7.41%
Kp (If issue at discount) = (8 / 92) x 100 = 8.7%

10. B. When the Preference shares are redeemable:
Where,
Kd = Cost of preference shares capital; D = Dividend; T = Tax rate;
MV = Maturity value; n= No. of year to maturity;
NP = Net Proceed = Issue price – Issue expenses
Kp (after tax) =
D + [(MV - NP) / n]
x 100
(MV + NP) / 2
Kp (before tax) =
Kp (after tax)
1 – T

11. Example 4:
ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Redeemable after 8
years at a premium of 10%. The cost of issue is Rs. 2 per share. Calculate the cost
of preference share capital after and before tax. Assuring a tax rate of 40%.
Solution:
Where, Kp = Cost of preference share capital; D (Dividend) = Rs. 8;
MV (Maturity value) = 100 + 10 = Rs. 110; n (No. of year to maturity) = 8;
NP (Net Proceed) = 100 – 2 = Rs. 98
Kp (after tax) = {[D + (MV-NP) / n] / [(MV+NP) /2} x 100
= {[8 + (110-98) / 8] / [(110 + 98) / 2} x 100
= {[8 + 1.5] / 104} x 100 = 9.13%
Kp (before tax) = Kp (after tax) / (1-T)
= 9.13 / (1 - 0.4) = 15.22%

12. COST OF
DEBT
CAPITAL
The cost of debt can be defined
in terms of the required rate of
return that the debt financed
investment must yield to prevent
damage to the shareholders
position i.e. to keep unchanged
the earnings available to equity
shareholders. If the company
earns less than this interest rate
then the income available to the
shareholders will be reduced and
the market value of shares will go
down. Therefore the cost of debt
capital is the contractual interest
rate adjusted further for the tax
liability of the firm.
12

13. The cost of debt is calculated in the following ways:
A. When the debts are irredeemable:
Where, Kd = Cost of debt capital; I = Interest ;
NP = Net Proceed = Issue price – Issue expenses
Kd (before tax) =
I
x 100
NP
Kd (after tax) =
I (1 - T)
x 100
NP
Where, Kd = Cost of debt capital; I = Interest ; T = Tax rate
NP = Net Proceed = Issue price – Issue expenses

14. Example 1:
B Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%.
The costs of advertisement are 2%. The tax rate applicable is 50%.
Compute the cost of debt-capital.
Solution:
Kd (before tax) = (I / NP) x 100
= (90,000 / 10,80,000) x 100 = 8.33%
Kd (after tax) = [I (1-T) / NP] x 100
= [90,000 (1 – 0.50) /10,80,000] x 100 = 4.17%
Where, Kd = Cost of debt capital; T (Tax rate) = 50%;
I (Interest) = 9% of 10,00,000 = Rs. 90,000;
NP (Net Proceed) = Issue price – Issue expenses =
10,00,000+1,00,000 – 20,000 = Rs. 10,80,000

15. B. When the debts are redeemable:
Where, Kd = Cost of debt capital; I = Interest; ; T = Tax rate;
MV = Maturity value; n= No. of year to maturity;
NP = Net Proceed = Issue price – Issue expenses
Kd (before tax) =
I + [(MV - NP) / n]
x 100
(MV+NP) / 2
Kd (after tax) =
I (1-T) + [(MV - NP) / n]
x 100
(MV + NP) / 2

16. Example 2:
A company issues Rs. 20,00,000, 10% redeemable debentures at a discount of 5%.
The costs of issue Rs. 50,000. The debentures are redeemable after 8 years.
Calculate before tax and after tax. Cost of debt assuring a tax rate of 40%.
Solution:
Where, Kd = Cost of debt capital; I (Interest) = 10% of 20,00,000 = Rs. 2,00,000;
T (Tax rate) = 40%; MV (Maturity value) = Rs. 20,00,000; n (No. of year to
maturity) = 8; NP (Net Proceed) = 20,00,000 – 1,00,000 – 50,000= Rs. 18,50,000
Kd (before tax) = {[I + (MV-NP) / n] / [(MV+NP) /2} x 100
= {[2,00,000 + (20,00,000-18,50,000)/8] / [(20,00,000-18,50,000)/2} x 100
= {[2,00,000 + 18,750] / 19,25,000} x 100 = 11.36%
Kd (before tax) = {[I (1-T) + (MV-NP) / n] / [(MV+NP) /2} x 100
= {[2,00,000 (1-0.4)+ (20,00,000-18,50,000)/8] / [(20,00,000-18,50,000)/2} x 100
= {[1,20,000 + 18,750] / 19,25,000} x 100 = 7.21%

17. Cost of Equity
Share Capital
Cost of equity share is the part of
cost of capital which allows the
payment to only the equity
shareholders. In this every
shareholders get the shares for
getting the return on the shares on
which they are investing so much.
The company must earn more than
cost of equity capital in order to be
unaffected by the market value of the
shares of its. Cost of equity can be
calculated from the following
approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P +
g) approach
• Earning price (E/P) approach
17

18. Dividend Price Approach
The cost of equity capital will be that rate of expected dividend which will
maintain the present market price of equity shares. It can be measured
with the help of the following formula:
Ke (after tax) =
D
x 100
MP
Ke (before tax) =
Ke (after tax)
1 - T
Where,
Ke = Cost of equity shares capital; D = Dividend per share; T = Tax
rate; MP = Market Price of equity share
Note: If market price of equity share is not given, then it is calculated
as follows:
Market Price = (Equity Share Capital + Retain Earning) / No. of
equity share

19. Example 5:
A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The company
has been paying 25% dividend to equity shareholders 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. 175?
Solution:
a) Cost of equity when share issued at 10% premium
Ke (after tax) = (D / MP) x 100
= (25 / 110) x 100 = 22.73%
Where, Ke = Cost of equity share capital; D (Dividend) = 25% of Rs 100 = Rs. 25; MP
(Market price per share) = 100 + 10 = Rs. 110
Note: Equity shares issue at 10% premium so it is available in market at Rs. 110.
b) When market price of share is Rs. 175
Ke (after tax) = (D / MP) x 100
= (25 / 175) x 100 = 14.29%
Where, Ke = Cost of equity share capital; D (Dividend) = 25% of Rs 100 = Rs. 25; MP
(Market price per share) = Rs. 175

20. Dividend Price Plus Growth Approach
The cost of equity is calculated on the basis of the expected dividend
rate per share plus growth in dividend. It can be measured with the help
of the following formula:
Where,
Ke= Cost of equity shares capital; D= Dividend per share;
MP= Market Price of equity share; G= Growth Rate
Note: If growth rate is not given then it will be calculated as
follows:
Growth Rate = (Difference in two years amount of dividend /
Previous year dividend) x 100
Ke (after tax) =
D
x 100 + G
MP

21. Example 6:
(a) The current market price of the shares of A Ltd. is Rs. 95. The dividend per
share amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are
required to calculate the cost of equity share capital.
(b) A company issue 10000 new shares of Rs. 100 each at a par. The floatation
costs are 4%. The company pays a dividend of Rs. 12 per share and growth in
dividends is expected to be 5%. Compute the cost of new issue of equity
shares
Solution:
(a) Ke (after tax) = [(D / MP) x 100] + G
= [(4.50 / 95) x 100] + 7 = 11.74%
Where, Ke = Cost of equity share capital; D (Dividend) = Rs. 4.50;
MP (Market price per share) = Rs. 95; G (Growth Rate) = 7%
(b) Ke (after tax) = [(D / MP) x 100] + G
= [(12 / 96) x 100] + 5 = 17.5%
Where, Ke = Cost of equity share capital; D (Dividend) = Rs. 12;
MP or NP = Rs. 100 – 4% of 100 = Rs. 96; G (Growth Rate) = 7%

22. Earning Price Approach
According to this approach cost of equity is calculated on the basis
of the future earning prospects of the equity. The formula for
calculating the cost of equity according to this approach is as
follows:
Where,
Ke= Cost of equity shares capital; EPS= Earning per share;
MP= Market Price of equity share
Note: Earning per share will be calculated as follows:
EPS = Profit for equity share / No. of equity share
Ke (after tax) =
EPS
X 100
MP

23. Example 7:
The following information are related to a company:
Number of existing equity shares =10 lakhs; Market value of existing share =Rs.100 and Net
earnings =Rs.100 lakhs
Compute the cost of existing equity share capital and of new equity capital assuming that
new shares will be issued at a price of Rs. 92 per share and the costs of new issue will be Rs.
2 per share.
Solution:
(a) Cost of existing equity share capital
Ke (after tax) = (EPS / MP) x 100
= (10 / 100) x 100 = 10%
Where, Ke = Cost of equity share capital; MP = Rs. 100;
EPS = Profit for Equity share / No. of Equity share = 100 / 10 =Rs. 10
(b) Cost of new equity share capital
Ke (after tax) = (EPS / MP) x 100
= (10 / 90) x 100 = 11.11%
Where, MP or NP= 92 – 2 = Rs. 90

24. Cost of
Retained
Earning
The companies do not generally
distribute the entire profits
earned by them by way of
dividend among their
shareholders. Some profits are
retained by them for future
expansion of the business called
retain earning. The cost of
retained earnings (Kr) is the
earnings foregone by the
shareholders. In other words, the
opportunity cost of retained
earnings may be taken as the
cost of retained earnings.
24

25. Cost of retained earnings can be calculated with the help of the
following formula:
Where,
Kr = Cost of retain earning; Ke= Cost of equity share;
Tp = Share holder personal tax rate; B= Rate of brokerage
Kr = Ke (1-Tp) ( 1 – B)

26. Example 8:
The following information are related to a company:
Number of existing equity shares =10 lakhs; Market value of existing share
=Rs.100 and Net earnings =Rs.100 lakhs; Average tax rate of shareholders is 30%
and Brokerage cost = 2%.
What is the cost of retained earnings?
Solution:
Where,
Kr = Cost of retain earning; Ke= Cost of equity share; MP = Rs. 100;
EPS = Profit for Equity share / No. of Equity share = 100 / 10 =Rs. 10
Tp (Share holder personal tax rate) = 30%; B (Rate of brokerage) = 2%
Ke (after tax) = (EPS / MP) x 100
= (10 / 100) x 100 = 10%
Kr = Ke (1 – Tp) (1 – B)
= 10 (1- 0.30) (1 – 0.02) = 6.86%

27. WEIGHTED
AVERAGE
COST OF
CAPITAL
 Firm’s Weighted Average Cost of
Capital (WACC) represents its blended
cost of capital across all sources,
including common shares, preferred
shares, and debt. It is the average rate of
return a company expects to compensate
all its different investors. In other
words, WACC is the average rate a
company expects to pay to finance its
assets.
 The weights are the fraction of each
financing source in the company's capital
structure.
27

28. 28

29. WACC calculated as follows:
Kw = Kd Wd + Kp Wp + Ke We + Kr Wr
Or
Kw = ΣXW / ΣW
Where,
Kd = Cost of debt capital; Kp = Cost of preference share capital; Ke= Cost
of equity share Kr = Cost of retain earning; Wd = Weight of debt capital; Wp
= Weight of preference share capital; We= Weight of equity share ; Wr =
Weight of retain earning;

30. Example 9:
A company gives the following book value and market value of each
type of its capital:
Determine the weighted average cost of capital using: (a) Book value
weights, and (b) Market value weights.
Types of Capital
Book Value
(Rs.)
Market Value
(Rs.)
Cost of
Capital (%)
Debenture
Pref. Share
Equity Share
Retain Earning
4,00,000
1,00,000
3,00,000
2,00,000
3,80,000
1,20,000
7,00,000
3,00,000
5
8
15
13
10,00,000 15,00,000

31. Solution:
Computation of Weighted Average Cost of Capital
A. Weighted Average Cost of Capital at Book Value
Kw = ΣXWB / ΣWB
= 99,000 / 10,00,000 = 0.099 or 9.9%
B. Weighted Average Cost of Capital at Market Value
Kw = ΣXWM / ΣWM
= 1,72,600 / 15,00,000 = 0.1151 or 11.51%
Types of
Capital
Book Value
(Rs.)
(WB)
Market
Value (Rs.)
(WM)
Cost of
Capital
(%) (X)
XWB XWM
Debenture
Pref. Share
Equity Share
Retain Earning
4,00,000
1,00,000
3,00,000
2,00,000
3,80,000
1,20,000
7,00,000
3,00,000
5
8
15
13
20,000
8,000
45,000
26,000
19,000
9,600
1,05,000
39,000
Total (Σ) 10,00,000 15,00,000 99,000 1,72,600

32. Example 10:
Mahindra Limited has the following capital structure based on market values:
The dividend per share expected for the next year is Rs. 3.50 and is expected to
grow at the rate of 12%. Preference shares are to be redeemable after 5 years at a
premium of 5% and debentures are to be redeemable after 10 years at face value.
The applicable tax rate for the company is 40%. You are required to calculate the
weighted average cost of capital using market value weight.
Solution:
Calculation of cost of Equity share:
Ke (after tax) = [(D / MP) x 100] + G
= [(3.50 /125) x 100] + 12 = 2.8 + 12 = 14.8%
Where, MP = 1,00,00,000 / 80,000 = Rs. 125; D = Rs. 3.50 & G = 12%
Types of Capital Rs.
80,000 Equity Share of Rs. 100 each 1,00,00,000
6,000 15% Preference Share of Rs. 100 each 6,21,000
10,000 14% Debenture of Rs. 100 each 9,70,000
16% Term Loan 8,00,000

33. Calculation of cost of Preference share:
Kp (after tax) = {[D + (MV-NP) / n] / [(MV+NP) /2} x 100
= {[15 + (105-103.50) / 5] / [(105+103.50) /2} x 100
= [(15 + 0.30) / 104.25] x 100
= (15.30 / 104.25) x 100 = 14.7%
Where, Kp = Cost of preference share capital; D (Dividend) =15% 0f 100=Rs. 15;
MV (Maturity value)=100+5=Rs. 105; n (No. of year to maturity) = 5;
NP (Net Proceed or Market Price)= 6,21,000 / 6,000 = Rs. 103.50
Calculation of cost of Debenture:
Kd (after tax) = {[I (1-T) + (MV-NP) / n] / [(MV+NP) /2} x 100
= {[14 (1-0.40)+ (100-97) / 10] / [(100+97) /2} x 100
= [(8.40 + 0.30) / 98.5] x 100
= (8.70 / 98.5) x 100 = 8.8%
Where, Kd = Cost of Debenture; I (Interest)=14% 0f 100=Rs. 14;
MV (Maturity value)=Rs. 100; n (No. of year to maturity) = 10; T (Tax Rate)=40%; NP
(Net Proceed or Market Price)= 9,70,000 / 10,000 = Rs. 97

34. Calculation of cost Term Loan:
Kt (after tax) = [I (1-T) / NP] x 100
= [1,28,000 (1-0.40) / 8,00,000] x 100
= (76,800 / 8,00,000) x 100 = 9.6%
Where, Kt = Cost of Term loan; I (Interest)=16% of 8,00,000 =Rs. 1,28,000;
T (Tax Rate)=40%; NP (Net Proceed or Market Price)= 8,00,000
Weighted Average Cost of Capital at Market Value
Kw = ΣXW / ΣW
= 17,33,447 / 1,23,91,000 = 0.1399 or 13.99%
Types of Capital
Market
Price (Rs.)
(W)
Cost of
Capital
(%) (X)
XW
80,000 Equity Share of Rs. 100 each 1,00,00,000 14.8 14,80,000
6,000 15% Preference Share of Rs. 100 each 6,21,000 14.7 91,287
1,000 14% Debenture of Rs. 100 each 9,70,000 8.8 85,360
16% Term Loan 8,00,000 9.6 76,800
1,23,91,000 17,33,447

35. 35
THANK
S