Cost of Capital , Cost of equity, Cost of Debentures, Cost of Preference Shares

1. Cost of Capital
Dr. Mangesh M. Bhople

2. Cost of Capital
MIT ACSC, Alandi 2
 THE MAIN OBJECTIVE OF THE FIRM
 SOURCES OF FUNDS
 DEFINATION OF COST OF CAPITAL
 HURDLE RATE
 MINIMUM BENCHMARK RETURN

3. What is the “Cost” of Capital?
• When we talk about the “cost” of capital, we are talking about the
required rate of return on invested funds.
• It is also referred to as a “hurdle” rate because this is the minimum
acceptable rate of return
• Any investment which does not cover the firm’s cost of funds will
reduce shareholder wealth (just as if you borrowed money at 10% to
make an investment which earned 7% would reduce your wealth)

4. ELEMENTS OF COST OF CAPITAL
COST OF EQUITY CAPITAL (Ke)
COST OF RETAINED EARNING (Kr)
COST OF PREFERRED CAPITAL (Kp)
COST OF DEBT (Kd)

5. COST OF EQUITY CAPITAL (Ke)
DEFINATION OF COST OF EQUITY CAPITAL
METHODS
i) Dividend Yield Method
ii) Dividend Growth Method
iii) Earning Price Method
iv) Capital Asset Pricing Model

6. DIVIDEND YIELD METHOD
Ke =(D/P)X100
Where,
Ke = Cost of Equity Capital
D = Annual Dividend per share on equity capital
P =Current Mkt price of Equity Share

7. 1. XYZ Co. is currently being traded at Rs. 350 per share and just
announced a dividend of 35 per share, which will be paid out next
year. Using historical information, an analyst estimated the dividend
growth rate of XYZ Co. to be 2%. What is the cost of equity?
2. What if the price will change by 20% negative and positive?
3. What if there is no growth rate?
4. What if the growth rate is @ 5% p.a?
5. What if the growth rate is @10%p.a.?
MIT ACSC, Alandi 7

8. 1. XYZ Co. is currently being traded at Rs. 350 per share and just announced a
dividend of 35 per share, which will be paid out next year. Using historical
information, an analyst estimated the dividend growth rate of XYZ Co. to be
2%. What is the cost of equity?
2. What if the price will change by 20% negative and positive?
3. What if there is no growth rate?
4. What if the growth rate is @ 5% p.a?
5. What if the growth rate is @10%p.a.?
MIT ACSC, Alandi 8

9. • Nestle India. is currently being traded at Rs. 520 per share and just
announced a dividend of Rs. 75 per share. The estimated the dividend
growth rate is to be taken @ 12%. What is the cost of equity?
2. What if the price will change by 20% negative and positive?
3. What if there is no growth rate?
4. What if the growth rate is @ 5% p.a?
5. What if the growth rate is @10%p.a.?
MIT ACSC, Alandi 9

10. 1. TATA Motors. is currently being traded at Rs. 520 per share and just
announced a dividend of Rs. 75 per share. The estimated the dividend
growth rate is to be taken @ 12%. What is the cost of equity?
2. What if the price will change by 20% negative and positive?
3. What if there is no growth rate?
4. What if the growth rate is @ 5% p.a?
5. What if the growth rate is @10%p.a.?
MIT ACSC, Alandi 10

11. DIVIDEND GROWTH METHOD
Ke =[(D/P) + g] X100
Where,
Ke = Cost of Equity Capital
D= Expected Dividend per Equity Share
P = Current Mkt price of Equity Share
g = Growth rate by which dividend are
expected to grow per year at a constant compound
rate

12. EARNING PRICE METHOD
Ke = (E/M) x 100
Where,
E = Earning per share
M = Market Price per share

13. CAPITAL ASSET PRICING MODEL
Ke = [ Rf + Bi(Rm-Rf)] x 100
Where,
Rf = Risk free return of return
Bi = Beta of Investment i.e. risk Of investment
Rm = Average market Return

14. COST OF RETAINED EARNING (Kr)
Kr = D (1-t) x 100
Where,
Kr = Cost of Retained Earnings
D = Dividend Rate
t = Tax rate of Individual

15. COST OF PREFERRED CAPITAL (Kp)
Cost of Irredeemable Preference Share
Kp = ( Dp/Np) x 100
Where,
Kp = Cost of Preference capital
Dp = Preference Dividend rate
Np = Net proceeds received from issue of
preference shares after meeting the issue expenses
(Floatation cost)

16. COST OF PREFERRED CAPITAL (Kp)
Redeemable Preference Share
{D+(Rv-Sv)]/N}
Kp = ---------------------------- X 100
(Rv+Sv)/2
Where,
Kp = Cost of Preference Share
D = Constant annual Preference
Dividend
N = No. of years to redemption
Rv = Redemption value of preference shares at the time of Redemption
Sv= Sale value of Pref. share less discount & flotation expenses

17. A company issues 20,000 irredeemable preference share at 8% whose face
value is Rs.50 each at 4% discount. Find out the Cost of Preference Share
Capital.
Solution: Dividend on Preference share (Dp) = 50*8/100 = 4
Discount = 50*4/100 = 2
Net Proceeds (NP) = 50-2 = 48
Kp = Dp/NP
=4/48
= 8.33%
MIT ACSC, Alandi 17

18. Example: Find out the cost of 10, 500 irredeemable preference shares if issues at 2% premium of
Rs.60 each. The dividend paid by the company is Rs. 6 each. The flotation cost is Rs. 8 per share.
• Solution: Premium amount = 60*0.02 = 1.2
Issue price = 60 + 1.2 = 61.2
Net proceeds = 61.2 - 8= 53.2
Kp = Dp/NP
= 6 / 53.2
= 11.27%
MIT ACSC, Alandi 18

19. Example: A preference share issues at 12% worth Rs 60,000 at 5%
discount and after 6 years it redeem at 10% premium. The
flotation cost is 5% and tax rate is 20%. Find out the cost of
preference share capital.
• Solution:
Dividend on preference share (Dp) = 60,000*12/100 = Rs.7200
Discount = 60,000*5/100 = Rs.3000
Flotation Cost = 60,000*5/100 = Rs.3000
Net Proceeds (NP) = Rs. (60,000-3000-3000) = Rs. 54,000
Premium amount = 60,000*10/100 =Rs. 6000
Redemption Value = Rs. (60,000+6000) = Rs. 66,000
Kp = Dp+ ((RV-NP)/n)/ (RV+NP)/2
= 7200+ ((66,000-54,000)/6) / (66,000+54,000)/2
= 9200/60,000
= 15.33%
MIT ACSC, Alandi 19

20. Example: A preference share issues at 12% worth Rs 60,000 at 5% discount and
after 6 years it redeem at 10% premium. The flotation cost is 5% and tax rate is
20%. Find out the cost of preference share capital.
MIT ACSC, Alandi 20

21. COST OF DEBT (Kd)
COST OF IRREDEEMABLE DEBT (Before
Tax)
Kd = I/NP * 100
Where,
Kdb = Cost of Debt
I = Interest
NP = Net proceeds of
issue of debenture
bonds
COST OF IRREDEEMABLE DEBT (after
Tax)
Kd = I(1-t)/NP * 100
Where,
Kda = Cost of Debt
I = Interest per annum
t = Companies effective corporate
tax
NP = Net proceeds of issue of
debenture bonds

22. • A company issued 10000, 10% debentures of `100 each
on 1.4. 2010. The company wants to know the current
cost of its existing debt. Compute the cost of existing
debentures assuming 50% tax rate.
MIT ACSC, Alandi 22

23. A company issues `10,00,000, 12% debentures of `100 each. The debentures are
redeemable after the expiry of fixed period of 7 years. The company is in 35% tax
bracket.
Required
(i) Calculate the cost of debt after tax, if debentures are issued at
a. Par
b. b. 10% discount
c. c. 10% premium
d. (ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?
MIT ACSC, Alandi 23

24. A company issue 10% irredeemable debentures of Rs.
10,000. The company is in 50% tax bracket. Calculate cost
of debt capital at par, at 10% discount and at 10%
premium.
MIT ACSC, Alandi 24

25. COST OF DEBT (Kd)
COST OF REDEEMABLE DEBT=
{I+(Rv-Sv)]/N} (1-t)
Kd = ---------------------------- x 100
(Rv+Sv)/2
Where,
Kd = Cost of Debt
I = Constant annual Interest
N= No. of years to redemption
Rv= Redeemable value of Debt at the time of
maturity
Sv= Sale value of debenture less discount & flotation
expenses
t = Company’s effective tax rate

26. A firm issued 100 10% debentures, each of Rs. 100 at 5% discount. The debentures
are to be redeemed at the end of 10th year. The tax rate is 50%. Calculate cost of
debt capital.
MIT ACSC, Alandi 26

27. The Weighted Average Cost of Capital
• We now need a general way to determine the
minimum required return
• This is a weighted-average, which can be
calculated as:
p
p
d
d
e
e k
w
k
w
k
w
WACC 



28. Table showing calculation of WACC
Sr.
No.
Source of the
Capital /
Finance
Amount
(Rs.)
Weight
(w)
Before
Tax Cost
(%)
After tax
cost (%) )
(x)
WACC (%)
(wx)
MIT ACSC, Alandi 28

29. Finding the Weights
• The weights that we use to calculate the WACC will obviously affect
the result
• Therefore, the obvious question is: “where do the weights come
from?”
• There are two possibilities:
• Book-value weights
• Market-value weights

30. Book-value Weights
• One potential source of these weights is the firm’s balance sheet,
since it lists the total amount of long-term debt, preferred equity, and
common equity
• We can calculate the weights by simply determining the proportion
that each source of capital is of the total capital

31. Market-value Weights
• The problem with book-value weights is that the book values are
historical, not current, values
• The market recalculates the values of each type of capital on a
continuous basis. Therefore, market values are more appropriate
• Calculation of market-value weights is very similar to the calculation
of the book-value weights
• The main difference is that we need to first calculate the total market
value (price times quantity) of each type of capital

32. Market vs Book Values
• It is important to note that market-values is always preferred over
book-value
• The reason is that book-values represent the historical amount of
securities sold, whereas market-values represent the current amount
of securities outstanding
• For some companies, the difference can be much more dramatic than
for RMM
• Finally, note that RMM should use the 10.27 WACC in its decision
making process

33. The Costs of Capital
• As we have seen, a given firm may have more than one provider of
capital, each with its own required return
• In addition to determining the weights in the calculation of the WACC,
we must determine the individual costs of capital
• To do this, we simply solve the valuation equations for the required
rates of return

34. Leverage or Trading on Equity
MIT ACSC, Alandi 34
and
2.2 Cost of Capital, Trading on Equity, Capital
Gearing and Leverages