BBA management education Cost of Capital bba document .pdf

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1. Cost of
Capital
BY: DR. ANUPAM JAIN

2. Meaning of Cost of Capital
Cost of Capital is the combination of two words:
•Total Expenses Occurred
•The amount paid for-Cost
•Long Term FinancingCapital

3. Meaning…
CostofCapitalisthatminimumrateofreturnwhichthefirmexpectsto
earnfromitsinvestmentsinordertoincreasethevalueofthefirm.
ForExample:Acompanyissuesdebenturesat10%interestperannum
isundertwoobligations,firsttopayinterestandpaybackprincipal
amountatthetimeofmaturity.Itmeansraisingandusingdebtisnot
free,ratheritbearssomecost.i.e.interestandprincipalamount.The
raisedfundwillbeusedtomakeinvestmentsincapitalassetsinorder
togeneraterevenues,atleast,equalofmorethan10%.Therequired
percentageofreturnisknownas‘CostofCapital’.

4. Definition
AccordingtoI.M.Pandey:“Theproject’sCostofCapitalisthe
minimumrequiredrateofreturnonfundscommittedtothe
project,whichdependsontheriskinessofitscashflows.”
AccordingtoHampton,JohnJ.:“CostofCapitalistherateof
returnthefirmrequiresfrominvestmentinordertoincreasethe
valueofthefirminmarketplace.”

5. Features of Cost of Capital
It is not a Cost: It is a rate of return which…
Minimum Rate of Return
Reward for risk

6. Factors Affecting Cost of Capital
Nature of Business
Requirements of the firm
Attitude of Management
Risk free rate of interest
Decision of Finance mix

7. Importance of Cost of Capital
Designing the Capital Structure
Capital Budgeting Decision
Comparative study of Sources of FInance
Evaluation of financial performance of top management
Knowledge of firm’s expected Income
Financing and Dividend decision

8. Classification of Cost of Capital
Historical &
Future Cost
Specific &
Composite
Cost
Average &
Marginal
Cost
Explicit &
Implicit Cost

9. Assumptions of Cost of Capital
The cost can be either Explicit or Implicit
The financial and Business risk are not affected by
investing in in new investment proposal
The firm’s capital structure remains unchanged
Cost of each source of capital is determined after tax
Cost of previously obtained capital are not relevant for
computing the cost of capital to be raised from a
specific source.

10. Components of Cost of Capital

11. Calculation of Specific Cost of Capital
AfirmcanraisefundsfromdifferentsourcessuchasEquity
Shares,PreferenceShares,Debentures,retainedEarnings
etc.AllthesesourcesarecalledcomponentsofCapital.
TheCostofCapitalofthesedifferentsourcesisknownas
SpecificCostofCapital.
Computation ofspecificcostofcapitalhelpsin
determiningtheoverallcostofcapitalforthefirm.The
computationofspecificcostofcapitalcanbediscussed
asbelow:

12. Specific Cost of Capital
Cost of Debt
Capital [ Kd]
Cost of
Preference
Share Capital
[Kp]
Cost of Equity
Share Capital
[Ke]
Cost of
Retained
Earning [Kr]

13. Cost of Debt Capital [Kd]
Cost of Debt Capital can be classified in two:
➢Cost of Irredeemable Debt :
Thedebentureswhichcannotberedeemableinlifetimeofthecompanyis
knownasIrredeemableDebt.
ForEx.:ABCLtd.Issued10%1000debenturesatpar@`100each.
➢CostofRedeemableDebt:
Thedebentureswhichareredeemableinlifetimeofthecompanylet’s
sayafter5or10years.
ForEx.:ABCLtd.Issued10%1000debenturesatpar@`100eachwhich
willberedeemableafter10years.

14. Formula for of Cost of Debt Capital
In case of Irredeemable Debt:
Kd=
??????
�??????
x 100
where:I = Interest Rate
NP= Net Proceeds
NP further can be calculated as below:
NP at Par = Par Value –Floatation Cost (Issue Expenses)
NP at Prm. = Par Value + Security Premium -Floatation Cost
NP at Dis. = Par Value –Discount –Floatation Cost

15. Formula for Cost of Debt Capital
In case of Redeemable Debt:
Kd=
??????+(��−�??????)/�
��+�??????/2
x 100
where:I = Interest Rate
MV = Maturity Value
NP = Net Proceeds
N = No. of Years to maturity

16. Kd-Tax Adjustments
Cost of Debt Capital always be calculated as Before Tax hence we have to
convert this as after tax in order to calculate Cost of Capital. Tax Adjustments
can be made as below:
Kd( AT) = Kd(BT) X (1-t)
or
=
??????
�??????
x 100 X (1-t)
or
=
??????1−??????+(��−�??????)/�
��+�??????/2
x 100

17. Example1:

18. Answers:
i.At Par(Tax Rate @20%) 12% and 9.6%
ii.At Premium (Tax Rate @30%) 10.9% and 7.63%
iii.At Discount (Tax Rate @30%) 13.33% and 7.9%
Note:Costofdebthastaxadvantage,itdeclinesastherateoftaxincrease.

19. Probable Conditions:
❖When debentures are issued at par redeemable at par
❖When debentures are issued at par redeemable at premium.
❖When debentures are issued at par redeemable at discount
❖When debentures are issued at premium redeemable at par
❖When debentures are issued at premium redeemable at premium.
❖When debentures are issued at premium redeemable at discount
❖When debentures are issued at discount redeemable at par
❖When debentures are issued at discount redeemable at premium.
❖When debentures are issued at discount redeemable at discount

20. Examples 2:

21. Examples 3:

22. Examples 4:

23. Answers:
Ex 2 (Issue at Par): 9.7% and 6.94%
Ex 3 (Issued at Dis. & Prm.):8.45% and 7.33%
Ex 4 (Redeemable at Prm.):9.15% and 6.73%

24. Cost of Preference Share Capital [Kp]
Cost of Preference Share Capital can be classified in two:
➢Cost of Irredeemable Preference Share Capital :
ThosePreferenceShareswhichcannotberedeemableinlifetimeofthecompany
isknownasIrredeemablePreferenceShareCapital.
ForEx.:ABCLtd.Issued10%1000preferencesharesatpar@`100each.
➢CostofRedeemablePreferenceShareCapital:
ThosePreferenceSharewhichareredeemableinlifetimeofthe
companylet’ssayafter5or10years.
ForEx.:ABCLtd.Issued10%1000PreferenceSharesatpar@`100each
whichwillberedeemableafter10years.

25. Calculation of Cost of Preference
Share Capital
In case of Irredeemable Preference Share:
Kp=
�
�??????
x 100
where:D = Dividend per share
NP= Net Proceeds
NP further can be calculated as below:
NP at Par = Par Value –Floatation Cost (Issue Expenses)
NP at Prm. = Par Value + Security Premium -Floatation Cost
NP at Dis. = Par Value –Discount –Floatation Cost

26. Calculation of Cost of Debt Capital
In case of Redeemable Preference Share :
Kp=
�+(��−�??????)/�
��+�??????/2
x 100
where:I = Dividend per share
MV = Maturity Value
NP = Net Proceeds
N = No. of Years to maturity

27. Tax Adjustments
CostofpreferenceSharewillalwaysbeaftertaxhenceifwehaveto
calculatethisbeforetaxthenfollowingformulawillbeapplicable:
Kp(Before Tax) =Kp(After tax) x
1
(1−??????)
or
=
??????
1−??????
�??????
x 100 X (1-t)
or
=
�/1−??????+(��−�??????)/�
��+�??????/2
x 100

28. Example 5:

29. Answers:
i.At Par 9.278% and 13.254%
ii.At Discount9.783% and 13.976%
iii.At premium8.737% and 12.48%

30. Cost of Equity Share Capital [Ke]
CostofEquityShareCapitalisnotaseasytocalculateas
thecostofdebtorthecostofpreferenceshare.Asin
equitysharepaymentofdividendisnotalegalbindingon
thecompany,moreoverthereisnotanyfixedpercentage
atwhichdividendtobepaidtoequityshareholders.But
thisdoesnotmakecostofequitysharecapitalfreeof
cost.Thusthereisnoexplicitmethod,butwiththehelpof
implicitmethodi.e.opportunitycost,costofequityshare
canbedeterminedbyanyofthefollowingmethod:

31. Methods of Cost of Equity Share
Capital
Dividend Yield
Method
Earning Yield
Method
Dividend Yield
plus Growth
Method
Cost of Newly
Equity Share

32. Dividend Yield Method
ThismethodisalsoknownasDividend/PriceRatioMethod.
Accordingtothismethod,thecostofequitysharecapital
isthediscountratethatequatesthepresentvalueof
futureexpecteddividendpersharewiththecurrent
marketprice.Thebasicassumptionsofthismethodare:
❑InvestorsgiveprimeimportancetoDividend.
❑Riskofthefirmremainunchanged.
❑Thereisnogrowthinfuturedividend.
❑Itdoesnotconsidertheretainedearnings.

33. Calculation of Dividend Yield Method
Ke =
�??????�
�??????�
x 100
Where DPS = Dividend per share
MPS = Market price per share

34. Earning Yield Method
Equityshareholdershavefullrightintheincomeofthecompany
remainedaftermeetingalltheexpenseswhethertheygetonlypart
ofitasdividend.Thereforecomputationofcostofcapitalonlyonthe
basisofdividendisnotjustified.Henceunderthismethodthecostof
equitysharecapitaliscalculatedbyrelatingthefutureexpected
earningswiththemarketpriceoftheshare.Thebasicassumptionof
thismethodare:
❑Investorsgivesprimeimportancetoretainedearnings.
❑Theydon’tonlyneeddividend.

35. Calculation of Earning Yield Method
Ke =
�??????�
�??????�
x 100
Where EPS = Earning per share
MPS = Market price per share

36. Dividend Yield plus growth Method
Whilecomputingthecostofcapitalunderdividendyield
method,ithasbeesassumedthatrateofdividendwill
remainthesameinfuturealso.Butinvestorsinvestinthe
companytogetmoreandmoredividendeveryyear.
Henceinthismethodgrowthrateindividendisalso
added.
Ke =
�??????�
�??????�
x 100 + G
Where DPS = Dividend per share
MPS = Market price per share
G = Growth Rate

37. Cost of Newly Issued Equity Shares
Whennewequityshareareissuedbyacompany,itisnot
possibletorealisethemarketpricepersharesonet
proceedsistakeninsteadofMarketPrice.
Ke =
�??????�
�??????
x 100
Or
Ke =
�??????�
�??????
x 100
Or
Ke =
�??????�
�??????
x 100 + G

38. Example 6:
Ke =
�??????�
�??????�
x 100 =
25
180
x 100 = 13.89%

39. Example 7:

40. Example 8:
(i) Ke =
�??????�
�??????
x 100 + G =
15
95
x 100 + 7=15.79+7=22.79%
(ii) Ke =
�??????�
�??????�
x 100 + G =
15
160
x 100 + 7=9.38+7=16.38%

41. Example 9:
Ke =
�??????�
�??????
x 100 + G =
1.76
24
x 100 + 10=7+10 =17%

42. Cost of Retained Earning [Kr]
Companies generally do not distribute the entire profits by way
of dividends among their shareholders. A part of such profits is
retained for future expansion and development. Thus year by
year, companies create sufficient funds for financing through
internal sources. But neither the company pays any cost nor
incurs any expenditure for such funds. Therefore, it is assumed to
be cost free capital and that is not true. Though retained
earnings like equity funds have no explicit cost but do have
opportunity cost. Thus the cost of retained earnings has the cost
equivalent to opportunity rate of earnings forgone by the equity
shareholders. It requires the below adjustments:

43. Adjustments for Retained Earnings:
I.Adjustment for Income- Tax:
(1-tp)
I.Adjustments for brokerage, Commission etc.:
(1-B)
II.Adjustment for Capital Gain:

1
1−????????????

44. Calculation of Cost of Retained
Earning:
Kr =
�??????� (??????−�?????? (??????−??????)
�??????� (??????−�??????)
x 100
Or
Kr =
�??????� (??????−�?????? (??????−??????)
�??????� (??????−�??????)
x 100
Or
Kr =
�??????�
�??????� (??????−�??????)
x 100 + G X (1-Tp) 1-B)

45. Example 10:

46. Example 11:

47. Example 12:

48. Cost of Weighted Average Capital
(Kw)
Once the specific cost of capital of the long term sources have
been calculated , the next step is to calculate overall cost of
capital of the firm. The capital raised from various sources is
invested in different projects. The profitability of these projects is
evaluated by comparing the expected rate of return with
overall cost of capital. The overall cost of capital is weighted
average of the cost of various sources of different funds where
weight is the proportion of each source of funds. Thus weighted
average cost of capital is the overall cost of capital which can
be calculated by applying weights as amount of individual
long term capital.

49. Calculation of weighted avg. cost of
Capital:
Step 1: Assignment of Weights:
A. Book Value Weights
B.Market Value Weights
Step 2: Computation of Specific Cost of Capital of Each Source
Step 3: Computation of Weighted Average Cost of Capital (Kw)
Kw =
∑��
∑�
Where : X = Specific Cost of Capital (After Tax)
W = Weights (Book Value/ Market Value)
∑ XW = Sum of Product of X & W

50. Example13:
Ans: 10.85%

51. Example 14:
Ans: 8.69%

52. Example 15

53. Solution 15:
Ke =
�??????�
�??????�
x 100 =
15
125
x 100 = 12%
Kd (Ist Issue) =
??????
�??????
x 100 X (1-t) = 6X.50 = 3%
Kd (2nd Issue) =
??????
�??????
x 100 X (1-t) = 7X.50 = 3.5%
Kp =
�??????�
�??????
x 100 = 8%
Kr =
�??????� (1−�??????)
�??????�
x 100 =
15 (1−.10)
125
x 100 = 10.8%

54. Solution Continue…
Sources Amount Weights (w)COC After
Tax (in %)
XW (weighted
Cost)
Equity Share
Capital
400000 4 12 48
Debenture (Ist) 200000 2 3 6
Debenture (2
nd
)100000 1 3.5 3.5
Pr. Sh. Capital200000 2 8 16
Retained
Earnings
100000 1 10.8 10.8
Total: 10 84.3
Kw =
∑��
∑�
=
84.3
10
= 8.43%

55. Example 16:
Ans: 9.535% & 10.167

56. Example 17:
Ans: Kw=14%, Ke=14.8%, Kp= 14.68%, Kd = 8.83% Kt= 9.60%