COST OF CAPITAL, COST OF DEBT, COST OF PREFERENCE SHARE CAPITAL, COST OF EQUITY SHARE CAPITAL.

Measuring the cost of capital is essential for businesses and investors to make informed decisions. The cost of capital refers to the return expected by investors or lenders for providing capital to a business. It's the minimum return required to justify investing in a project or venture. The cost of capital refers to the minimum return required by investors or lenders for providing capital to a business. It's the expected return on investment (ROI) that investors demand for putting their money at risk. In other words, it's the cost of using someone else's money to fund a business or project.

The cost of capital represents the opportunity cost of investing in a business, as investors could earn a similar return by investing in other assets with similar risk profiles. A company's cost of capital is essentially the minimum return it must earn on its investments to satisfy its investors and creditors.

1. FINANCIAL MANAGEMENT UNIT- COST OF CAPITAL DEBT, PREFERNCE SHARE CAPITAL AND EQUITY SHARE CAPITAL Dr. P. Indhumathi Assistant Professor of Commerce, D.K.M. College for Women (Autonomous), Vellore- 01

2. Cost of redeemable debt COST OF IRREDEEMABLE PREFERENCE SHARE CAPITAL COST OF REDEEMABLE PREFERENCE SHARE CAPITAL COST OF EQUITY SHARE CAPITAL PROBLEMS AND SOLUTIONS

3. PROBLEM -1 ISSUED AT PAR; REDEEMABLE AT PREMIUM SRINIVAS Ltd issued 10,000 10% debentures of Rs . 100 each. The debentures are redeemable after 10 years at a premium of 5%. Compute before tax and after tax cost of debt

4. COST OF REDEEMABLE DEBT COMPUTATION OF ANNUAL COST BEFORE AND AFTER TAX PARTICULARS RS. RS. Interest on Debentures (10,000x100) 10,00,000 x 10 % 100000 ADD Issue Expenses/Floatation cost Nil Discount on issue of Debentures Nil Premium on redemption of Debentures 10,00,000x5% = 50000/10years 5000 5000 105000 LESS Premium on issue of Debentures 105000 *Annual cost before tax 105000 Less- Tax(105000x50%) 52500 *Annual cost after tax 52500

5. AVERAGE VALUE OF DEBT= NET PROCEEDS + REDEMPTION VALUE 2 Net proceeds = Face value- issue expenses = 10,00,000 -0 = 10,00,000 Redemption Value = Face Value + Premium 1000000 + 1000000x 5% = 10,50,000 Average value of Debt =10,00,000+ 10,50,000 2 =10,25,000 COST OF DEBT BEFORE TAX= ANNUAL COST BEFORE TAX AVERAGE VALUE OF DEBT X 100 = 105000/1025000x 100 = 10.24% COST OF DEBT AFTER TAX= ANNUAL COST AFTER TAX AVERAGE VALUE OF DEBT X 100 = 52500/1025000 x100 = 5.12%

6. PROBLEM -2 ISSUED AT DISCOUNT; REDEEMABLE AT PREMIUM MALINI Ltd issued 15,000 12% debentures of Rs . 100 each at a discount of 10%. The debentures are redeemable after 10 years at a premium of 10%. Compute before tax and after tax cost of debt if tax rate is 40%

7. COST OF REDEEMABLE DEBT COMPUTATION OF ANNUAL COST BEFORE AND AFTER TAX PARTICULARS RS. RS. Interest on Debentures (15,000x100) 15,00,000 x 12 % 180000 ADD Issue Expenses/Floatation cost Nil Discount on issue of Debentures 15,00,000x10% = 150000/10years 15000 Premium on redemption of Debentures 15,00,000x10% = 150000/10years 15000 30000 210000 LESS Premium on issue of Debentures NIL *Annual cost before tax 210000 Less- Tax(210000x40%) 84000 *Annual cost after tax 126000

8. AVERAGE VALUE OF DEBT= NET PROCEEDS + REDEMPTION VALUE 2 Net proceeds = Face value- Discount- issue expenses = 15,00,000 – 1,50,000 = 13,50,000 Redemption Value = Face Value + Premium 1500000 + 1500000x 10% = 16,50,000 Average value of Debt =13,50,000+ 16,50,000 2 =15,00,000 COST OF DEBT BEFORE TAX= ANNUAL COST BEFORE TAX AVERAGE VALUE OF DEBT X 100 = 210000/15,00,000x 100 = 14% COST OF DEBT AFTER TAX= ANNUAL COST AFTER TAX AVERAGE VALUE OF DEBT X 100 = 126000/1500000 x100 = 8.4%

9. Cost of Irredeemable preference share capital Cost of irredeemable preference share capital= Annual Preference Dividend/Net Proceeds x 100 Net Proceeds is to ascertained Shares issued at Par Net Proceeds = Face Value – Issue Expenses (ii) Shares issued at premium Net Proceeds = Face Value + Securities Premium – Issue Expenses ( iii) Shares issued at Discount. Net Proceeds = Face Value - Discount – Issue Expenses

10. Dinesh ltd has issued 9% 10,000 preference shares of 100 each. The issue expenses are Rs.3 per share. You are required to ascertain the cost of preference share capital if the shares are issued a) at par, b) at a premium, c) at a discount of 5%. Problem-1

11. solution Cost of irredeemable preference share capital= Annual Preference Dividend/Net Proceeds x 100 10000 preference shares x 100 = 1000000 Issue Expenses = 10000x 3 = 30000 Annual Preference Dividend= 10,00,000x9% = 90000

12. Cost of irredeemable preference share capital= Annual Preference Dividend/Net Proceeds x 100 Shares issued at Par Net Proceeds = Face Value – Issue Expenses 1000000-30000 9,70,000 === 90000/970000 x100 = 9.27% (ii) Shares issued at premium Net Proceeds = Face Value + Securities Premium – Issue Expenses =1000000+1000000x10% - 30000 = 10,70,000 === 90000/10,70,000x100 = 8.41% (iii) Shares issued at Discount. Net Proceeds = Face Value - Discount – Issue Expenses =1000000-1000000x5%- 30000 = 9,20,000 ===90000/9200000x100 = 9.78%

13. COST OF REDEEMABLE PREFERENCE SHARE CAPITAL COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100 COMPUTATION OF ANNUAL COST BEFORE AND AFTER TAX PARTICULARS RS. RS. Preference Dividend Xxx ADD Issue Expenses/Floatation cost/Marketing Cost/Commission to Brokers Xxx Discount on issue Xxx Premium on redemption of Shares Xxx LESS Premium on issue of Shares Xxx *Annual cost before tax Xxxxxx Less- Tax Xxx *Annual cost after tax Xxxxxx

14. AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES = NET PROCEEDS + REDEMPTION VALUE/2 2 COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100

15. Sandhiya ltd has issued 12% 12,000 preference shares of 100 each. The issue expenses are 4%. The Shares are redeemable after 10 years at a premium of 10%. Calculate the effective cost of redeemable preference share capital. Problem-1 ISSUED AT PAR , REDEEMABLE AT PREMIUM

16. COST OF REDEEMABLE PREFERENCE SHARE CAPITAL COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100 COMPUTATION OF ANNUAL COST BEFORE AND AFTER TAX PARTICULARS RS. RS. Preference Dividend 12000x100= 12,00,000x12% 144000 ADD Issue Expenses 12,00,000x4% 48000/10 years 4800 Discount on issue Nil Premium on redemption of Shares 12,00,000x10% = 120000/10years 12000 16000 LESS 160800 Premium on issue of Shares - Discount on redemption of Shares - *Annual cost before tax 160800

17. AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES = NET PROCEEDS + REDEMPTION VALUE/2 Net Proceeds = Face Value – Issue Expenses 1200000-48000= 1152000 Redemption Value = 12,00,000+120000= 13,20,000 1152000+1320000/2 = 12,36,000 COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100 160800/1236000x100 = 13.01%

18. Jeffi ltd has issued 8% 7500 preference shares of 100 each at a premium of 10% The floatation cost are 5%. The Shares are redeemable after 7.5 years. Calculate the effective cost of redeemable preference share capital. Problem-2 ISSUED AT PREMIUM , REDEEMABLE AT PAR

19. COST OF REDEEMABLE PREFERENCE SHARE CAPITAL COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100 COMPUTATION OF ANNUAL COST BEFORE AND AFTER TAX PARTICULARS RS. RS. Preference Dividend 7500x100 = 750000x8% 60000 ADD Issue Expenses/Floatation cost 750000x5% 37500/7.5yrs 5000 Discount on issue Nil Premium on redemption of Shares Nil 5000 LESS 65000 Premium on issue of Shares 750000x10% 75000/7.5yrs 10000 10000 Discount on redemption of Shares *Annual cost before tax 55000

20. AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES = NET PROCEEDS + REDEMPTION VALUE/2 Net Proceeds = Face Value + premium – Issue Expenses = 750000+75000-37500 = 787500 Redemption Value =750000 787500+750000/2 = 768750 COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100 55000/768750x100 = 7.15%

21. Bhagat ltd has issued 10% 4400 preference shares of 100 each at a discount of 10% The floatation cost are 4%. The Shares are redeemable after 8 years. Calculate the effective cost of redeemable preference share capital. Problem-3 ISSUED AT DISOUNT , REDEEMABLE AT PAR

22. COST OF REDEEMABLE PREFERENCE SHARE CAPITAL COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100 COMPUTATION OF ANNUAL COST BEFORE AND AFTER TAX PARTICULARS RS. RS. Preference Dividend 4400x100 440000x10% 44000 ADD Issue Expenses 440000x4% 17600/8years 2200 Discount on issue 440000x10% 44000/8years 5500 Premium on redemption of Shares Xxx 7700 LESS 51700 Premium on issue of Shares Nil Discount on redemption of Shares Nil *Annual cost before tax 51700 Less- Tax Xxx *Annual cost after tax Xxxxxx

23. AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES = NET PROCEEDS + REDEMPTION VALUE/2 Net Proceeds = Face Value - Discount – Issue Expenses = 440000-44000-17600 = 378400 Redemption Value = 440000 378400+440000/2 = 409200 COST OF REDEEMABLE PREFERENCE SHARE CAPITAL ANNUAL COST BEFORE TAX/ AVERAGE VALUE OF REDEEMABLE PREFERENCE SHARES X 100 51700/409200x 100 =12.63%

24. COST OF EQUITY SHARE CAPITAL Dividend yield method or Dividend Price Method Cost of equity share capital= Expected Dividend per share / Net Proceeds x100 (or) ke = D1/ kp x100 Cost of Equity Capital, when the market price is given Cost of equity share capital= Expected Dividend per share / Market Price x100 (or) ke = D1/MP x100

25. PROBLEM - 1 ARR ltd issued 500000 Equity Shares of Rs. 10 each at a premium of 10%. The Company has been paying a dividend of 27% regularly for the past 5years. It is expected to maintain the dividend in future also. You are required to calculate Cost of Equity Capital b) Cost of Equity Capital if the market price of the share is Rs . 50

26. COST OF EQUITY SHARE CAPITAL Dividend yield method or Dividend Price Method Cost of equity share capital= Expected Dividend per share / Net Proceeds x100 Expected Dividend per share= 27% x10 0.27x10= 2.7 Net Proceeds = 10+10x10% =11 ke = 2.7/11x100 = 24.54% Cost of Equity Capital, when the market price is given Cost of equity share capital= Expected Dividend per share / Market Price x100 ke = 2.7/50 x100 = 5.4%

27. PROBLEM - 2 Ram ltd issued Equity Shares of Rs. 10 each for public subscription at a premium of 20%. The company pays@ 5% as underwriting commission on issue price. Expected Rate of dividend by equity shareholders is 25% regularly for the past 10 years. It is expected to maintain the dividend in future also. You are required to calculate Cost of Equity Capital b) Cost of Equity Capital if the market price of the share is Rs . 16

28. COST OF EQUITY SHARE CAPITAL Dividend yield method or Dividend Price Method Cost of equity share capital= Expected Dividend per share / Net Proceeds x100 Expected Dividend per share= 25% x10 0.25x10= 2.5 Net Proceeds = 10+10x20%- Issue Expenses(12x5%) =10+2-0.60= 11.40 ke = 2.5/11.40x100 = 21.92% Cost of Equity Capital, when the market price is given Cost of equity share capital= Expected Dividend per share / Market Price x100 ke = 2.5/16 x100 = 15.625%

29. Dividend yield +growth method Cost of equity share capital= Expected Dividend per share / Market Price x100 + Growth rate ke =D1/MP +G Problem – 1 The Market Price of an equity share of mill ltd is Rs . 120. The expected equity dividend is Rs . 2.40. The share holders anticipate the growth of 10% in dividends. You are required to calculate Cost of equity share capital

30. Cost of equity share capital= Expected Dividend per share / Market Price x100 + Growth rate 2.40/120 x 100 + 10% == 2%+10% == 12%