Chapter 8

COST OF CAPITAL

Learning 0bjectives
After studying this chapter, youare able to understand:
o Meaning of Cost of Capital
a Cost of Equity Capital
O Cost of Retained Earnings
a Cost of Redeemable and Irredeemable Preference Share Capital
O Cost of Redeemable and Irredeemable Debentures
O Cost of Deep Discount Bonds, Convertible Debentures and Term Loans
D Calculation of Weighted Average Cost of Capital
o Opportunity Cost of Capital and Marginal Cost of Capital
The main objective of a business firm is to maximize the wealth of its shareholders in the long-un
the management should only invest in those projects which give a return in excess of cost of funds
invested in the projects of the business. The difficulty will arise in determination of cost of funds
if it raised from different sources and different quantums. The various sources of funds to the
company are in the form of equity and debt. The cost of capital is the rate of return the company
has toto the
due payfact
to various supliers of funds in the company. There are variation in the costs of capital
that different kinds of investment carry different levels of risk which is compensated
for by different levels of return on the investment. There are two main sources of
capital tor a
company - shareholders and lenders. The providers of debt generally include debenture holders
and financial institutions. The costs of equity and costs of debt are the rates of
to be offered to these two groups of suppliers of capital in order to return that ned
attract funds from them
Determination of cost of capital is essential for capital budgeting decisions. The cost of capital s
used as the discount rate in NPV calculations and as a
project's Internal rate of return. target rate of return for comparing wind
Cost of capital is defined 'as the minimum rate of
so that market value per return that a firm must earn on its investmes
shareremains unchanged". When the
is used in the project appraisal, the IRR of the project is internal rate of return ([RR) meu IL
capital.
provides ayardstick to measure the worth of compared with the cost of
accept or reject criterion. It is also referred toinvestment proposal andthus performs the role of
required rate of return and standard as cutoff rate, target rate, minimum
rate, return,a
firm has to earn to maintain its market return etc. Cost of capital is the hurdlerate of
value and value of its minimum istobe
determined to helpin managerial decision making like shares. Cost of capital
eacceptance of linvestment proposas,
 Chapter 8 Cost of Capital 221

anpraisal of profitability and viability of subunits, restructuring of capital, raising of additional

Bnances etc Cost ot capital is the minimum rate of returnwhich consists of risk free return plus
nremium for risks associated with the particular business, The risks of a business firm can be
categorized into: (a) Business risk and (b) Financial risk. Business risk arises when there is volatility
in carnings of afirm due to changes in demand, supply, cconomic environment, business
conditions etc Financial risk arises when the firm depends more on debt funds, since the payment
of interest charges and repayment of principal amount is to be made in time as per the loan
obligations. Therefore, the business risk and financial risk associated with a particular firm calls
for payment of additional return to the providers of capitaland debt, called as 'riskpremiunt. The
long-term funds requirement of the firm is generally met from the following sources:
(0 Equity share capital
(i) Preference share capital
(i) Retained earnings
(iv) Debentures and bonds
(v) Term loans from financial institutions and banks
The firm will incur cost in using the said funds. The costs would be differing for different sources
It depends upon the rights and obligations of the firm, the rights of providers of long-term funds
risks associated with the each source of finance, the expectations of theinvestors, market rates of
return of different forms of finance, participation in management, stability and growth of the firm
firm's ability in meeting financial obligations, personal taxation of investors, opportunity cost of
funds etc. Cost of capitalis the hurdle rate, if the firm earns above its cost of capital can enable to
maximize the firm's value as well as shareholders wealth. Therefore, a firm should accept
investment proposals whose internal rate of return is above its cost of capital. Cost of capital acts
asa minimumbenchmark return, a firm should earn enough profits to meet its cost of capital. The
cost of capital consists of the following elements:
(a) Cost of Equity Capital (K)
(b) Cost of Retained Earnings (K)Eistiash
(c) Cost of Preferred Capital (K)
(d) Cost of Debt, includes both Debentures, Bonds and Term Loans (K,)

Cost of Equity Capital (K)

The funds required for the project are raised from the equity shareholders which are of permanent
nature. These fundsneed not be repayable during the life time of the organization. Hence it is a
permanent source of funds. The equity shareholders are considered to be the owners of the
company. The main objective of the firm is to maximize the wealth of the equity shareholders.
Equity share capital is the risk capital of the company. If the company's business is doing well the
ultimate beneficiaries arethe equity shareholderswho will get the return in the form ofdividends
Iromthe company and the capital appreciation for their investment. If the company comes for
liquidation due to losses, the ultimate and worst sufferers are the cquity shareholders. Sometimes
they may not get their investment back during the liquidation process. Profits after taxation, less
preterence dividends paid out tothe preference shareholders, are funds that belong to the equity
shareholders which are reinvested in the company and therefore, those retained funds should be
included in the category of equity, the cost of retained earnings is discussed separately from cost
l cquity capital. The cost of equity may be delined as the minimum rate of return that a company
must earn on the equity sharecapital financed portion of an investment project so that market
Price of theshares remain unchanged. The following methods are used in calculation of cost of
equity
 llustration 8.7inalepbnboad nbokskeeoa
valuc is Rs. 45 cach. The after
Prabhat Ltd. has 50,000 equity shares of Rs. 10 each and itscurrent market
9,60,000.Calculate the cost of capital
tax profit of the company for the yearended 31st March, 2009 is Rs.
based on price/earning method.
Solution RS, 9 . 6 0 . 0 0 0 a u l t n l o p a bol
EPS Rs. l19.20
50,000 equity shares
E 19.200,4267 or 42.679%
M45laoiesdaieobleiladettotsirlenneee
Modelnteiteddhtlde
Capital Asset Pricing
The capital asset pricing model (CAPM) divides the cost of equity into two components, the near
risk-free return available on investing in government bonds and anin additional risk premium lor
premium turn comnprises the average
investing in a particular share or investment. This risk
return on the overall market portfolio andthe beta factor (riskfactor) of the particular investment.
Putting this all togethertheCAPM assesses the cost of equity for an investment as the following
K = R+ b, (Rm- R)
Where,abieraelerence Shares
al R = Risk-free rate of returnslistheei
Rm = Average market return
Enoitusteutll
b, = Beta of the investment
The appropriate discount rate to apply to the forecasted cashflows in an investmentappraisal is
the opportunity cost of capital for that investment. The opportunity cost of capital is the cxpected
rate of return offered in the capital markets for investments of a similar risk profile. Thus ít
depends on the risk attached to the investment's cashflows. (For deiailed study please refer to
Chapter 29 on 'Capital Asset Pricing Model and Modern Portfolio Theory').
 Cost of Debt (K)
The capital structure of a firm normally include the debt component also. Debt may be in the form
of debentures, bonds, term loans from financial institutions and banks etc. The debt is carried a
fixed rate of interest pavable to them, irrespective of the profitability of the company. Since the
coupon rate is lixed,the lirm increases its earnings through debtfinancing. Then, after payment
of fixed interest charges more surplus is available for equity shareholders, and hence EPS will
increase. An important point to be remembered that dividends payable to equity shareholders and
preference shareholders is an appropriaton of profit, whereas theinterest payable on debt isa
charge against profit. Therelore, any payment towards interest will reduce the prolit and
uttimatety the company'staxliability would decrease, This phenomenon is called tax shield, TF
tax shield is Viewed as a benel+t acerues to the companywhich is geared.To gain the fulltax shiela
the following conditions apply:
() The company must be able to show a taxable profit every year to take fulladvantage of the
tax shield.
(ü) If the company makes loss, the tax shield goes down and cost of borrowing increases.
 Weighted Average Cost of Capital
company's fin
The CIMA defines the weighted average cost of capital "as the average cost of theelement bears to
(cquity, debentures, bank loans) weighted according to the proportion each
yields and cosre
total pool of capital, weighting is usually based on market valuations current
tax'.
Cast of capital is the overallcomposite cost of capital and may be defined as the average of the r
of each specific fund) Weighted average cost of capital (WACC) is defined as the weightedof avera
finan
of the cost of various sources of finance, weight being the market value of each source
outstanding. Cost of various sources of finance refers to the return expected by the respective
investorsAfirm may procure long-term funds from various sources like equity share capital
preference share capital, debentures, term loans etc. at different costs depending on the rist
perceived by the investors(When all these costs of different forms of long-term funds weighted by
their relative proportions to get overall composite cost of capital termed as 'weighted average cost
of capital (WACCDThe firm's WACC should be adjusted for the risk characteristics of aproject for
which the long-term funds are raised. Therefore, project's cost of capital is WACC plus risk
adjustment factor) The argumentin favour ofusing WACC stems from the concept that investment
capital Irom var+ous sources should be seen as apool of available capital for all the capital projects
of an organization. Hence cost of capital should be weighted average cost of capital. Financing
decision, which determines the optimal capital mix, is traditionally made without making any
reference to WACOptimal capital structure is assumed at a point where WACC is minimum. For
project evaluation, WACC is considered as the minimum rate of return required from
off the expected returnof the investors and as such WACC is generally referred to asproject
to pay
the
rate of return?The relative worth of a project is determined using this required rate of 'requiredas
the discounting rate. Thus, WACC gets much importance in both the return
decisions)
Simple WACC The simple WACC is calculated without consideration to the impact of tax on
capital.([The combined cost of equity capital and debt capital is the WACC for a company as cost whole.
ot
If the company is all equity financed, the cost of equity will be the cost of
companies, the WACC can be stated as follows capital. In case of geared
owACC = (Cost of Equity X 96 Equity) + (Cost of Debt X %Debt)
Jllustration 8.21sbtbi ilrisl
ABCLtd. has a gearing ratio of 40%. Its cost ofwonelenc hauattinoaotl wineoa atlo
equity is 219% and the cost of debt is 15%. lo
-Calculate the company's
Solution
WACC.hhntl becbdaldses lo bastnli
WACC (219% X 0.60) + (159% X 0.40)= 12.6% +
llustration 8.22Du lat 69%= 18.6%
 Solution
(6)
9.6
Rate of return on cquity funds (16% X 0.60)
48
Rate of return on debt funds (12% X 0,40)
144
Oxerallrate of return required to earn by the firm
Verification - This nmeans suppose the total project cost or investments made by the firm is Rs. 10,00,000
Rs 600,000 equity and Rs. 4,00,000 debt). Company must earn 144% on its overall investnents ic.
Rs l44.000 which willbe just sufficient to give equity holdersarate of return of 16) This can be further
(Rs)
explained as follows: 2hl0itebnsi
Total earnings ollldt autse onrbbt144,000
Less: Intereston debts (4,00,000 X 12/100) 48,000
Amount available for equity holders 96,000

96,000
Rate of Return on Equity = X 100 = 16%
6,00,000ass
The weighted average cost of capital of a company is calculated in two ways.
0 Based on weight of costs by the book value of the different forms of capital.
() Based on weight of market value of each form of capital.
Market Value of Funds and WACC
The market value approach is mnore realistic for the reasons given below:
La The cost of funds invested at market prices is familiar with the investors.
b Investments are generally rated by the reference to their earnings yield, and the companyhas
a responsibility to maintain that yield.
e Historicbook values have no relevance in calculation of real cost of capital.
Ld The market value represents near to the opportunity cost of capital.
WACC is the discount rate that can be used to evaluate the company's new investments, provided
that they have the same risk profile as the company as awhole and provided that they used the same
combination of debt and equity to finance the proposed investments, or financed by company
reserves.