Unit 2 - Cost of Capital

Cost of capital
K = rj +b + f
Where,
K = cost of capital
rj = riskless cost of particular type of finance
b = business risk premium
f = financial risk premium

Cost of debt
𝐼
Kd = 𝑃

Cost of Irredeemabe debt

A company may issue irredeemable debentures or bonds in order to retain constant debt in its
capital structure. It is also called perpetual debt.
Cost of debt – tax rate
𝐼
Kd = 𝑁𝑃
* [1 − 𝑡]

Where Kd = Cost of debt capital, I = annual interest payable,

NP = Net proceeds of debenture, T = Tax rate
Cost of debt issued at par
Kd = (1-t) R
Where Kd = Cost of debt capital, t = tax rate, R = Debenture interest rate
Debt issued at premium or discount
𝐼
Kd = 𝑁𝑃
* [1 − 𝑡]

Cost of Redeemable debt

𝐼
⎡𝐼 (1−𝑡)+ 𝑛 [𝑃−𝑁𝑃]⎤
⎣ ⎦
Kd = 1
2
[𝑃+𝑁𝑃]

Cost of debt redeemable in Instalments

Before tax
𝑛
[𝐼1+ 𝑃1] [𝐼2+ 𝑃2] [𝐼𝑛+ 𝑃𝑛] [𝐼𝑡+ 𝑃𝑡]
Vd = 1 + 2 + …………… or Vd = ∑
(1+𝐾𝑑) (1+𝐾𝑑) (1+𝐾𝑑)𝑛 𝑖=0 (1+𝐾𝑑)𝑡
 Where
Vd= present value of the bond
In = Annual interest period
Pn = periodic payments
n = number of years to maturity
Kd = cost of debt or required rate of return

Cost of preference share capital

Cost of irredeemable preference share capital
𝑃𝐷
Kp = 𝑁𝑃

Cost of redeemable preference share capital

1
𝑃𝐷+ 𝑛 (𝑀𝑉−𝑁𝑃)
Kp = 1
2
(𝑀𝑉+𝑁𝑃

Where
MV or RV= Maturity value or reedemable value
PD = preference dividend
NP = net proceeds

COST OF EQUITY CAPITAL

It is the expectation of the equity shareholders in terms of returns on their investment. There are
alternative methods to calculate the same that depends on factor like dividend, growth etc.
Dividend Yield/Price Approach
According to this approach the cost of equity capital (ke) is defined as the discount rate
that equates the present value of all expected future dividends per share with the net
proceeds of the sale (or the current market price) of a share. This method is based on the
assumption that the market price per share is the present value of its future dividends.
According to this method, there is a direct relation between market value of equity shares
and future dividends. Another assumption of this approach is that future dividend is
constant means there is zero growth in dividend. This method can be used in constant and
variable growth situations and also in no-growth companies for estimation of cost of
equity. This approach is based on the following assumptions:–
Assumptions:
(a) Market values of the shares are directly related to the future dividends on the
shares.
(b) Future dividend per share is expected to be constant and the company is
expected to earn at least this yield over a period of time.
Limitations:
(a) This method does not consider any growth rate i.e. future dividend assumed to
be constant. But practically, shareholders used to expect that the return on their
equity investment would grow over time.
(b) It does not include the effect of future earnings or retained earnings.
(c) This approach can lead to ignore the capital appreciation of value of share.
𝐷
Formula = Ke = 𝑃𝑜

Where,
Ke = Cost of equity share capital
D = Expected divined per share
Po = Current market price per share

Earnings Price Approach

According to this approach, the cost of equity share capital is determined by dividing the
earnings per share by the current market price per share. The cost of equity share is
determined on the basis of earning per share. Earnings per share is calculated by dividing
the earnings available to equity shareholder by the number of equity shares. Again,
earnings available to equity share holder are computed after giving the preference
dividend to the Preference shareholders. When firm has no need of debt capital in its
capital structure, firm uses this method to determine the cost of equity share capital. This
method depends on the assumption that even if the firm is not distributing it’s earning as
dividend, means the earning is kept as the retained earnings. These retained earnings will
 lead to future growth of the earnings and as a result the future market price of the share
will increase.
𝐸
Formula: Ke = 𝑃

Ke = Cost of equity share capital

E = Earnings per share
P = Current market price per share

Dividend Growth Approach or Gordon’s Model

Every equity shareholder expects dividend to increase year after year and not to remain
constant. In this case the expected growth in dividend is taken into consideration for
computation of cost of equity. The growth in expected dividend in future may be either at
a uniform normal rate or it may vary. Therefore, the dividend growth approach takes into
account expected dividend under different growth assumptions. This approach is based
on certain assumptions.
Assumptions
(a) The current market price of share depends on future expected dividend.
(b) The initial dividend D0 is greater than 0.
(c) The dividend payout ratio is constant.

Where,
K e = Cost of equity share capital
D1 = Next expected divined =[D0 (1 + g)]
P0 = Current market price per share
g = Constant growth rate of dividend
Determination of ‘g’
a) Average model
 Where

b) Gordon’s model
According to this method, a growing stream of future dividends arises from a growing
level of investment by the firm in profitable projects, and it will, therefore, be this rate of
investment which will partially determine the growth rate. This model is based on the
following assumptions:
(a) The firm is an all-equity firm.
(b) Only source of additional investment is retained earnings.
(c) Every year firm re-invested a constant portion of retained earnings.
(d) Retained earnings produce a constant of annual return
It can be calculated as below:
Growth (g) = b × r
Where
g = Future dividend growth rate
b = Constant portion of retained earnings each year*
r = Average rate of return fund invested
*Proportion of earnings available to equity shareholders which is not distributed
as dividend.

Realized Yield Approach

It is the easy method for calculating cost of equity capital. Under this method, cost of equity is
calculated on the basis of return actually realized by the investor in a company on their equity
capital.

Where,
Ke = Cost of equity capital
PVƒ = Present value of discount factor
D = Dividend per share

Capital Assets Pricing Model (CAPM) Approach

The Capital Asset Pricing Model (CAPM) was developed by William F. Sharpe and John Linter
in the 1960s. This model is useful for measuring the cost of equity capital of the firm, it shows
the relationship between the unavoidable risk and expected return from a security. The model is
based on the following assumptions:
(a) The capital markets are highly efficient.
(b) No investor is large enough to affect the market.
(c) All investors have the same expectations about the risk and return.
(d) There are negligible restrictions on investment.
(e) There are two types of investment opportunities i.e. risk-free security and market portfolio of
common stock.
According to CAPM,

Where,
ke = Expected rate of return to the investors, or cost of equity capital
Rf = Risk free rate of return
Rm= Market rate of return
β = Beta coefficient by which the market risk is determined
Weighted Average Cost of Capital
The weighted average cost of capital is the expected average future cost of funds over the
long run founded by weighting the cost of each specific type of capital by its proportion
in the firm's capital structure.
∑𝑋𝑊
WACC = ∑𝑋

Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = weight , proportion of specific sources of finance
The simple average cost of capital is not appropriate to use because firms hardly use
various sources of funds equally in the capital structure. It is also important to remember
that the weighted average after tax costs of the individual component of capital is to be
taken not the before tax weighted average cost.
The main reason behind the computation of overall cost of capital is to use this rate as the
decision criterion in capital budgeting or investment decision. Generally, it may be stated
that this cost of capital is taken to be the cut-off rate for determining the profitability of
proposed projects.
Steps taken for calculation of WACC
Step-1: Compute the specific cost of each source of capital.
Step-2: Calculate the proportion (or %) of each source of capital to the total
capital (weight)
Step-3: Multiply the cost of each source by its proportion in the capital structure.
Step-4: Add the weighted component cost to get the WACC.
This is noted that the weighted average cost of capital may change due to
(i) change in the cost of each component or
(ii) change in the relative important of each companies i.e. the change in
proportion or weight or
(iii) change in both.
.
Assignment of Weights
The aspects relevant to the selection of appropriate weights are
(i) Historical weights versus Marginal weights:
(ii) Historical weights can be - (a) Book value weights or (b) Market value weights.
 Historical versus Marginal Weights: The first aspect of the decision regarding the
selection of appropriate weights for computing the overall cost of capital is: which
system of weighting marginal or historical is preferable? The critical assumption in any
weighting system is that the firm will raise capital in the specified proportions.
Marginal Weights: The use of marginal weights involves weighting the specific costs by
the proportion of each type of fund to the total funds to be raised. The marginal weights
represent the %age share of different financing sources the firm intends to raise/employ.
The basis of assigning relative weights is, therefore, new/additional/ incremental issue of
funds and, hence, marginal weights.
However, WACC can be computed by using the following three types of weight.
(a) Book value weight
(b) Market value weight
(c) Marginal book value weight

PROBLEMS
Problems to be discussed in class
1. MNC Ltd. paid dividend per share of ` 4 and the current market price of equity share is
`20. Calculate the cost of equity share capital Ke
2. AB Ltd. issued shares of ` 100 each at a premium of 10%. The issue involved
underwriting commission of 5%. The rate of dividend expected by the shareholders is
12%. Determine the cost of equity capital (Ke).
3. A company issues 20000 equity shares of Rs 100 each at a premium of 10%. The
company has been paying 20% dividend to equity shareholders for the past 5 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 180?
4. The earnings available to the shareholders amount to ` 40,000. Firm is represented by
10,000 equity shares and the current market price of equity share is ` 25. Calculate the
cost of equity share capital.

5. The earnings per share is Rs 18 and the current market price is Rs 150. Compute the cost
of equity capital

6. Mamon Ltd. is expected to earn ` 30 per share. Company follows fixed payout ratio of
40%. The market price of its share is `200. Find the cost of existing equity if dividend tax
of 15 % is imposed on the distributed earnings when:
(a) dividend to the shareholders is reduced by the extent of dividend tax.
(b) current level of dividend amount is maintained.
7. XYZ Company’s share is currently quoted in the market at ` 20. The company pays a
dividend of ` 2 per share and the investors expect a growth rate of 5% per year. You are
required to calculate (a) cost of equity capital of the company and (b) the market price per
share if the anticipated growth rate dividend is 7%.
8. A company plans to issue 2000 shares of 100 each at par. The flotation costs are expected
to be 5% of the share price. A company pays a dividend of 10 per share initially and the
growth in divideds is ex to be 5%. Compute the cost of new equity share. If the current
market price of an equity share is 160, calculate the cost of new existing share.
9. From the following information, determine the cost of equity capital using the CAPM
approach.
a. Required rate of return on risk-free security, 8%.
b. Required rate of return on market portfolio of investment is 13%.
c. The firm’s beta is 1.6.

10. The beta coefficient of Target Ltd. is 1.4. The company has been maintaining 8 % rate of
growth in dividends and earning. The last dividend paid was `4 per share. The return on
government securities is 10 % while the return on market portfolio is 15 %. The current
market price of one share of Target Ltd. is ` 36.
(a) What will be the equilibrium price per share of Target Ltd?
(b) Would you advise for purchasing the share?

11. Calculate the cost of equity capital of Mamon Ltd., whose risk free rate of return equals
10%. The firm’s beta equals 1.75 and the return on the market portfolio equals to 15%.

12. If the risk free rate of return and the market rate of return of an investment are 14% and
18% respectively, calculate the cost of equity share capital if (a) β=1, (b) β= 2/3 and (c)
β=5/4.

13. A firm’s Ke (return available to shareholders) is 10%, the average tax rate of shareholders
is 30% and it is expected that 2% is brokerage cost that shareholder will have to pay
while investing their dividends in alternative securities. What is the cost of retained
earnings?
14. A company’s Ke is 20% of the average tax rate of shareholders is 40% and it is expected
that 2% is brokerage cost that shareholders will have to pay while investing their
dividends in alternative securities. What is the cost of retained earnings?
15. The following is the capital structure and the firm's expected after-tax component costs of
the various sources of finance
Sources of finance Amount Expected after-tax cost (%)
Equity share capital 650,000 20%
Retained earnings 250,000 20%
Preference share capital 150,000 15%
Debt capital 450,000 12%
Calculate WACC.
16. A company has the following capital structure. Find out the WACC.
Sources of finance Amount Expected after-tax cost (%)
Equity share capital 10,00,000 12%
Retained earnings 4,00,000 8%
Preference share capital 4,00,000 14%
Debt capital 8,00,000 5%
26,00,000
Calculation of WACC
17. A firm has the following capital structure and after-tax. Find out the WACC.
Sources of finance Amount Expected after-tax cost (%)
Debt 1500000 5%
Preference share 1200000 10%
Equity shares 1800000 12%
Retained earnings 1500000 11%
6000000

18. In considering the most desirable capital structure for a company, the following estimates
of debt and equity capital have been made at various levels of debt equity mix.
Debt as a % of total capital employed Cost of debt (%) Cost of equity (%)
0 5 12
10 5 12
20 5 12.5
30 5.5 13
40 6 14
50 6.6 16
60 7 20

You are required to determine the optimal debt equity mix by calculating composite cost
of capital
19. A company has on its books the following amounts and specific costs of each type of
capital.
Type of capital Book value Market value Specific costs (%)
Debt 400000 380000 5
Preference 100000 110000 8
Equity 600000 1200000 15
Retained earnings 200000 13
1300000 1690000
Determine the WACC using a) book value b) market value
 How are they differing? Can you think of a situation where he WACC would be the same
using either of the weights?

20. Swan ltd has assets of Rs 320000 which has been finances with Rs 104000 of debt Rs
180000 of equity and a general reserve of Rs 36000. The company’s total profit after
interest nad taxes for the year ended 31/03/2021 were Rs 27000. It pays 8% interest on
borrowed funds and is in the 30% tax bracket. Int has 1800 equity shares of Rs 100 per
share presently selling at a market value of Rs 120 per share. what is the WACC of Swan
ltd.

Marginal Cost of capital

Marginal cost of capital may be defined as the cost of raising additional rupee of capital. The
weighted average cost of new or incremental capital is also known as marginal cost of capital.
The marginal cost of capital is derived when are calculate the weighted average cost of capital by
using marginal weight.
This concept is used in capital budgeting decision. It is used as cut-off rate for any investment.
To calculate the marginal cost of capital, the intended financing proportion should be applied as
weight to marginal component cost. When a firm raises funds in proportional manner and the
components cost remains unchanged, there ask be no difference between average cost of capital
of the total funds and the marginal cost of capital.

Problem 21
The following is the capital structure of ABC Ltd. as on 31.12.2021
Sources of Finance Amount
Equity Shares: 5000 shares (of Rs100 each) 5,00,000
10% Preference Shares (of Rs100 each) 2,00,000
12% Debentures 3,00,000
The market price of the company’s share is Rs 110 and it is expected that a dividend of Rs 10 per
share would be declared for the year 2021. The dividend growth rate is 6%:
(i) If the company is in the 40% tax bracket, compute the weighted average cost of capital.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund
of Rs5 lakhs bearing 14% rate of interest, what will be the company’s revised weighted average
cost of capital? This financing decision is expected to increase dividend form Rs10 to Rs 12 per
share. However, the market price of equity share is expected to decline form Rs 110 to Rs105 per
share.

Problem 22
XYZ Ltd. has the following book value capital structure:
Equity Capital (in share of Rs 10 each, fully paid up at par) Rs 30 crore
10% Preference Capital (in shares of Rs 100 each, fully paid up at par) Rs 2 crore
Retained Earnings Rs 40 crore
14% Debentures ( of Rs 100 each) Rs 20 crore
15% Term Loans Rs 25 crore
The next expected dividend on equity shares per share is Rs 3.60; the dividend per share is
expected to grow at the rate of 5%. The market price per share is Rs 30.
Preference stock, redeemable after six years, are selling at Rs 80 per debenture.
The income tax rate for the company is 30%.
(i) Required to calculate the current weighted average cost of capital using:
(a) Book value proportions; and
(b) Market value proportions
(ii) Determine the weighted marginal cost of capital schedule for the company, if it raises Rs 20
crores next year, given the following information:
(a) The amount will be raised by equity and debt in equal proportions;
(b) The company expects to retain Rs 3 crores earning next year;
(c) The additional issue of equity shares will result in the net price per share being fixed
at Rs 25
(d) The debt capital raised by way of term loans will cost 15% for the first Rs 5 crores
and 16% for the next 5 crores.