UNIT-V

LESSON
20
COST OF CAPITAL
CONTENTS
20.0 Aims and Objectives
20.1 Introduction
20.2 Meaning and Assumptions of Cost of Capital
20.3 Measurement of Cost of Debt
20.4 Cost of Preference Share Capital
20.5 Cost of Retained Earnings
20.6 Weighted Average of Cost of Capital
20.7 Let us Sum up
20.8 Lesson-end Activity
20.9 Keywords
20.10 Questions for Discussion
20.11 Suggested Readings
20.0 AIMS AND OBJECTIVES
The purpose of this lesson is to discuss about the cost of capital which is used as a
phenomenon for the decision criterion in the case of studying the worth of long-term
assets. After studying this lesson you will be able to:
(i) understand meaning and assumptions of cost of capital
(ii) describes measurement of cost of debt
(iii) solve problems on cost of debt
(iv) solve problems on cost of preference share of capital
(v) describe cost of retained earnings.
20.1 INTRODUCTION
It is imperative to study the importance of cost of capital to the tune of financing decision
of the firm. The financing decision of the firm normally facilitates the firm to raise the
financial resources to the requirements of the firm. The raising of the financial resources
should be carried out not only to the tune of financial requirements but also it should
mind about the cost of availing the resource; which means that the cost of raising and
applying the resources in and of the organization. The cost is the most limiting factor of
influence for the success of the firm, the reason is that the cost of capital is the major
determinant of success of the business firm. The firm must be facilitated to raise the
financial resources at cheaper cost in order to earn more and more.
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The cost of capital is used as a phenomenon for the decision criterion in the case of
studying the worth of long-term assets, which have got greater importance in the success
of the firm. The cost of capital is instrumented in the Net present value method and
Internal rate of return method of studying the worth of long-term assets under the capital
budgeting decisions of the enterprise.
20.2 MEANING AND ASSUMPTIONS OF COST OF
CAPITAL
It is the Minimum rate of return which the firm should or must earn only in order to
maintain the value of the shareholders.
Classification of the cost of capital: The cost of capital can be classified into two
categories viz specific cost of capital and weighted cost of capital.
Assumptions
It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothing
but determinant of influence is Fixed Cost of Operations. The cost of capital is
subject to the volume of fixed cost of operations of the firm.
On the basis of Financial Risk i.e., with reference to Financial Commitments of
the firm which in other words as financial Risk. The Interest on debenture,
Preference Dividend on Preference share capital should be paid without fail
irrespective of the firms' earnings according to the terms and conditions of the
issue. The greater the fixed financial commitments require the firm to earn more
and more in order to retain the interest of the shareholders of the firm.
Operational Terms - capital structure remain unchanged; unless the cost of capital
of the firm would change.
For new projects, funds are raised only at same proportion.
How the cost of capital is to be denominated in terms ?
Whether the cost of capital is to be denominated in terms of after tax or before tax. Why
it has to be expressed in terms of after tax ? Why not the before tax cost should be taken
into consideration?
For appraising the projects, the return of the investments are considered for comparison
which are nothing but the resultant of earnings of the firm immediately after the payment
of tax. To study the quality of the projects, both factors must be at common at parlance
for comparison.
While computing the cost of capital, the cost of specific sources should be to the tune of
after tax only in order to have an effective comparison.
L Then, the cost of capital is further bifurcated into two categories viz Explicit
cost of capital and Implicit cost of capital.
L Explicit cost of capital: The discount rate that equates the present value of
the cash inflows that are incremental to the taking of the financing opportunity
with the present value of its incremental cash outflows.
It is further explained that rate of return of cash flow of the financing opportunity. It
normally takes place only at the moment of raising of financial resources.
Implicit cost of capital: It is nothing but the Opportunity cost of capital of the
firm to earn through investing elsewhere by the shareholders themselves or by the
company itself. It is rate of return which is associated with the best investment
opportunity for the firm and its shareholders that would have to be forgone, which
were presently considered by the firm.
Specific cost of specific source of capital: Each source of capital has its own
cost at the moment of raising which form part of the computation of total cost of
capital of the firm.
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Cost of Capital
20.3 MEASUREMENT OF COST OF DEBT
The cost of the perpetual debt is nothing but the cost of raising the debt financial resource,
in which the time period of repayment of the principal is not known.
This particular specific source has two different classifications viz cost of interest and
cost of debt.
Interest
Cost of interest (Ki) =
Sale value
Tax adjusted Interest
Cost of Debt (Kd) =
Sale value
Problem on Cost of Debt
A company has 10 percent perpetual debt of Rs.1,00,000. The tax rate is 35 per
cent. Determine the cost of capital (before tax as well as after tax) assuming the
debt is issued at i) at par ii) at 10% discount iii) at 10% premium.
Check Your Progress
1. A company is considering raising Rs 100 lakh by one of the two alternative
methods. viz 14 percent institutional term loan and 13 percent non - convertible
debentures. The term loan option would attract no major incidental cost. The
debentures would have to be issued at a discount of 2.5 per cent and would
involve Rs. 1 lakh as cost of issue.
Advise the company as to the better option based upon the effective cost of
capital in each case. Assume tax rate of 35 per cent.
The next method of computing the cost of debt is only for the debt finance which knows
the repayment period of the principal and the payment of the interest periodicals.
This process of computation could be divided into two categories
First one is the periodical repayment of the principal along with the periodical payment
of interest periodicals.
t
) kd 1 (
COPn COIt
CIo
+
+
=
The second one is the lump sum repayment of the principally only at the end of the term
of the debenture.
At par
Cost of Interest
Ki= Rs.10,000/Rs.1,00,000=10%
Cost of Debt
Kd= Rs.10,000(1-.35)/Rs.1,00,000= 6.5%
At Discount
Cost of Interest
Ki=Rs.10,000/ Rs.90,000= 11.11%
Cost of Debt
Kd= Rs.6,500/90,000= 7.22%
At Premium
Cost of Interest
Ki= Rs.10,000/Rs.1,10,000=9.09%
Cost of Debt
Kd=Rs 6,500/Rs.1,10,000=5.90%
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t n
COIt COPn
CIo = +
(1+kd) (1+Kd)
Problem on cost of debt
A company issues a new 10 percent debentures of Rs.1,000 face value to be
redeemed after 10 years. The debenture is expected to be sold at 5 percent discount.
It will also involve flotation cost of 5 per cent of face value. The companys tax
rate is 35 per cent what would be the cost of debt be ? Illustrate the computations
i) trial and error approach and ii) shortcut method.
Trial Error approach:
The first step is to determine the cash flows involved in the process of the debentures issue
10
t
T 1
n
Rs 65 Rs. 1,000
Rs. 900 = +
(1+Kd) (1+kd) =
The present value of the future cashflows should be found out one after the another.
The determination of present value at 7% and 8%
The value of Cost of debt is 8%
The short cut method is as follows

I(1 t) + (f +d + pred - pi)/N

Kd =
(RV+SV)/2
I=Annual interest payment
T=tax rate
F=Flotation cost
d=Discount on debentures
pred=premium on redemption
pi=premium on issue of debentures
RV=Realisable value
SV=Sale value
Kd= 7.9%
Years Particulars
0 Rs.900 at the moment of raising i.e., cash in flow
during the issue of debentureRs.1,000Rs.50
Rs.50
1-10 Regular flow interest payment
The interest outflow which is subject to the
adjustment of taxation Rs100(1 0.35)=Rs.65
10 Final repayment of the principal
The last payment is nothing but the repayment of
the principal Rs.1,000
Present value Total Present value Years Cash
@ 7% @ 8% @7% @ 8%
1-10 Rs.65(Annuity Table) 7.024 6.710 Rs.456.56 Rs.436.15
10 1,000(Single flow table) 0.508 .463 Rs.508.00 Rs.463.00
964.56 899.15
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Cost of Capital
Check Your Progress
A company issues 11 percent debentures of Rs.100 for an amount aggregating
Rs.1,00,000 at 10 percent premium, redeemable at par after five years. The
companys tax rate is 35 per cent. Determine the cost of debt using the
shortcut method.
20.4 COST OF PREFERENCE SHARE CAPITAL
The next specific source of cost is cost of preference share capital
Cost of preference share capital - From the angle of interest on the amount of
debentures it is also like a fixed in charge but not contractual obligation, but the
interest payment is contractual in obligation in accordance with the terms and
conditions of the issue agreement reached earlier with the company, irrespective
of the profits earned.
Preference dividend is to be paid only with reference to availability of profits.
Normally the Expectations of the preference shareholders are nothing but the
preference dividends. The preference shares are classified into two categories viz
Redeemable and Irredeemable
Let us discuss at first about the Irredeemable preference shares during the issue
The first one is the methodology for the computation of the cost of irredeemable
preference share

Dividend preference share

Kp =
P0 (1f)
The second methodology incorporates the dividend taxation which is normally
borne by the company during the moment of declaration.
Kp=Dividend prefernce(1+Dt)
Kp =
P0 (1f)
ABC company issues 11 percent irredeemable preference shares of the face value of
Rs. 100 each. Flotation costs are estimated at 5 per cent of the expected sale price a) par
value b) 10% premium c) 5% discount and also compute the Dividend tax at 13.125%
The next methodology under the preference share capital is the cost computation for
redeemable preference share capital. Under this the period of payment of capital is
known along with the payment periodical preference dividends.
At par
Cost of Preference share capital
Kp= Rs11./Rs 95.=11.57%
Cost of preference share with dividend tax
Kp = Rs.11(1+.13125) = 13.09%
Rs.95
At Discount
Cost of Preference share capital
Kp=Rs.11/ Rs.110(.95).= 10.5%
Cost of preference share with dividend tax
Kp = Rs.11(1+.13125) = 13.81%
Rs 110(.95)
At Premium
Cost of Preference share capital
Ki= Rs.11/Rs.95(.95)=12.2%
Cost of preference share capital with dividend tax
Kd = Rs.11(1+.13125) = 13.78%
Rs 95(.95)
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t n
Dp Pn
Po (1-f) = +
(1+kp) (1+kp)
Problem on the preference share capital
Xion Ltd has issued 11% preference shares of the face value of Rs.100 each to be
redeemed after 10 years. Floatation cost is expected to be 5% Determine the cost
of preference shares Kp
10
t
T 1
10
Rs 11 Rs. 1,000
Rs. 95 = +
(1+Kd) (1+kp) =
The value of the Kp is lying in between the two rates of discounts viz 11% and 12%
Determination of present value in between 11% and 12%
Cost of preference share capital is Kp= 11.9%
The next important cost to be determined is that cost of equity share capital:
Equity dividends is not at par with Interest and Preference dividends, these two
are subject to fixed in principle. The payment of dividends are subject to the availability
of earnings and the future prospects of the firm in the future to grow.
Equity shareholders are the last claimants of the company not only in sharing the
profits of the company at the end of every year immediately after anything paid to
the preference shareholders. It never carries any fixed rate of dividends subject
to the availability of profits to disburse.
Market value of shares are determined by the Equity dividends which are nothing
but the return expect to get.
Ke= a minimum rate of return which the firm should earn from the equity portion
of financing of the project in order to maintain the value of the share prices.
There are many more models in the computation of cost of equity
i) Dividend valuation model
ii) Capital Asset Pricing Model
Dividend valuation model: The Cost of equity capital Ke is in terms of required
rate of return to the tune of future dividends to be paid to the investors.
L It is discount rate which equates the present value of future dividends per
share with sale proceeds of a share (after adjusting the expenses of flotation
of a share)
L
Dividend of the first year1
Po =
Ke g
Dividend of the first year1 + G
Ke =
Po
Year Cash outflow Present value @ Total Present value @ Rs
1 to 10 years Rs11 5.889 5.65 64.78 62.15
10
th
yr completion Rs.100 .362 .322 35.15 32.20
99.93 94.35
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Cost of Capital
Problem:
Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25
What would be market price of a share after 1 year and 2 year
Ke= Re.1/25+ 6%= 4%+ 6%= 10%
The market price at the end of 1 year
Rs.1.06
P1 = = Rs.26.5
10%-6%
The market price at the end of 2nd year
Rs.1.12
P2 = = Rs.28
10%-6%
Capital Asset Pricing Model approach: The cost of equity share capital is
computed by registering the Beta with reference to the non diversifiable risk in
addition to the diversifiable risk of the equity share with reference to market
responsiveness.
The basic assumptions of the CAPM approach
(i) The efficiency of the security markets
(ii) Investor preferences
The efficiency of the security markets is embedded with the following assumptions:
(a) All investors are common expectations about the expected returns, variances and
correlation of the expected returns among the various securities in the market
(b) All investors have equivalent amount of information
(c) All investors are rational
(d) No transaction costs
(e) No single investor influence the market
The investors' preference with reference to two different types of returns
(i) Highest level return at minimum level risk or
(ii) Lowest level of risk for given level of return
The above alternatives are subject to two different type of risk viz Systematic and
Unsystematic risk.
Systematic risk which cannot be reduced i.e., undiversifiable risk for which allowances
are given to the investors.
Unsystematic risk which can be reduced to the level of minimum for which no other
allowances are given to the investors.
The allowances are given to the investors only subject to the market responsiveness
Beta coefficient
Ke= Rf+ b(KmRf)
Problem
The hypothetical ltd wishes to calculate the cost of equity capital using the CAPM
approach. From the information that the risk free rate of return equals 10% ; the
firms beta equals 1.50 and the return on the market portfolio equals 12.5% Compute
the cost of equity capital
Ke= 10% + 1.5(12.5%-10%)=13.75%
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20.5 COST OF RETAINED EARNINGS
The next important cost of specific source of capital is cost of retained earnings.
The cost of retained earnings is to be computed on the basis of opportunity cost. It does
not have any direct cost, instead, the amount of retained earnings loses the opportunity
of the investors to earn in the form of dividends due to retained earnings; which are
foregone by them one side and on the other side the earnings which are retained are
invested in some other investments, would be in a position to yield the return, is the cost
of retained earnings.
It could be defined as "cost of retained earnings is the opportunity cost in terms of
dividends foregone by with held from the equity shareholders." The cost of retained
earnings is nothing but the external criterion which is equal to the Ke. Practically speaking,
Ke is more than the Kr due to the floatation cost involved in the process of issue of
shares.
20.6 WEIGHTED AVERAGE OF COST OF CAPITAL
The term cost of capital is nothing but the overall cost of capital which is to be computed
to the tune of the proportion of the funds in the mixture; should computed only to the tune
of assignment of weights. The weight average cost of capital has its own steps to follow
during the process of computation.
Assigning the weights
Multiplying the weights with the specific cost of the fund
Dividing the total cost immediately after adding them together by the summation of
weights
It is denominated by Ko
The weights are normally classified into two major classification viz
Marginal weights
Historical weights
Marginal weights: Assignment of weights to the specific cost by the proportion of the
each fund to be raised to the total fund
Historical weights: The weights are assigned to the specific source of fund to the tune
of the proportion of the fund in the existing capital structure. This type of historical
weight is further classified into two different categories viz:
Book value weights and Market value weights.
Book value weights are assigned to the tune of book values to measure the proportion
of each type of capital.
Market value weights are assigned to the tune of market value to measure the proportion
of each type of capital.
Problem
A company has on its books the following amounts and specific cost of each type of capital.
Type of capital Book value Market value Specific cost Rs
Debt Rs.4,00,000 3,80,000 5
Preference 1,00,000 1,10,000 8
Equity 6,00,000 15
Retained earnings 2,00,000 12,00,000 13
13,00,000 16,90,000
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Cost of Capital
Determine the weighted average cost of capital using (a) Book value weights and (b)
Market value weights.
The determination of the weighted average cost of capital using book value weights
Rs.1,44,000
Ko = 100 = 11.1%
Rs.13,00,000
The determination of Market value weights
Rs.2,01,000
Ko = 100=11.9%
Rs.13,00,000
20.7 LET US SUM UP
The cost is the most limiting factor of influence for the success of the firm, the reason is
that the cost of capital is the major determinant of success of the business firm. The cost
of capital is used as a phenomenon for the decision criterion in the case of studying the
worth of long-term assets. Cost of capital is the minimum rate of return which the firm
should or must earn only in order to maintain the value of the shareholders. The cost of
the perpetual debt is nothing but the cost of raising the debt financial resource, in which
the time period of repayment of the principal is not known. This particular specific source
has two different classifications viz cost of interest and cost of debt.
The term cost of capital is nothing but the overall cost of capital which is to be computed
to the tune of the proportion of the funds in the mixture; should computed only to the tune
of assignment of weights. The weight average cost of capital has its own steps to follow
during the process of computation.
20.8 LESSON-END ACTIVITY
A company has issued 15% preference shares of the face value of Rs.100 each to be
redeemed after 20 years. Flotation cost is expected to be 5% of the expected sales
price. Determine the cost of preference shares.
20.9 KEYWORDS
Cost of capital: It is the minimum rate of return to be earned at which the capital is
raised
Implicit cost of capital: It is the minimum rate of return to be earned by the firm, at the
moment of retaining the earnings, towards the investment decision
Type of capital Book value Specific cost Rs Total costs BV* K
Debt Rs.4,00,000 5 19,000
Preference 1,00,000 8 8,000
Equity 6,00,000 15 1,35,000
Retained earnings 2,00,000 13 39,000
13,00,000 2,01,000

Type of capital Market value Specific cost Rs Total costs BV* K
Debt 3,80,000 5 Rs.20,000
Preference 1,10,000 8 8,000
Equity 9,00,000 15 90,000
Retained earnings 3,00,000 13 26,000
16,90,000 1,44,000

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Explicit cost of capital: It is the cost incurred by the firm at the moment of raising
Specific cost of capita: It is the cost incurred at every moment for raising the specific
resource of capital
Book value weights: Weights assigned to the tune of the book value of the capital
Weighted average cost of capital: The aggregate of the weighted specific resources
cost of capital is weighted average cost of capital
20.10 QUESTIONS FOR DISCUSSION
1. Define cost of capital.
2. Explain the various types of cost of capital.
3. Explain the methodology involved in the process of computing the weighted average
cost of capital.
4. Explain the meaning of assigning the weights on the specific sources of capital.
20.11 SUGGESTED READINGS
R.L. Gupta and Radhaswamy, Advanced Accountancy.
V.K. Goyal, Financial Accounting, Excel Books, New Delhi.
Khan and Jain, Management Accounting.
S.N. Maheswari, Management Accounting.
M.P. Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi.
S. Bhat Financial Management, Excel Books, New Delhi.
Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw
Hill, New Delhi (1994).
I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.