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FUNDAMENTALS OF FINANCIAL MANAGEMENT.

B.B.A 2nd SEM

GRADED ASSIGNMENT I

Q.1) Explain in detail the methods of calculating the cost of capital with the help of suitable
example for the following sources:

Before dealing these all terms we must understand the meaning of cost of capital and its
importance.
The primary meaning of cost of capital is simply the cost an entity must pay to raise funds. The
term can refer, for instance, to the financing cost (interest rate) a company pays when securing a
loan.
Cost of capital
It is the cost an organization pays to raise funds, e.g., through bank loans or issuing bonds. Cost
of capital is expressed as an annual percentage.
Cost of capital = interest rate at zero level risk + premium for business risk + premium for
financial risk

If a company has not power to earn , cost of capital , then this company cannot get fund from
public .

Importance of cost of capital

1. Basis of capital budgeting decisions: -


A company wants to invest his money in different project. Then it will compare their cost of
capital and company will never invest his money in that project whose cost of capital is less than
other project.

2. Basis of redesigning of capital structure: -


Cost of capital affects capital structure designing. Capital structure is just mixed of debt and
equity sources which company wants to get from investors. At that time company selects that
mixture of debt and equity in which cost of capital will be become minimum. With this company
can increase the value of shares.

3. Basis of other decisions:-


There are large number decision & like dividend policy, interest policy which is depend on
correct calculation of cost capital.
The different terms with examples are explained below.
Cost of equity capital

Cost of equity is calculated with dividend yield method, or dividend yield plus growth
rate method or earning yield method or realized yield method .

1) Dividend yield method :-

KE=DPS/MP100
for example:
if the dividend per share is 10 and company issue 100 shares at Rs. 100 plus premium
10% then cost of equity

KE= 10 / 110 X 100


KE = 9.9%

2) Dividend yield plus growth rate of dividend method: -

KE=(DPS/MP100) + G
for example:
The present market price of a company equity share is Rs.60 and dividend paid for
previous year per share is Rs.4.50. G=8%.Then find cost capital

KE=4.50(1+.08)/60100) + 8
KE=8.1+8 =16.1%

3) Earning yield method

KE=EPS/MP100
for example:
EPS=1.20
MP=RS.16
Soln:
KE=1.20/16100
KE=7.5%
4) Cost of newly issued Equity shares
To ascertain the cost of capital, dividend per share or earning per share is dividend by the amount
of net proceeds.

KE=DPS/NP100 OR KE=EPS/NP100
FOR EXAMPLE:
A company issues 50,000 equity shares of rs.10 each at a premium of 20% and the company
pays 5% as flotation cost on issued price.dividend is Rs.2.5 per share,find cost of equity.
KE=DPS/NP100
KE=2.5/11.40100
KE=20%.
.
Cost of debt capital
When companies borrow funds from outside or take debt from financial institutions or other
resources the interest paid on that amount is called cost of debt. The cost of debt is computed
by taking the rate on a risk-free bond whose duration matches the term structure of the
corporate debt, then adding a default premium. This default premium will rise as the amount
of debt increases (since, all other things being equal, the risk rises as the cost of debt rises).
Since in most cases debt expense is a deductible expense, the cost of debt is computed as an
after tax cost to make it comparable with the cost of equity (earnings are taxed as well).
Company wants to get debt from public, then calculating the cost of debt is the rate which
calculated by dividing value of interest on loan with amount of principal.

KD=R+(MV-NP/N)/(MV+NP/2)100.

a) Cost of debt before tax adjustment


KD=R+(MV-NP/N)/(MV+NP/2)100.
Acompany issue 12% debentures of Rs.5,00,000 redeemable after 10 years at a
premium of 5% and incurs Rs.10,000 as issue expenses,the cost of debt capital
will be-

KD=R+(MV-NP/N)/(MV+NP/2)100.
=60,000+[5,00,000-5,15,000/10]/ [5,00,000+5,15,000/2]100
=11.53%
Solving the above equation, we will get 11.53%. This is before tax cost of debt capital and
therefore it is not the real cost of capital for us.

b) Cost of debt after tax adjustment

KD=KD(AFTER TAX)(1-T)
KD=11.53.70

KD=8.07%

After tax cost of debt capital. If the tax rate is say 30%, the cost of debt capital is 8.07%

Cost of pref. share capital

Cost of pref. share capital is rate which should company earn for paying dividend to pref.
shareholders because , it effects also the value of shares . With following formula we can
calculate cost of pref. share capital.

KP=DPS/NP100

Example:

Let us calculate the cost of 11% preference capital of 11,000 preference shares whose face value
is $110. The market price of the share is currently $120.
Annual dividend = 11% of $110 = $11 per share
Kp = $11/$120 = 9.6%.

Cost of Retained Earning


Retained earnings refers to the portion of net income (or loss) that is retained by a
company rather than distributed to its owners as dividends. Retained earnings and losses
are cumulative from year to year, with losses offsetting earnings. Retained earnings can
be expressed as a ratio known as the "retention rate. "

The cost of retained earnings or internal funds within a capital structure is similar to the cost
of common stock, since it is a component of equity. We can think of the cost of retained
earnings in relation to the opportunity cost of how we can use these funds elsewhere.
Generally, the cost of retained earnings is slightly less than the cost of common stock.

Calculation of cost of retained earning :

THERE ARE 2 METHODS FOR THE CALCULATION OF RETAINED EARNING.

1. OPPORTUNITY CASE
KR=D(1-TP)(1-B)/MP 100
Example:
Q.)find out the cost of retained earning from the following data.
DPS=RS.15
TP=30%
MP=RS.110
B=1%
Soln:
KR=15(1-.3)(1-.01)/110 100
KR=9.45%

2. RIGHT OFFER APPROACH


KR=D(1-TP)(1-B)/MP(1-TC) 100
Example:
Q.)find out the cost of retained earning from the following data.
TC=20%
DPS=RS.9
TP=30%
MP=RS.100
Soln:
KR=15(1-.30)/100(1-.20) 100
KR=7.85%.
If growth rate is given then,
KR=(D/MP 100 + G) (1-TP)(1-B)
Q.)find out the cost of retained earning from the following data.
DPS=RS.14
TP=22%
MP=RS.140
B=3%
G=5%
Soln:
KR=(14/140 100 + 5%) (1-.22)(1-.03)
KR=(15)(0.78)(0.97)
KR=11.35%