Financial Management

Study Material-1

1 Unit-3
1.2 COST OF CAPITAL II
COST OF CAPITAL II
2

COST OF CAPITAL II

Smriti Chawla
Shri Ram College of Commerce
University of Delhi

CHAPTER OBJECTIVES

Computation of weighted average cost
of capital
Marginal cost of capital
Cost of Equity using Capital Asset
Pricing Model
Illustrations
Lets Sum Up
Questions

Computation of Weighted Average Cost of Capital

Weighted average cost of capital is the average cost of the costs of various source of financing.
Weighted average cost of capital is also known as composite cost of capital, overall cost of capital
or average cost of capital. Once the specific cost of individual sources of finance is determined, we
can compute the weighted average cost of capital by putting weights to the specific costs of capital
in proportion of various sources of funds to total. The weights may be given either by using
thebook valueof source ormarket value of source. If there is a difference between market
value and book value weights, the weights, the weighted average cost of capital would also differ.
The market value weighted average cost would be overstated if market value of the share is higher
than book value and vice versa. The market value weights are sometimes preferred to the book
value weights because the market value represents the true value of investors. However, the market
value weights suffer from the following limitations:

(i) It is very difficult to determine the market values because of frequent fluctuations.
(ii) With the use of market value weights, equity capital gets greater importance.

For the above limitations, it is better to use book value which is readily available. Weighted
average cost of capital can be computed as follows:
Kw=
Kw= Weighted average cost of capital
X = Cost of specific source of finance
W = Weight, proportion of specific source of finance
Illustration1: A firm has the following capital structure and after-tax costs for the different
sources of funds used:

Source of Funds Amount Proportion After-tax cost

Rs. % %
Debt 15,00,000 25 5
Preference Shares 12,00,000 20 10
Equity Shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
Total 60,00,000 100

You are required to compute the weighted average cost of capital.

Solution:

Computation of Weighted Average Cost of Capital

Source of Funds Proportion % Cost % Weighted Cost %

Proportion Cost
(W) (X)
(XW) %

Debt 25 5 1.25
Preference shares 20 10 2.00
Equity Shares 30 12 3.60
Retained Earnings 25 11 2.75
 Weighted Average Cost of 9.60%
Capital

Illustration2: Continuing illustration 1, the firm has 18,000 equity shares of Rs. 100 each
outstanding and the current market price is Rs. 300 per calculate the market, value weighted
average cost of capital assuming that the market values and book values of the debt and preference
capital are same.

Solution:
Amount Proportion Cost Weighted
(Rs.) %W %X Cost
Sources of Funds
Proportion
Cost XW
Debt 15,00,000 18.52 5 0.93
Preference Capital 12,00,000 14.81 10 1.48
Equity Share Capital
(18000 shares @ Rs. 300) 54,00,000 66.67 12 8.00
81,00,000 100
Weighted Average Cost of Capital 10.41%

Marginal Cost of Capital

The marginal cost of capital is the weighted average cost of new capital calculated by using
the marginal weights. The marginal weights represent the proportion of various sources of funds to
be employed in raising additional funds. In case, a firm employs the existing proportion of capital
structure and the component costs remain the same the marginal cost of capital shall be equal to
the weighted average cost of capital. But in practice, the proportion and /or the component costs
may change for additional funds to be raised. Under this situation the marginal cost of capital shall
not be equal to weighted average cost of capital. However, the marginal cost of capital concept
ignores the long-term implications of the new financing plans, and thus, weighted average cost of
capital should be preferred for maximisation of shareholders wealth in the long-run.

Illustration3: A firm has the following capital structure and after-tax costs for the different
sources of funds used:
Source of Funds Amount(Rs.) Proportion (%) After-tax
Cost(%)
 Debt 4,50,000 30 7
Preference Capital 3,75,000 25 10
Equity Capital 6,75,000 45 15
15,00,000 100

(a) Calculate the weighted average cost of capital using book-value weights.
(b) The firm wishes to raise further Rs. 6,00,000 for the expansion of the project as below.
Debt Rs. 3,00,000
Preference Capital Rs. 1,50,000
Equity Capital Rs. 1,50,000
Assuming that specific costs do not change, compute the weighted marginal cost of capital.

Solution:
Computation of Weighted Average Cost of Capital (WACC)

Source of Proportion (%) After tax cost Weighted Cost

Funds (W) (%) (X) % (XW) %

Debt 30 7 2.10
Preference Capital 25 10 2.50
Equity Capital 45 15 6.75
Weighted Average Cost of Capital (WACC) 11.35%

Computation of Weighted Marginal Cost of Capital (WMCC)

Source of Marginal After tax cost Weighted

Funds Weights (%) (X) Marginal Cost %
Proportion (%)
(W)

Debt 50 7 3.50
Preference Capital 25 10 2.50
Equity Capital 25 15 3.75

Weighted Marginal Cost of Capital (WMCC) 9.75%

Cost of Equity Using Capital Asset Pricing Model (CAPM)

The value of an equity share is a function of cash inflows expected by the investors and risk
associated with cash inflows. It is calculated by discounting the future stream of dividends at
required rate of return called capitalization rate. The required rate of return depends upon the
element of risk associated with investment in share. It will be equal to the risk free arte of interest
plus the premium for risk. Thus required rate of return Ke for the share is,
Ke = Risk free rate of interest + Premium for risk
According to CAPM, the premium for risk is the difference between market return from diversified
portfolio and risk free rate of return. It is indicated of beta coefficient (b):
Risk premium= (Market return of a diversified portfolio Risk free return) x b I =b I (Rm - Rf )
Thus, cost of equity, according to CAPM can be calculated as below:
Ke = Rf + b I (Rm - Rf )
where, Ke = Cost of equity capital
Rf = Risk free rate of return
Rm = Market return of a diversified portfolio
b I = Beta coefficient of the firms portfolio

Illustration3: You are given the following facts about a firm:

1.Risk free rate of return is 11%.
2.Beta co-efficient bI of the firm is 1.25.
Compute the cost of equity capital using Capital Asset Pricing Model (CAPM) assuming a market
return of 15 percent next year. What would be the cost of equity if bI rises to 1.75.
Solution:

Ke = Rf + b I (Rm - Rf )
when bI = 1.25
Ke =11% +1.25(15%-11%)
=11%+5% =16%
when bI =1.75 Ke= 11%+1.75(15%-11%)
=11%+7%
=18%

Illustration 4: The following is an extract from the financial statement of KPN Ltd.


Rs.lakhs
(Operating Profit 105
Less :Interest on debentures33
72

Less: Income tax
(50%)36
Net Profit
36
Equity Share capital (shares of Rs.10 each) 200
Reserves and Surplus 100
15%Non-
convertible debentures (of Rs.100 each)220
520

The market price per equity share Rs.12 and per debenture Rs.93.75.
1.What is the earning per share?
2. What is the percentage cost of capital to the company for the debenture funds and the equity?
Solution:


1.Calculation of Earnings per Share:
Earnings Per Share (EPS) = Profit After Tax/ No. Of Equity Shares
= 36,00,000/20,00,000=Rs.1.80

2.Computation of Percentage Cost of Capital.

a) Cost of Equity Capital:

Cost of Equity (Ke) = D/MP
or Ke(%)= 1.80/12 *100= 15%
where D = expected earnings per share
and MP= Market price per share.

b)Cost of Debenture Funds:

At Book Value At Market Value
(Rs. Lakhs) (R
Lakhs)
Value of 15% debenture 220.00 206.25
Interest cost for the year 33.00 33.00
Less: Tax at 50% 16.50 16.50
Interest cost after tax 16.50 16.50

Cost of Debenture Fund
(%) 16.50/220 x100 16.50/206.25x100
= 7.5% = 8%.

Illustration5:Given below is the summary of the balance sheet of a company as

at 31st December, 1999:

Liabilities Rs. Assets

Rs.

 Equity share capital
20,000 shares of Rs.100 each 2,00,000 Fixed Assets 4,00,000
Reserves and surplus 1,30,000 Investments 50,000
8% debentures 1,70,000 Current assets 2,00,000
Current Liabilities
Short term loans 1,00,000

Trade creditors 50,000

6,50,000 6,50,000

You are required to calculate the companys weighed average cost of capital using balance sheet
valuations: The following additional information is also available:

(1) 8%Debentures were issued at par.

(2) All interests payments are up to date and equity dividends is currently 12%.

(3) Short term loan carries interest at 18% p.a

(4) The shares and debentures of the company are all quoted on the Stock Exchange and
current Market prices are as follows:
Equity Shares Rs.14 each
8% Debentures Rs.98 each.

(5) The rate of tax for the company may be taken at 50%.

Solution:
Calculation of the Cost of Equity: Rs.

Equity Share 2,00,000

Reserves and Surplus1,30,000

Equity (Shareholders )Fund 3,30,000

Book Value Per Share = 3,30,000/20,000 =Rs.16.50.
Equity Dividend Per Share = 12/100*10 =Rs.1.20
Therefore, Cost Of Equity (%)= 1.20/16.50*100= 7.273 %

Computation of Weighted Average Cost of Capital:

 Capital Structure or
Type of Capital Amount (Rs) Before Tax After Tax Weighted Average cost
Cost% (Rs.) Cost%


Equity Funds 3,30,000 7.273% 7.273% 24,000
Debentures 1,70,000 8% 4% 6,800

Total 5,00,000
30,800

Weighted Average Cost of Capital = 30,800/5,00,000*100 =6.16 %.

Summary of Formulae
S.No Purpose Formula

Kdb=
1 Before tax cost of debt Kda= Kdb(1-t) =

2 After cost of debt

Kda= Kdb(1-t)
3 Before tax cost of redeemable debt

Vd=
4 After tax cost of redeemable debt

Kp=
5 Cost of debt redeemable at premium



6 Cost of debt redeemable in instalments
Ke=

Ke=
 7 Cost of irredeemable preference share
capital
Kr =

Kw=



8 Ke = Rf + b I (Rm - Rf )
Cost of redeemable preference share capital



Cost of equity dividend yield approach
9

Cost of equity dividend yield plus constant

10
growth



Cost of retained earnings
11


Weighted average cost of capital
12




Cost of equity CAPM approach
13

Lets Sum Up
The cost of capital is the minimum required rate of return which firm must earn on its funds in
order to satisfy the expectation of its supplier of funds. If the return from capital budgeting
proposals is more than cost of capital then difference will be added to wealth of shareholders.
The concept of cot of capital has a role to play in capital budgeting as well as in finalizing the
capital structure for the firm. The cost of capital depends upon the risk free interest rate and
risk premium, which depends upon the risk of investment and risk of firm.
The cost of capital may be defined in terms of (1) explicit cost, which the firm pays to supplier,
and (2) implicit cost. i.e. opportunity cost of funds to firm. The cost of capital is calculated in
after tax terms.
Different sources of funds available to firm may be grouped into Debt, Pref. share capital,
Equity share capital and retained earning and these sources have their specific cost of capital.
However the overall cost of capital of the firm may be ascertained as the weighted average of
these specific costs of capital.
The cost of retained earnings is lower than cost of equity as former does not have any floatation
cost.
The Weighted average cost of capital WACC may be ascertained by applying book value weights
or market value weights of different sources of funds. The WACC is denoted as Kw.
 QUESTIONS
1. What is the relevance and significance of cost of capital in capital budgeting? How does the
cost of capital enter the capital budgeting process?
2. Define the concept of cost of capital? State how you would determine the weighted average
cost of capital of a firm?
3. How cost of equity capital is determined under CAPM?
4. Write short notes on (a) Marginal cost of capital (b) Cost of retained earnings
5. The cost of preference capital is generally lower than cost of equity. State the reasons?
6. What are the problems in determining the cost of capital?
7. How is the cost of zero coupon bonds determined?