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Cost of Capital
Important Points
1. This Summary Sheet shall only be used for Quick Revision after you have
read the Complete Notes
4. Questions in the exam are concept based and reading only summary
sheets shall not be sufficient to answer all the questions
➢ Cost of Capital: It is the cost of a company's funds (both debt and equity), or, from an
investor's point of view "the required rate of return on a company's existing securities or
investments". It is the minimum return that investors expect for providing capital to the
company, thus setting a benchmark that a new project has to meet
➢ Importance of Cost of Capital:
✓ For making capital budgeting decisions (selection of investment proposals)
✓ For making Firm’s capital structure decisions (proportion of debt and equity)
✓ For evaluation of Firm’s performance (Profitability occurs when cost of capital is low)
✓ For making important financial decisions (dividend policy, selection between debt
and equity for financing projects, etc.)
➢ Opportunity Cost: It is the rate of return available on the next best alternative which you
have not chosen. That is, it is the rate of return that could have been earned by putting the
same money into a different investment with equal risk
➢ Rate of return demanded by each investor varies depending on the amount of risk born
➢ Risk Premium: It is the return in excess of the risk-free rate of return (return earned on
investments that are immune to default)an investment is expected to yield
➢ Cost of capital for a firm would be weighted average rate of returns required by all the
investors
➢ Different Components which provide capital to the company:
Components of Capital
➢ Cost Of Debt:
Debt Components/Types
➢ Cost of Debt Issued at Par – Before Tax: Debt issued at par means Face value = Issue price
➢ Note: When debt is issued at par then required rate of return is equal to rate at which
debt is issued
Example: A company decided to issue a bond of face value 100 at 100 itself. The coupon rate is
15% and duration is 7 years. Find the required rate of return or cost of capital before tax
Solution: Using the short cut,
Kd = I/Bo
I = 15% of 100 = 15
So Kd = 15/100 = 15%
Formula for Cost of Debt issued for Infinite Period or Irredeemable Debt
➢ Example: Company Y issued debentures worth 200000 at a premium of 10%. The rate of
interest is 9%. Compute the before tax cost of debt assuming infinite period of debt
Solution: Using the formula for Irredeemable Debt,
I = 9% of 200000 = 18000
Po = 200000 + 10% of 200000 = 220000
So Kd = 18/220000 = 8.18%
➢ Example: A company decided to issue a bond of face value 100 at 94 itself. The coupon rate
is 15% and duration is 7 years. Find the required rate of return or cost of capital after tax if
the corporate tax is 35%
Solution: Coupon Interest Payment = 15% of 100 = 15
Maturity Value = 100
➢ Cost of Preference Shares: These can also be of two types: Redeemable and Irredeemable
Preference Shares
➢ Redeemable preference share: It has a maturity date on which date the company will repay
the capital amount to the preference shareholders and discontinue the dividend payment
thereon
➢ Irredeemable preference shares (Perpetual Preference Shares): It does not have any
maturity date but it has fixed dividend and enjoy priority in payment of both dividend and
capital over the equity shares
➢ Cost of Irredeemable Preference Shares:
Formula for Perpetual or Irredeemable Shares
Kp = D1 / V
But sometimes some expenses are involved in the issuing and in such a case
we use the following formula
Kp = D1 / P
➢ Example: Company issues 10% perpetual preference shares. Face value is 100 but the issue
price is 95. What is the cost of the preference share?
Solution: Using the Formula for Perpetual Shares,
D1 = 10% of 100 = 10
V = 95
Kp = 10/95 = 10.53%
➢ Example: A company issues 1,00,000 10% preference share of 10 each. Calculate the cost of
preference capital if it is redeemable after 10 years at 5% premium.
Solution: Using the formula for Redeemable Preference Shares,
Dividend Payment = 10% of 10 = 1
N = 10
Maturity Value = 10 + 5% of 10 = 10.5
Net Proceeds = Market Value – Expenses = 10 – 0 = 10
Kp = (1 + ([10.5-10]/10)) / (10.5+10)/ 2 = 10.24%
➢ Cost of Equity
➢ Example: A Company is expected to give dividend of Rs. 20 for next 3 years. The current
price is 119.2. What is the cost of capital or required rate of return assuming after 3 years
the sell price of share is 100?
Dividend Payment = 20
N=3
Maturity Value = 100
Net Proceeds = Market Value = 119.2
Ke = (20 + ([100-119.2]/3)) / (100+119.2)/ 2 = 12.4%
➢ Cost of Internal Equity – Stable Dividends (Zero Growth) for Infinite Years
Ke = D1 / V
D = 20% of 100 = 20
V = 150
Ke = 20/150 = 13.33%
➢ Example: The Company gave a dividend of 20 this year and is expected to give dividends for
next 3 years with growth of 5% each year. What is the Cost of Capital if the required rate
present value is 129.83 and price after 3 years is 100?
Solution: V =129.83
g = 5% or .05
D0 = 20
D1 = 20 * (1+.05) = 21
D2 = 20 * (1+.05)2 = 22.05
D3 = 20 * (1+.05) 3 = 23.15
K =?
P =100
➢ Cost of Internal Equity – Dividends with Normal Growth G for Infinite Years
Where,
V = Present Value or Market Price
D1 = Dividend in first year
K = Rate of return or Cost of Capital
G = Growth Rate of Dividend
Solution: V =70.66
K =?
G = 6% 0r .06
D0 = 4
D1 = D0 (1+g) = 4 * (1+.06) = 4.24
70.66 = 4.24 / (K - .06)
K = 12%
➢ Cost of External Equity – Stable Dividends (Zero Growth) for Infinite Years
Ke = D1 / P
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Where,
V = Issue Price and not the Market Price
D1 = Dividend in first year
K = Rate of return or Cost of Capital
G = Growth Rate of Dividend
In case there is an issuing cost involved then we have to subtract the same from V
➢ Example: ABC Ltd plans to issue 1, 00,000 new equity share of Rs. 10 each at par. The
floatation costs are expected to be 5% of the share price. The company pays a dividend of
Rs. 1 per share next year and from there onwards the growth rate in dividend is expected to
be 5%. Compute the cost of new issue share if the market price is 12
Solution V = 10
P = 10 – 5% of 10 = 9.5
D1 = 1
K =?
G = 5% or .05
9.5 = 1 / (K - .05)
K = 15.53%
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