COST OF CAPITAL

COST OF DEBT
I. Cost of Irredeemable Debt :

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥

Cost of debt before tax (kdb) = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 (𝑁𝑃)

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

Cost of debt after tax (kda) = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 (𝑁𝑃)

(OR)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Cost of debt (kd) = (1 − 𝑇)
𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 (𝑁𝑃)

Net Proceeds is ascertained as follows:

Debt issued at par -> NP = Face value - Issue expenses

Debt issued at premium -> NP = Face value + Securities Premium - Issue expenses

Debt issued at discount -> NP = Face value - Discount - Issue expenses

II. Cost of Redeemable Debt :

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥

Cost of debt before tax (kdb) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

Computation of Annual Cost Before Tax

Interest on debt xxx

Add : issue expenses xxx
Add : discount on issue xxx
Add : premium on redemption xxx
Less : Premium on issue of debt xxx
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ANNUAL COST BEFORE TAX xxx
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Computation of Average value of Debt

𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 (𝑁𝑃)+ 𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 (𝑅𝑉)

Average Value of Debt = 2

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡−𝑇𝑎𝑥 𝑠𝑎𝑣𝑖𝑛𝑔𝑠

Cost of debt after tax (kda) = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

(OR)

𝐼+(𝑃 − 𝑁𝑃)/ 𝑛
Cost of debt before tax (kdb) = (𝑃 + 𝑁𝑃)/2

Cost of debt after tax (kda) = kdb x (1 - Tax)

COST OF PREFERENCE CAPITAL
𝐷𝑝
Cost of Preference Capital (Kp) = 𝑁𝑃
Kp - Cost of preference share capital
Dp - Preference dividend
NP - Net Proceeds

𝐷𝑝 +(𝑃 − 𝑁𝑃)/ 𝑛
Cost of Redeemable Preference Shares (Kp) = (𝑃 + 𝑁𝑃)/2

COST OF EQUITY CAPITAL

 To find out the cost of capital using Dividend Price Approach:-

Incase of new issue of shares

𝐷
Ke =
𝑁𝑃
D - Dividend per share
NP - Net Proceeds

Incase of existing shares

𝐷
Ke =
𝑀𝑃
D - Dividend per share
MP - Market price per share

 To find out the cost of capital using Dividend Price plus Growth Approach:-

Incase of new issue of shares

𝐷
Ke = 𝑁𝑃
+ 𝑔
D - Dividend per share G - Growth rate
NP - Net Proceeds

Incase of existing shares

𝐷
Ke = + 𝑔
𝑀𝑃
D - Dividend per share G - Growth rate
MP - Market price per share

 To find out the cost of capital using Earnings Price Approach :-

Incase of new issue of shares

𝐸𝑃𝑆
Cost of equity Ke = 𝑁𝑃
EPS - Earnings per share
NP - Net Proceeds

Incase of existing shares

𝐸𝑃𝑆
Cost of equity Ke = 𝑀𝑃
EPS - Earnings per share
MP - Market price per share
COST OF RETAINED EARNINGS

𝐷(1−𝑇)
Kr = 𝑀𝑃
𝑥100

(OR)

Cost of Equity (Ke) XXX

Less : Tax on cost of equity XXX

------

XXX

Less: Brokerage XXX

------

Cost of Retained Earnings XXX

(OR)

Kr = Ke (1 - T) (1 - B)

Ke - Cost of equity capital

T - Tax rate
B - Brokerage

WEIGHTED AVERAGE COST OF CAPITAL

FORMAT (BOOK VALUE WEIGHTS & MARKET VALUE WEIGHTS)

Statement showing Weighted Average Cost of Capital

Sources of Amount Proportion to After tax cost Weighted cost
Funds Total (%) (%)
Debentures XXX w1 kda kda x w1

Preference share XXX w2 Kp Kp x w2

capital
Retained XXX w3 Kr Kr x w3
Earnings
Equity share XXX w4 Ke Ke x w4
capital
Total XXX WACC XXX%
 CAPITAL BUDGETING

PAY BACK PERIOD

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶0
Pay Back Period = 𝐶𝐹𝐴𝑇
= 𝐶

INTERNAL RATE OF RETURN

𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑁𝑃𝑉
IRR = 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 + 𝑥 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑟𝑎𝑡𝑒
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒𝑑 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒𝑠

Acceptance Rule:-
 r>k - Accept the project
 r<k - Reject the project
 r=k - May accept the project

PROFITABILITY INDEX

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

PI = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠

Acceptance Rule:-
 PI > 1 - Accept the project
 PI < 1 - Reject the project
 PI = 1 - May accept the project

NET PRESENT VALUE (NPV)

NPV = Present value of cash inflows - Present value of cash outflows

 C C2 C3 Cn 
NPV   1      C0
 (1  k ) (1  k ) (1  k ) 3 (1  k ) n 
2

n
Ct
NPV    C0
t 1 (1  k )
t

Acceptance Rule:-
 NPV is Positive [NPV > 0] - Accept the project
 NPV is Negative [NPV < 0] - Reject the project
 NPV is zero [NPV = 0] - May accept the project

ACCOUNTING RATE OF RETURN (ARR)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑐𝑜𝑚𝑒
ARR = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑥100

Acceptance Rule:-
 ARR > minimum rate - Accept the project
 ARR < minimum rate - Reject the project
 WORKING CAPITAL MANAGEMENT

NET WORKING CAPITAL

Net Working Capital = Current Assets - Current Liabilities

COMPUTATION OF OPERATION CYCLE

Days
Raw materials purchased xxx
Add: Work-in-progress holding period xxx
Finished goods storage period xxx
Debtors collected period xxx
-----
xxx
Less: Creditors payment period xxx
-----
Operating cycle period xxx
-----

(a) Raw materials purchased

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘 𝑜𝑓 𝑟𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠
𝑥365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑟𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠
𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦

(b) Work-in-progress holding period

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘 𝑜𝑓 𝑊. 𝐼. 𝑃
𝑥365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
𝑝𝑒𝑟 𝑑𝑎𝑦

(c) Finished goods storage period

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘 𝑜𝑓 𝑓𝑖𝑛𝑖𝑠ℎ𝑒𝑑 𝑔𝑜𝑜𝑑𝑠
𝑥365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠
𝑠𝑜𝑙𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦

(d) Debtors collection period

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝑥365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦

(e) Creditors payment period

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝑥365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦

COMPUTATION OF WORKING CAPITAL REQUIRED

Statement showing Working Capital Requirements

Particulars Rs. Rs.
Current assets:
(i) Stock:
 Raw materials xxx
 Work-in-process:
Raw materials (100%) xxx
Labour (50%) xxx
Overheads (50%) xxx xxx
 Finished goods xxx xxx
(ii) Trade debtors xxx
(iii) Cash Balance xxx
-----
Current Assets xxx
 Less: Current Liabilities:
(i) Trade creditors xxx
(ii) Outstanding wages xxx
(iii) Outstanding overheads xxx
Current Liabilities xxx
Networking Capital (CA-CL) xxx
Add: Provision for contingencies xxx
Working Capital Required xxx

CASH BUDGET (RECEIPTS AND PAYMENTS METHOD)

Cash Budget for three months ended 30th June 2015

Particulars April May June
Estimated opening cash balance xxx xxx xxx
Add: Estimated Cash Receipts:
Cash Sales xxx xxx xxx
Collection from debtors xxx xxx xxx
Sale of assets xxx xxx xxx
Dividends xxx xxx xxx
Interest on bonds xxx xxx xxx
Other receipts xxx xxx xxx
Total Receipts (A) xxx xxx xxx
Less: Estimated Cash Payments:
Cash Purchases xxx xxx xxx
Payment to creditors xxx xxx xxx
Payment of expenses xxx xxx xxx
Purchase of fixed assets xxx xxx xxx
Other payments xxx xxx xxx
Total Payments (B) xxx xxx xxx
Estimated closing cash balance xxx xxx xxx

CASH BUDGET (ADJUSTED PROFIT AND LOSS METHOD)

Cash Budget for the period ended 30th June 2015

Particulars Rs. Rs.
Estimated opening cash balance xxx
Add: (i) Adjusted net profit:
Net profit as given in the budgeted P& LA/c xxx
(+) Depreciation xxx
Goodwill written off xxx
Fictitious assets written off xxx xxx
(ii) Decrease in current assets xxx
(iii) Increase in current liabilities xxx
(iv) Issue of shares and debentures xxx
(v) Sale of fixed assets xxx
xxx
Less: (i) Increase in current assets xxx
(ii) Decrease in current liabilities xxx
(iii) Prepayments xxx
(iv) Purchase of fixed assets xxx
(v) Payment of dividends & tax xxx xxx
Estimated closing cash balance xxx