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Unit Structure
13.0 Chapter Objectives: At the end, the students would be able to understand
the,
• Concept of Cost of Capital
• Classification of Cost of Capital
• Various factors influencing Cost of capital and its Significance
• Determination of Cost of Capital
• Calculate the WACC of a given capital structure
Assumptions: while computing the cost of capital, the following assumptions are
made -
• The cost can be either explicit or implicit.
• The financial and business risks are not affected by investing in new
investment proposals.
• The firm’s capital structure remains unchanged.
• Cost of each source of capital is determined on an after tax basis.
• Costs of previously obtained capital are not relevant for computing the cost of
capital to be raised from a specific source.
The explicit cost of a source of finance would be calculated by discounting the cash
flows at discount rate, which will equate the present value of cash outflows with
present value of cash inflows. There exist some approximate methods to calculate the
various sources of finance.
13.5.1 Cost of Debt Capital:
Debt may be in the form of debentures, bonds, term loans from financial
institutions and banks etc. it may be raised at par, at premium or at a discount.
The cost of debt is the rate of return expected by the lenders. It is the interest rate
specified at the time of issue. The debt may also be redeemable or perpetual debt.
Therefore, the cost of debt can be defined in the terms of the required rate of
return that the debt financed investment must yield to prevent damage to the
shareholders position. Since the interest charges are allowed for tax purposes, the
effective cost of capital would always be the after tax cost of debt.
But the real cost of debt can be identified with net proceeds from the issue of
debentures. The net proceeds is equal to the issue price of the debentures or
amount of loan minus all floatation costs. The floatation costs are the cost of
issuing debentures or obtaining loans. These are generally expressed as
percentage of face value. In nutshell, the net proceeds in different situations can
be calculated as under –
At Par = Par value – Floatation costs
At Premium = Par Value + Premium – Floatation costs
At Discount = Par Value – Discount – Floatation Costs
Further the cost of debt capital will be calculated on the basis of average capital.
The average capital is computed by dividing the total of net amount received at
the time of issue and amount payable on maturity by two.
R + {MV – NP}
n
Kd = * 100
{MV + NP}
2
Where, Kd = Cost of debt
MV = Maturity Value of debt
NP = Net Proceeds
n = Number of years to maturity
R = Annual interest payment
1. When debentures are issued at discount, the net amount realized at the time of
issue will be less than the amount to be paid on maturity. Therefore, the annual
average of the difference between these two amounts (MV – NP) will be deducted
from the interest payable per year and the cost of capital will be calculated on average
capital.
Illustration 1: Shri Ram company issues 12% debentures of Rs 5,00,000 repayable
after 10 years at a discount of 4% and incurs Rs 10,000 for underwriting, brokerage
etc. corporate tax rate being 30% then, the cost of debt capital will be –
Solution:
60,000 + (5, 00,000 – 4, 70,000) / 10
Kd = x 100
(5, 00,000 + 4, 70,000) / 2
2. When debentures are issued at par, and there is no floatation cost, the cost of
debt capital as calculated by the above formula will be equal to the contractual rate of
interest as verified below –
60,000 + (5, 00,000 – 5, 00,000) / 10
Kd = x 100
(5, 00,000 + 5, 00,000) / 2
Cost of Perpetual Debt – debentures which cannot be redeemed during the life
time of the company shall be ascertained by dividing the amount of interest by the
net proceeds.
Kd = Interest (1-t)
NP or MP
Where, Kd = Cost pf debt
NP = Net Proceeds
MP = Market Price
t = tax rate
From the above equation, the market price of debenture may be calculated as
MP = Interest
Kd
a) Issued at par :
45000
Kd (before tax) = x 100
500000
Kd (after tax) = 9% (1 - 0.4) = 5.4 %
b) Issued at 5% discount:
45000
Kd (before tax) = x 100 = 9.47 %
475000
DPS
Kp = x 100
NP
Kp = DPS x 100
NP
50, 000
= x 100 = 10%
5, 00,000
50, 000
Kp = x 100 = 10.53%
4, 75, 000
50, 000
Kp = x 100 = 9.52%
5, 25,000
2. Cost of Redeemable Preference share capital: As per Companies (amendment)
Act, 1996, issue of irredeemable preference shares has been abolished. Therefore, in
practice only redeemable preference shares are issued. Such shares are redeemed at
maturity date either at par or premium. Therefore, the cost of capital is computed in
the same way as in case of redeemable debentures. Only the word D – Dividend is
used in place of Interest (R) in the formula.
D + (MV – NP) / 10
Kp = x 100
(MV + NP) / 2
Illustration 6: Shyam Ltd issues 50, 000 10% preference shares of Rs 100 each
redeemable after 10 years at a premium of 5%. The cost of issue is Rs 2 per share.
Calculate the cost of preference share capital. Assume 30% corporate tax rate.
10 + (105 – 98) / 10
Kp = x 100 = 10.54%
(105 + 98) / 2
For example, if a company issues 4, 00, 000 equity shares of Rs 10 each and the
current market price of these shares is Rs 15 per share. If the company has paid
dividend at the rate of Rs 1.20 per share, the cost of equity share capital would be
–
1.20
Ke = x 100 = 8%
15
Illustration 7: A company issues equity shares of Rs 10 each at a premium of 50%.
The company incurs 2% of the issue price as expenses. If the rate of dividend
expected by the equity shareholders is 20%, calculate the cost of equity capital.
Solution:
Ke = [DPS / NP] x 100
DPS = Rs 2 per share [20% of Rs 10]
NP = Rs 10 + Rs 5 [50% premium] – 0.30 [2% of issue expenses
on Rs 15 per share]
Ke = [2 / 14.70] x 100 = 13.61%
2. Earnings Yield Method: Under this model, the earnings per share are used to
estimate the market price of the share. Equity shareholders have full right in the
income whether they get only part of it as dividend. Therefore, computation of
cost of capital only on the basis of dividend is not justified. Hence, under this
method, the future expected earnings are related to the market price of the shares.
It is also called ‘Earnings Price Ratio’ or ‘E/P ratio’ method. Symbolically,
Ke = EPS x 100
MP
Where, EPS = Earning per share, Mp = Market Price per share.
Illustration 8: A firm is currently earning Rs 2, 00, 000 and its share is selling at a
current market price of Rs 200. The company has 10, 000 shares outstanding and
has no debt. It decides to raise additional funds of Rs 5, 00, 000. If the floatation
costs are Rs 10 per share and the company can sell the share for Rs 180, what is
the cost of equity? Assume that the earnings are stable.
Solution: Cost can be calculated using the Earning per share basis.
Earnings per share = [2, 00, 000 / 10, 000] = Rs 20
Market price = Rs 180 – 10 = Rs 170
Ke = 20 x 100 = 11.76%
170
Illustration 9: A company issues 5, 00, 000 equity shares of Rs 10 each and has
earned a profit of Rs 6, 00, 000 after tax. If the market price of these shares is Rs
16 per share, the cost of capital will be,
Illustration 10: A ltd has issued 2, 000 equity shares of Rs 100 each as fully paid. The
company has earned a profit of Rs 20, 000 after tax. The market price of these shares
is Rs 160 per share. On these shares, dividend has been paid at the rate of Rs 8 per
share.
Find out the cost of equity capital using:
(a) Dividend Yield Method (b) Earnings Yield Method
Ke = DPS x 100
MP
= Rs 8 x 100 = 5%
Rs 160
Ke = EPS x 100
MP
Ke = Rs 10 x 100 = 6.25%
Rs 160
3. Dividend yield plus growth in dividend yield method:
Although it is assumed that the present rate of dividend will remain constant in
future also, the management estimates that the company’s present dividend will
increase continuously for the years to come, then an allowance for future growth
in dividend is added to the current dividend yield. The growth rate in dividend is
assumed to be equal to the growth rate in earnings per share. Symbolically,
Ke = DPS x 100 + g
MP
Where, DPS = Dividend per share, MP = Market Price per share, Growth rate in
dividend i.e. expected annual percentage rate of increase in future dividend.
Example: The current market price per share is Rs 110 and the current dividend
per share is Rs 5.50, assuming that the dividends grow at the rate of 5%, calculate
the cost of equity capital.
Solution:
Ke = 5.50 x 100 + 0.05 = 10%
110
Illustration 11: Sun Ltd. has its hare of Rs 10 each quoted on the stock exchange;
the current price per share is Rs 34. The gross dividend per share over the last
four years has been Rs 1.20, Rs 1.32, Rs 1.45 and Rs 1.60. Calculate the cost of
equity capital.
Solution:
Ke = DPS x 100 + g
MP
The dividends are growing @ 10% and are expected to continue to grow at this
rate.
The risk free rate of return is earned by an asset with no risk, generally on govt.
securities in India. And the market risk premium is the difference between the
expected return on market and risk free rate of interest.
If the share has a risk different from the market risk, we need to adjust its premium to
reflect this difference. The adjustment factor is represented by Bi (beta) of a security.
For example: if rf is 12% and Bi is 2 and return on market portfolio is 15%, the cost
of equity capital as per CAPM will be,
Ke = Rf + Bi [Rm – Rf]
Ke = 12 + 2 [15 – 12] = 18%
Illustration 12: The beta co-efficient of ABC Ltd is 1.40. The risk free rate of return
on government securities is 7%. The expected rate of return on company’s equity
shares is 15%. Calculate the cost of equity capital based on CAPM.
13.5.4 Cost of Internal equity or Retained earnings: The retained earnings are the
funds accumulated by a company over a period by keeping part of profits
without distribution. It is a major source of finance mostly used for expansion
and diversification programs. The cost of retained earnings is an opportunity
cost to be measured in terms of income foregone by the shareholders that they
could have earned by investing the dividends foregone in some alternative
investments. Hence, the cost of retained earnings is equal to cost of equity. To
the extent of personal tax rate and floatation costs, the costs of retained
earnings will be cheaper. Thus, as per “Opportunity Cost Approach”, Kr is
calculated by any of the following formulae,
Kr = Ke [1 – f] [1 - T]
Or
Kr = D [1 – f] [1 - T] x 100
MP
Or
Kr = D x 100 + g x [1 – f] [1 - T]
MP
Where, f = floatation costs and T = Personal Tax rate, g = growth rate in dividend,
MP = Market Price.
Illustration 13: Narendra Mart is currently earning a net profit of Rs 60, 000 p.a. the
shareholder’s required rate of return [Ke] is 15%. If earnings are distributed among the
shareholders they can invest in securities of similar type carrying a return of 15% p.a.
however, the shareholder’s will have to incur 2% brokerage charges for making new
investments. They are also in the 30% tax bracket. Compute the cost of retained earnings
to the company.
Solution:
Kr = Ke [1 – f] [1 - T]
= 15% [1- 0.02] [1 – 0.30]
= 10.29%
Verification: Suppose the company’s pay out Ratio is 100%.
Dividends payable to the shareholders = Rs 60, 000
Less: Personal Income Tax 18, 000
After Tax Dividends 42, 000
Less: Brokerage @ 2% on Rs 42, 000 840
Net Amount available for investment 41, 160
Shareholders can earn at 15% on Rs 41, 160 – Rs 6174. This is the opportunity income
foregone by shareholders if the company retains Rs 60, 000. Hence, the required rate of
return for Rs 60, 000 is Rs 6174 and the rate of return is 10.29%. Hence, the required rate
of return expected by the shareholders from the company is 10.29%, which is the cost of
retained earnings.
Illustration 14: Find out the cost of retained earnings from the following data:
Dividend per share Rs. 15
Personal income tax Rate 30%
Market price per share Rs. 110
Brokerage on investment of dividend 1%
Solution:
Kr = D [1 – f] [1 - T] x 100
MP
= 15 [1 – 0.01] [1 – 0.30] x 100
110
= 15 x 0.99 x 0.70 x 100 = 9.45%
110
Solution:
Illustration 16: Calculate the weighted average cost of capital from the following
information:
a. Capital Structure of Y Ltd: (Rs)
Equity capital: Shares of Rs 10 each fully paid 1, 00, 000
Reserves (General) 50, 000
Long Term Debt 1, 00, 000
b. Market price per share of AB Ltd is Rs 60 and earning per share is Rs 6. The expected
growth rate earnings are 5% p.a.
c. Cost of debt (before tax) = 12% p.a
d. Applicable corporate tax = 40%
e. Use market values as weights and show your workings.
Solution:
a. Cost of equity (using Earnings Growth method)
Ke = E + g = Rs 6 + 0.05 = 0.1 +.05 = 0.15 or 15%
P Rs 60
b. Cost of Reserves ( using external yield criterion)
Kr = Ke = 15%
c. Cost of Long term debt
Kd = r(1- t)
= 0.12 (1 – 0.4) = 0.072 or 7.2%
Weights: Market value of Equity and General Reserve = 60 x 10, 000 = 6, 00, 000
Divided in the ratio 2:1, we get,
Market value of Equity = 6, 00, 000 x 2 = Rs 4, 00, 000
3
Market value of Reserves = 6, 00, 000 x 1 = Rs 2, 00, 000
3
Statement of WACC
Capital Source Market value Weight % [b] Cost [net of Weighted cost
[Rs in lakhs] tax] % [c] of capital [b] x
[a] [c]
Equity Capital 4, 00, 000 0.57 15 8.55
Reserves 2, 00, 000 0.29 15 4.35
Long Term 1, 00, 000 0.14 7.2 1.01
Loan
Total 7, 00, 000 1.00 13.91
Merits of WACC:
This approach is widely used in determining the required return on a firm’s investments.
It offers a no. of advantages including the following:
• It employs a direct and reasonable methodology and is easily calculated and
understood. Hence, it is a straightforward and logical approach.
• It is responsive to changing conditions as small changes in the capital structure will
be noted in the overall cost of capital of the firm
• During the period of normal profits, it is proved more accurate as a cut-off rate in
selecting capital budgeting proposals.
• It has proved as an ideal criterion for selecting capital expenditure proposals by
providing a cut-off rate that determines the lower limit for accepting an investment
proposal.
Limitations of WACC:
This approach has some weaknesses. Some of them are:
Inclusion of short term loans in the calculation of cost of capital will result in low
weighted average cost. Hence, unsuitable in case of low cost debt.
If a firm is experiencing low profits, weighted average cost will be inaccurate and
of limited value.
The main difficulty is to assign weights to different components of capital
structure.
The selection of capital structure to be used for determining the weighted average
cost of capital is not an easy task.
13.8 Summary
The Cost of Capital of a company is the average rate of return required by the
investors who provide long term funds.
Strictly speaking the cost of capital of a firm is an appropriate discount rate for a
project that is a carbon copy of the firm’s existing business. However, in practice,
the cost of capital is used as a benchmark hurdle rate that is adjusted for variations
in risk and financing patterns.
There are different types of cost of capital namely (1) Future Cost & Historical
Cost, (2) Specific Cost & Combined Cost, (3) Explicit Cost & Implicit Cost, (4)
Average Cost & Marginal Cost.
The Concept of Cost of Capital helps the company’s management in designing the
optimum capital structure for the firm, taking Capital Budgeting Decisions, in
making a comparative study of different sources of financing, in the evaluation of
financial performance of top management and taking financing and dividend
decisions.
There are various factors which affect the Cost of Capital of a firm. Important
among them are the nature of business of the firm, the financial requirements of
the firm, the attitude of management regarding risk, the financing mix decision
and the Business Risk & Financial Risk involved with the firm.
The cost of a specific source of finance is measured as a rate of discount that
equates the present value of the expected post-tax payments to that source of
finance with the net funds received from that source of finance.
Since there are no fixed contractual payments on equity stock. As there are no
other securities, it is not easy to estimate the cost of equity.
Several methods have been suggested to figure out the return expected by equity
shareholders: (1) Dividend Yield Method, (2) Earnings – Price Ratio Method, (3)
Dividend yield plus growth in dividend yield method, (4)Capital Asset Pricing
Model. As none of these methods is perfect, you may have top use more than one
method to get a reasonable handle on the cost of equity.
For calculating the Weighted Average Cost of Capital, you have to multiply the
cost of each source of finance with its respective weights. The weights may be
based on (1) Book Value, (2) Market Values. We recommend the use of market
value weights unless market values are not available or highly unreliable or
distorted.
1. Define the concept of ‘Cost of Capital’. State how you would determine the
weighted average cost of capital of the firm.
2. What is meant by Cost of Capital of a firm and what relevance does it have in
decision making? How is it calculated with different types of sources of capital
funds?
3. Explain the concept of Cost of Capital as a basis for corporate investment and
financial decisions. Also explain different types of costs.
4. The current market price of the shares of A Ltd is Rs. 95. The floatation costs are
Rs. 5 per share. Dividend per share amounts to Rs. 4.50 and is expected to grow at
a rate of 7%. You are required to calculate the cost of equity share capital.
[Ans: 12%]
5. ABC Ltd. Has the following capital structure
Equity (expected dividend 12%) Rs. 10, 00, 000
10% Preference Rs. 5, 00, 000
8% Loan Rs. 15, 00, 000
Calculate the company’s weighted average cost of capital, assuming 50% as the
arte of income tax, before and after tax.
[Ans: Before Tax – 9.66%, After Tax – 7.67%]