Chapter 14

THE COST OF CAPITAL

 OUTLINE
• Introduction
• Cost of Debt
•Cost of preference share
• Cost of Equity
• Weighted Average Cost of Capital
• Book value weight
•Market value weight
 COST OF CAPITAL

The cost of capital of any investment (project,

business, or company) is the rate of return the
suppliers of capital would expect to receive if the
capital were invested elsewhere in an investment
(project, business, or company) of comparable risk

• The cost of capital reflects expected return

• The cost of capital represents an opportunity

cost
Measurement of cost of capital
 Cost of debt
 Redeemable
 Irredeemable
 Cost of Preference share
 Redeemable
 Irredeemable
 Cost of Equity
 Security market line
 Dividend Growth model
 Earning Per share approach
 COST OF DEBT

When debt is redeemable

F= Face Value
P0= Net proceed
I + (F – P0)/n I= Amount of Interest
Kd =
n= No. of Years
0.6P0 + 0.4F
Kd= Cost of debt
For Irredeemable debt (Debenture)

Kd = Int/P0

Int= Amount of interest

P0= Net Proceeds
Post tax cost of Debt = Pre-tax cost of debt (1-Tax rate)
 COST OF PREFERENCE

Given the fixed nature of preference dividend and

principal repayment commitment and the absence of tax

deductibility, the cost of preference is simply equal to its

yield.
Redeemable: F= Face Value
P0= Net proceed
D + (F – P0)/n D= Amount of Dividend
Pd =
0.6P0 + 0.4F n= No. of Years

For Irredeemable preference share

Pd= D/P0

D= Amount of Dividend
P0= Net Proceeds
 COST OF EQUITY

• Equity finance comes by way of (a) retention of earnings

and (b) issue of additional equity capital.

• Irrespective of whether a firm raises equity finance by

retaining earnings or issuing additional equity shares,
the cost of equity is the same. The only difference is in
floatation cost.

• Floatation costs will be discussed separately.

 APPROACHES TO ESTIMATE
COST OF EQUITY

• Security Market Line Approach

• Dividend Growth Model Approach

• Earnings-Price Ratio Approach

 SECURITY MARKET LINE
APPROACH
rE = Rf + E [E(RM) – Rf ]
rE = required return on the equity of the company
Rf = risk-free rate
E = beta of the equity of the company
E(RM) = expected return on the market portfolio

Illustration
Rf = 7%, E = 1.2, E(RM) = 15%
rE = 7 + 1.2 [15 – 7] = 16.6%
 DIVIDEND GROWTH MODEL APPROACH

If the dividend per share grows at a constant rate of g

percent.
D1= Dividend in next year
P0= Net proceeds
g= Growth Rate

D1
KE = + g
P0
Thus, the expected return of equity shareholders, which in
equilibrium is also the required return, is equal to the
dividend yield plus the expected growth rate
 EARNINGS-PRICE RATIO APPROACH
Cost of equity = E1 / PO
where E1 = the expected EPS for the next year
PO = the current market price
This approach provides an accurate measure in the
following two cases:
• When the EPS is constant and the dividend payout
ratio is 100 percent.
• When retained earnings earn a rate of return equal to
the cost of equity.
 FLOATATION COSTS
• Floatation or issue costs consist of items like
underwriting costs, brokerage expenses, fees of
merchant bankers, under pricing cost, and so on.

• A better approach is to leave the WACC unchanged but

to consider floatation costs as part of the project cost.

Revised WACC = WACC/1-Floating cost

Thank You