Cost of capital

What Number Goes in the

Denominator?
 Discount
Rate - Rate at which you can
move money of similar risk through time.

 Anindividual moves money into the future

by buying securities such as stock, bonds,
and depositing funds into a savings,
checking, or other bank account.
 An individual moves money from the future
to today by borrowing, or selling securities.
 COST OF CAPITAL
 The rate of return that an organization must earn on
its project investment to maintain its market value.

 Minimum rate of return which a company is expected

to earn from a proposed project so as to make no
reduction in the earning per share to equity
shareholders and its market price.

Also known as - Cut-off rate

- Target Rate
- Required rate of return
 Importance of CoC

 Evaluating Investment / Capital Budgeting decisions and

allocating the firm’s funds

 Designing the Corporate Financial Structure

 Deciding about the method of financing – in lieu with capital

market fluctuations i.e. Designing a firm’s debt policy

 Performance of top management

 Other areas – eg., dividend policy, working capital

 Explicit or Implicit

 Explicit Cost
The explicit cost is the discount rate that equates present value of inflows with
the present value of outflows (similar to IRR).

 Implicit Cost
 Opportunity costs are technically referred to as implicit cost of capital.
 The rate of return associated with the best investment opportunity that
would be forgone is implicit cost.
Sources of funds

 Equity Shares
 Preference Shares
 Term Loans, Debentures and Long term debt
 Reserves

Each carries a cost denoted by ‘ K ’

 Cost of Equity Capital (Ke )

The cost of equity may be defined as the minimum rate of

return that a company must earn on equity shares capital.

Ke is defined as the minimum rate of return that a firm

must earn on the equity-financed portion of an
investment project in order to leave unchanged the
market price of the shares.

The cost of equity capital is higher than that of

preference and debt because of greater uncertainty of
receiving dividends and repayment of principal at the
end.
Methods for calculating Cost of Equity

The two approaches to measure ke are

i.Dividend valuation approach and

A)Dividend yield method
B)Dividend Growth Model

ii.Capital asset pricing model. CAPM

Dividend valuation model

 Itassumes that the value of a share equals

the present value of all future dividends
that it is expected to provide over an
indefinite period.

 Ke accordingly is defined as the discount

rate that equates the present value of all
expected future dividends per share with
the net proceeds of the sale (or the
current market price) of a share.
Assumptions of the Dividend Approach
 The market value of shares depends upon the
expected dividends.

 Investors can formulate subjective probability

distribution of dividends per share expected
to be paid in various future periods. The
initial dividend is greater than 0.

 Dividend payout ratio is constant.

 Investors can accurately measure the riskiness

of the firm so as to agree on the rate at which
to discount the dividends.
Dividend yield method

Ke = D1
Po
Where,
Ke = cost of Equity Capital
D1 = annual dividend per share on equity capital in period 1
(expected dividend)
Po = current market price of equity share

When the Equity shares are newly issued

Ke = D1
NP

Where NP = Net proceeds of issue (after deducting floating

expenses and discount from Inflows)
D1 = total expected dividend
DIVIDEND GROWTH MODEL

Ke = D1 + g
Po
Where,
Ke = cost of Equity Capital
D1 = expected dividend per share
Po = CMP of equity share
g = growth rate at which dividends are expected to grow per year

When Equity shares are newly issued:

Ke = D1 + g
NP

Where, NP = net proceeds

When the last declared dividend is known:

Ke = Do*(1+g) + g
Po
 Capital Asset Pricing Model

Ke = Rf + βi (Rm – Rf)

Where,

Rf = risk free rate of return

Rm= average market return
βi = beta of investment or firm
Q6) Janet Jackson ltd is planning to raise money
from the capital markets which are expected to give
a return (Rm) of 14%. The t-bill going rate is 8%. The
beta of the firm is 0.9. Calculate the cost of equity
based on CAPM model

Solution:
Ke = Rf + βi (Rm – Rf)
= 0.08 + 0.9*(0.14-0.08)
= 13.4%
Q7) Micheal-bhai Jackson ltd is planning to raise money
from the capital markets. Sensex is expected to give a
10% return in the last one year. The 10 year government
yield going rate is 8%. The Covariance of the Rm and
IPOs is 0.12 and their market variance is 0.9. Calculate
the cost of equity based on CAPM model

Solution:
Beta = Cov (Rp, Rm) / VARm. = 0.12 / 0.9 = 0.133

Ke (capm) = 0.08 + 0.133*(0.10-0.08) = 0.0826 = 8.26%

Cost of Preference Capital

Cost of Irredeemable Preference Shares (Perpetual

Security)

Kp = Dp
NP
Where,
Kp = Cost of preference share
Dp = Expected preference dividend
NP = Net proceeds received Issue price of Preference Share
Cost of Preference Capital

Q8) Kylie Minogue ltd, issues 11% irredeemable preference shares of the face value
of Rs. 100 each. Floatation costs are estimated at 5% of the expected sale price.
What is the Kp, if preference shares are issued at (i) par value, (ii) 10% premium
and (iii) 5% discount.
Solution:
Issued at par: 11 / 100*(1-0.05) * 100 = 11.6 percent
Issued at premium: 11/ {110*(1-0.05)} *100 = 10.5 percent
Issued at discount: 11 /{95*(1-0.05)}*100 = 12.2 percent
Cost of Redeemable Preference shares

Kp = Dp + (RV – SV) / n * 100

{(RV+SV) / 2}
Where,
Kp = cost of preference share
Dp = expected dividend at time t
RV= Redemption value or Maturity value of preference share (when shares are
redeemed/repaid)
SV = Sales value or Net proceeds (at time of issue)
n = Maturity period
Cost of Redeemable Preference shares

Q9) Avril ltd has Rs. 100 preference share redeemable at a premium of 10% with
15 years maturity. The coupon rate is 12%. Floatation cost is 5%. Sale price is
Rs. 95 (net). calculate the cost of preference shares.

Solution:
Kp = 12 + (110-95)/15
(110+95)/2
Kp = ?
Cost of Debt

Cost of Irredeemable debt

Before tax cost of debt:

Kd = I / SV
Where,
Kd = Before tax cost of debt I = Annual interest payment SV = Sales
proceeds of bonds / debentures (Net proceeds, amount received at time
of issue)

Tax adjusted cost of debt

Kd = {I / SV} * ( 1- t )
Where,
Kd = Tax adjusted cost of debt I = Annual Interest payment SV = Sale
proceeds of bonds / debentures
Q10 ) Madonna ltd has 10% perpetual debt of Rs.100,000. The tax rate is 35%.
Determine the cost of capital (before tax as well as after tax)
assuming the debt is issued at (i) par , (ii) 10% discount, and (iii) 10%
premium

Solution:
(i) Debt issued at par: Before tax = 10,000/100,000*100 = 10%, After tax= 10%
(1-0.35) = 6.5%

(ii) Debt issued at discount: Before tax = 10,000/90,000*100 = 11.11%, After

tax= 11.11% (1-0.35) = 7.22%

(iii) Debt issued at premium: Before tax = 10,000/110,000*100 = 9.09%, After

tax= 9.09% (1-0.35) = 5.91%
Cost of Redeemable debt
Before tax
Kd = I + {(RV – SV) / n}
(RV + SV) / 2
Where,
I = Annual interest payment
RV = Redemption value of debentures (amount payable on maturity
of debentures)
SV = Sale proceeds of debentures (amount received at time of issue)
n = Number of years to maturity

After tax
Kd = I (1-t) + {(RV – SV) / n} x100
(RV + SV) / 2

t = tax rate
 Q11) Calculate the explicit cost of debt (after tax) for
Annie Lenox limited in each of the following situations:

(a) Debentures are sold at par and floatation costs are 5%

(b) Debentures are sold at premium of 10% and floatation costs are 5% of
issue price
(c) Debentures are sold at discount of 5% and floatation costs are 5% of
issue price.
(d) Assume Interest rate on debentures is 10%, face value is Rs. 100
maturity period is 10 years and tax rate is 35%

 Solution:
(a) Kd = [10 (1-t) + {(100-95)/10} ] / {(100+95)/2} * 100= ?

(b) Kd = [10 (1-t) + {(100-104.5 #)/10} ] / {(100+104.5)/2} * 100 = ?

[# 100+10%-5%of 110]

(c) Kd = [10 (1-t) + {(100-90.25#)/10} ] / {(100+90.25)/2} * 100 = ?

[#100-5% - 5%of 95]
Cost of Retained Earnings

 Opportunity cost approach

Kr = D (1- t) or Kr = Ke (normally used)

Where,
Kr = cost of retained earning D = rate of dividend
t = tax rate of dividend

Q12) Neely limited has paid dividend on equity share @ 24%. The
tax rate is 35%.
Calculate cost of retained earnings.

Solution = 0.24 x (1-0.35) *100 = 15.6%

Weighted Average Cost of Capital
CIMA defines WACC as “the average cost of the company's finance (equity, preference
and debt) weighted according to the proportion each element bears to the total
pool of capital”
WACC = (Cost of equity x % of Equity) + (Cost of debt x % of debt)

Where,
Ko = Kd (1-T) Wd + KeWe OR Ko = Weighted average cost of capital
Kd (1-T) = After tax cost of debt
 
Ke = Cost of Equity
Ko = Kd (1-T)* D + Ke* E D = amount of debt
E = amount of equity
D+E D+E
 
Two approaches: Book Value based and Market value based
Example:
Q13 ) The required rate of return on equity is 16% and cost of debt is 12% . The
firm has a capital structure mix of 60% equity and 40% debt. What is the
overall rate of return the firm Gwen ltd should earn,Tax rate 50%?
Solution: WACC = (0.16*0.6)+(0.12(1-0.5)*0.40) = 12%

Q14) Stefani ltd has a capital gearing ratio of 40%. Its cost of equity is 21% and cost
of debt is 15%. Compute WACC
Solution: WACC = (0.21 * 0.60) + (0.15 * 0.40)
 Q15) Sheena Cements ltd has given you the following capital structure, Calculate WACC
based on book values and market values. Cost of capital is net of tax.

Sources Market Book Cost

Values Values (%)
Equity 80 120 18
 Preference 30 20 15
Debentures 40 40 14

WACC based on Market values WACC based on book values

Sources Book   Cost WACC

Sources Market   Cost WACC
  Values   (%)  
  Values   (%)  
Equity 120 0.666667 18 12
Equity 80 0.533333 18 9.6
Preference 20 0.111111 15 1.666667
Preference 30 0.2 15 3
Debentures 40 0.222222 14 3.111111
Debentures 40 0.266667 14 3.733333
Total 180 1 47 16.77778
WACC
Total 150 1 47 =16.333
WACC = 16.78%
 Q16) Britney Spears limited is considering raising of funds of about Rs. 100 lakhs by one
of the two alternative methods viz., 14% institutional term loan and 13% non-convertible
debentures. The term loan option would attract no major incidental cost. The
debentures would have to be issued at a discount of 2.5% and would involve a cost of
issue of Rs. 1 lakh. You are to advise the company as to the better option based on the
effective cost of capital in each case. Assume a tax rate of 50%.

 Solution:

Particulars Option 1 Option 2

14% Tloan 13%NCD
FV 100 100
less: discount 0 2.5
100 97.5
less: cost of issue 0 1
Net amount raised 100 96.5
Interest charges 14 13
Less: savings in Interest
`@ 50 % tax rate 7 6.5
Net Interest cost 7 6.5
Effective cost of capital 7% 6.74%
`(7/100)*100) `(6.50/96.5)*100)

Recommendation: the cost of capital is lower i.e. 6.74%, if company raises 13% non-
convertible debentures (NCDs) and hence it is suggested to issue NCDs and raise
funds.
17. Caselet: Aries limited wishes to raise additional finance of Rs. 10 lakhs for meeting
its investment plans. It has Rs. 210,000 in the form of retained earnings available for
investment purposes. The following are the further details:
debt-equity mix 30:70
cost of debt up to 180,000, 10 percent (before tax); beyond 180,000. 12 percent
(before tax)
EPS = Rs. 4 per share (paid)
Dividend payout, 50 percent of earnings
 Expected growth rate in dividend, 10 per cent
 CMP = Rs. 44 (on BSE).
Tax rate = 35%

YOU are required to

(a) determine the pattern for raising the additional finance, assuming the firm intends
to maintain existing debt-equity mix
(b) to determine post –tax average cost of additional debt
(c) to determine cost of retained earnings and cost of equity (d) compute overall cost
of capital after tax of additional finance
Solution: (a) Pattern for raising additional finance:
Debt = 0.3*10L = Rs. 3 Lakh; Equity: 0.7*10 L = Rs. 7 Lakh
Break up of Source of Funds:
Retained Earnings 210,000 + Equity (b.f.) 490,000 = Total Equity Funds = Rs. 700,000
Debt funds (Rs 300,000): 10% debt = 180,000 + 12% debt 120,000 = Total = Rs. 300,000
(b) Kd = I (1-t) / NP x 100: (18000+14400)(1-0.35)/300,000 = 7.02%
(c) Ke = Rs 4(50%) (1+0.10) + 0.10 = 15% Kr = Ke = 15%
Rs. 44
(d) Overall cost (WACC)

Source Amount Proportion Post-tax cost Total cost

Equity 490000 0.49 0.15 0.0735
Retained 210000 0.21 0.15 0.0315
Debt 300000 0.3 0.0702 0.02106
1000000 1 total cost = 0.12606
Cost of Capital Practices in India
 The most frequently used (67% cases) discount rate to evaluate
capital budgeting decision is based on the overall cost (WACC) of the
corporate.

 Depending upon the risk characteristics of the project, multiple risk-

adjusted discount rates are used by about 1/5 th of corporate
enterprises in India

 The CAPM model is most popular method of estimating the cost of

equity (54% cos.)

 The Gordon`s dividend model is equally popular method to compute

the cost of equity (52% cos.)

 As regards debt, the cost of debt, the most widely used method is the
interest tax shield method