JAMAL MOHAMED COLLEGE (Autonomous)

Accredited (3rd Cycle) with ‘A’ Grade by NAAC

(Affiliated to Bharathidasan University)

Tiruchirappalli - 620 020

PG & RESEARCH DEPARTMENT OF COMMERCE
(SF-MEN)

FINANCIAL MANAGEMENT
(20UCO6CC14)

COST OF CAPITAL

SINCE 1951

Dr. P. ANWAR BASHA

Assistant Professor of Commerce
Jamal Mohamed College (Autonomous)
Tiruchirappalli
 COST OF CAPITAL

MEANING
It is the minimum rate of return the firm earns as its investment in order to satisfy the expectations of
investors, who provide funds to the firm. Cost of capital is the measurement of the sacrifice made by
the investors in order to the capital formation with a view to get a fair return on investment

DEFINITIONS
According to the definition of John J. Hampton “Cost of capital is the rate of return the firm
required from investment in order to increase the value of the firm in the market place”.

According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure”.

COMPONENT OF COST OF CAPITAL

• Cost of debt
• Cost of preference share
• Cost of equity
• Cost of retained earnings

COST OF DEBT
Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at
par, at premium or at discount and also it may be perpetual (Irredeemable) or redeemable.

COST OF PREFERENCE SHARE

Cost of preference share capital is the annual preference share dividend by the net proceeds
from the sale of preference share. There are two types of preference shares irredeemable and
redeemable.

COST OF EQUITY
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value. Conceptually the cost of equity capital (Ke) 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”.

Cost of equity can be calculated from the following approach:

• Dividend price approach
• Dividend price plus growth approach
• Earning price approach

COST OF RETAINED EARNINGS

Retained earnings is one of the sources of finance for investment proposal; it is different from
other sources like debt, equity and preference shares. Cost of retained earnings is the same as
the cost of an equivalent fully subscripted issue of additional shares, which is measured by
the cost of equity capital.
SIGNIFICANCE OF THE COST OF CAPITAL
Designing the capital structure: The cost of capital is the significant factor in designing a
balanced and optimal capital structure of a firm. While designing it, the management has to
consider the objective of maximizing the value of the firm and minimizing cost of capital.
Comparing the various specific costs of different sources of capital, the financial manager can
select the best and the most economical source of finance and can designed a sound and
balanced capital structure.

Capital budgeting decisions: The cost of capital sources as a very useful tool in the process
of making capital budgeting decisions. Acceptance or rejection of any investment proposal
depends upon the cost of capital. A proposal shall not be accepted till its rate of return is
greater than the cost of capital. In various methods of discounted cash flows of capital
budgeting, cost of capital measured the financial performance and determines acceptability of
all investment proposals by discounting the cash flows.

Comparative study of sources of financing: There are various sources of financing a

project. Out of these, which source should be used at a particular point of time is to be
decided by comparing costs of different sources of financing. The source which bears the
minimum cost of capital would be selected. Although cost of capital is an important factor in
such decisions, but equally important are the considerations of retaining control and of
avoiding risks.

Evaluations of financial performance: Cost of capital can be used to evaluate the financial
performance of the capital projects. Such as evaluations can be done by comparing actual
profitability of the project undertaken with the actual cost of capital of funds raise to finance
the project. If the actual profitability of the project is more than the actual cost of capital, the
performance can be evaluated as satisfactory.

Knowledge of firms expected income and inherent risks: Investors can know the firms
expected income and risks inherent there in by cost of capital. If a firms cost of capital is
high, it means the firms present rate of earnings is less, risk is more and capital structure is
imbalanced, in such situations, investors expect higher rate of return.

Financing and Dividend Decisions: The concept of capital can be conveniently employed as
a tool in making other important financial decisions. On the basis, decisions can be taken
regarding dividend policy, capitalization of profits and selections of sources of working
capital.

TYPES OF COST OF CAPITAL

 COST OF DEBT
Perpetual (Irredeemable)

Irredeemable debt is debt which is not redeemed during the life time of the company.

Cost of debt before tax can be calculated with the help of the following formula

K db = I/NP
Where,

K db = Cost of debt before tax.

I = Annual interest payable
NP= Net proceeds of the debenture
Net proceeds of the debenture can be calculated with the help of the following formula

a) When Debt is Issued at Par

NP = Face Value – Issued expenses
b) When Debt Issued at Premium
NP = Face Value + Premium – Issued expenses
c) When Debt Issued at Discount
NP = Face Value – Discount – Issued expenses
Cost of debt after tax can be calculated with the help of the following formula

K da = Before Tax (1-T)

Where,

K da = Cost of debt after tax T = Tax

Before Tax (Kdb)

PROBLEM NO 1
(a) A Ltd. issues Rs. 1, 00,000, 8% debentures at par. The tax rate applicable to the company
is 50%. Compute the cost of debt capital.
(b) B Ltd. issues Rs. 1, 00,000, 8% debentures at a premium of 10%. The tax rate applicable
to the company is 60%. Compute the cost of debt capital.
(c) A Ltd. issues Rs. 1, 00,000, 8% debentures at a discount of 5%. The tax rate is 60%,
compute the cost of debt capital.
(d) B Ltd. issues Rs. 10, 00,000, 9% debentures at a premium of 10%. The costs of floatation
are 2%. The tax rate applicable is 50%. Compute the cost of debt-capital.

Solution
at par.
K db = I/NP
I = 1, 00,000 x 8/100 =8,000
NP = Face Value – Issued expenses
NP = 1, 00,000 – 0 = 1, 00,000
Kdb = 8,000/1, 00,000
K db = 0.08 or 8%

After Tax Cost of Debt

K da = K db(1-T )
K da = 0.08 (1 -50%)
K da = 0.08 (1 -0.5)
K da = 0.08 (0.5)
K da = 0.04 or 4%
at a premium of 10%
I = 1, 00,000 x 8/100 =8,000
NP = Face Value + Premium – Issued expenses
NP = 1, 00,000 +10 % (1, 00,000 x 10/100) – 0
NP = 100000 + 10,000
NP = 1, 10,000
Kdb = 8,000/1, 10,000
K db = 0.07272 or 7.272%
 After Tax Cost of Debt
K da = K db(1-T )
K da = 0.07272 (1 -60%)
K da = 0.07272 (1 -0.6)
K da = 0.07272 (0.4)
K da = 0.0290 or 2.90%
at a discount of 5%.
I = 1, 00,000 x 8/100 =8,000
NP = Face Value – Discount – Issued expenses
NP = 1, 00,000 - 5 % (1, 00,000 x 5/100) – 0
NP = 100000 - 5,000
NP = 95,000
Kdb = 8,000/95,000
K db = 0.0842 or 8.42%
After Tax Cost of Debt

K da = K db(1-T )
K da = 0.0842 (1 -60%)
K da = 0.0842 (1 -0.6)
K da = 0.0842 (0.4)
K da = 0.0336 or 3.36 %
at a premium of 10%
I = 10, 00,000 x 9/100 =90,000
NP = Face Value + Premium – Issued expenses
NP = 10, 00,000 +10 % (10, 00,000 x 10/100) – 2% (11, 00,000 x 2/100)
NP = 10, 00,000 + 1, 00,000 – 22,000
NP = 10, 78,000
Kdb = 90,000/10, 78,000
K db = 0.08348 or 8.348%
After Tax Cost of Debt
K da = K db(1-T )
K da = 0.08348 (1 -50%)
K da = 0.08348 (1 -0.5)
K da = 0.08348 (0.5)
K da = 0.04174 or 4.174%
Redeemable

Redeemable debt refers to debt which is to be redeemed after the stipulated period.
Cost of debt before tax can be calculated with the help of the following formula

K db = I+ (P-NP) /n
(P+NP)/2
Where,

I = Annual interest payable

NP= Net proceeds of the debenture
P = Par value of debt
n = Number of years to maturity

PROBLEM NO 2
A company issues Rs. 20, 00,000, 10% redeemable debentures at a discount of 5%. The costs
of floatation amount to Rs. 50,000. The debentures are redeemable after 8 years. Calculate
before tax and after tax. Cost of debt assuring a tax rate of 55%.
Solution

K db = I+ (P-NP) /n
(P+NP)/2

I = 20, 00,000 x 10/100 = 2, 00,000

P = 20, 00,000
NP = Face Value – Discount – Issued expenses
NP = 20, 00,000 – 5 %( 20, 00,000x5/100) – 50,000
NP = 20, 00,000 – 1, 00,000 – 50,000
NP = 1,85,0000
n = 8 years
Kdb = 2, 00,000+(20,00,000-1850000)/8
(20, 00,000+1850000)/2

Kdb = 200000+(150000)/8
(3850000)/2

Kdb = 200000 + 18750

1925000

Kdb = 218750
1925000
Kdb = 0.1136 or 11.36%

After Tax Cost of Debt

K da = K db(1-T )
K da = 0.1136 (1 -55%)
K da = 0.1136 (1 -0.55)
K da = 0.1136 (0.45)
K da =0.05112 or 5.11%

 COST OF PREFERENCE SHARE

Cost of redeemable preference share capital is calculated with the help of the following
formula:
Kp = DP/NP
Where,
Kp = Cost of preference share
DP = Fixed preference dividend
NP = Net proceeds of the preference share

PROBLEM NO 3

XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate cost of preference share capital if these shares are issued (a) at par, (b) at a
premium of 10% and (c) at a Discount of 6%.
Solution
Kp = DP/NP
at par
DP = 20,000 x 100 = 20, 00,000 x 8/100 = 1, 60,000
NP = Face Value – Issued expenses
NP = 20, 00,000 – (20,000x2= 40,000)
NP = 1960000
Kp = 1, 60,000/1960000
KP = 0.0816 or 8.16%
at a premium of 10%

DP = 20,000 x 100 = 20, 00,000 x 8/100 = 1,60,000

NP = Face Value + Premium – Issued expenses
NP = 20, 00,000 + 10 %( 2000000 x 10/100) – (20,000x2= 40,000)
NP = 200000 + 200000- 40000
NP =2160000
KP = 1, 60,000/2160000
KP = 0.0740 or 7.40%
at a Discount of 6%.

DP = 20,000 x 100 = 20, 00,000 x 8/100 = 1, 60,000

NP = Face Value – Discount – Issued expenses
NP = 20, 00,000 + 6 %( 2000000 x 6/100) – (20,000x2= 40,000)
NP = 200000 -120000- 40000
NP = 1840000
KP = 1, 60,000/1840000
KP = 0.0869 or 8.69%

Cost of irredeemable preference share is calculated with the help of the following formula:

K p =DP+ (P-NP) /n
(P+NP)/2
Where,

Kp = Cost of preference share

DP= Fixed preference share
P = Par value
NP = Net proceeds of the preference share
n = Number of maturity period

PROBLEM NO 4
ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Redeemable after 8 years at a
premium of 10%. The cost of issue is Rs. 2 per share. Calculate the cost of preference share
capital.
Solution

K p =DP+ (P-NP) /n
(P+NP)/2

DP = 20,000 x 100 = 20, 00,000 x 8/100 = 1, 60,000

P = Face Value + Premium
P = 20, 00,000+2, 00,000 =22, 00,000
NP = Face Value – Issued expenses
NP = 20, 00,000 – (20000 x2=40,000) =19, 60,000
n= 8 years
 KP = 160000 + ( 2200000 - 1960000)/8
(2200000+1960000)/2
Kp = 160000 + (240000)/8
4160000/2
KP = 160000+ 30000
2080000
KP = 190000
2080000
KP = 0.0913 or 9.13%

 COST OF EQUITY
Dividend Price Approach

The cost of equity capital will be that rate of expected dividend which will maintain the
present market price of equity shares.

Dividend price approach can be measured with the help of the following formula:

Ke = D/NP (OR) Ke = D/MP

Where,

Ke = Cost of equity capital

D = Dividend per equity share
NP = Net proceeds of an equity share
MP = Market price of an equity share

PROBLEM NO 5
A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The company
has been paying 25% dividend to equity shareholders for the past five years and expects to
maintain the same in the future also. Compute the cost of equity capital. Will it make any
difference if the market price of equity share is Rs. 175?

Solution

Ke = D/NP
D = 100 x 25/100 = Rs 25
NP = Face Value + Premium – Issued expenses
NP = 100 + 10% (100 x 10/100 = 10)- 0
NP = 100 + 10 = 110
Ke = 25/110 = 0.2272 or 22.72%
Ke = D/MP
D = 100 x 25/100 = Rs 25
MP = Rs 175
Ke = 25/175 = 0.1428 or 14.28%

Dividend Price plus Growth Approach

The cost of equity is calculated on the basis of the expected dividend rate per share plus
growth in dividend.
It can be measured with the help of the following formula:
Ke = D/NP + g (OR) Ke = D/MP +g
Where,

Ke = Cost of equity capital

D = Dividend per equity share
g = Growth in expected dividend
NP = Net proceeds of an equity share
MP = Market price of an equity share

PROBLEM NO 6
A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are
expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share
initially and growth in dividends is expected to be 5%.

a) Compute the cost of new issue of equity shares.

b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing
equity share capital
Solution

a) Compute the cost of new issue of equity shares.

Ke = D/NP + g
D = Rs 12
NP = Face value – Issued expenses
NP = 100 – 4% (100 x 4/100 = 4)
NP = 100 – 4 = 96
g = 5%
Ke = 12 / 96 + 5%
Ke = 0.125 + 0.05
Ke = 0.175 or 17.5%
b) Compute the cost of existing equity share capital
Ke = D/MP + g

D = Rs 12
MP = Rs 120
g = 5%
Ke = 12 / 120 + 5%
Ke = 0.10 + 0.05
Ke = 0.15 or 15%

Earning Price Approach

Cost of equity determines the market price of the shares. It is based on the future earnings
prospects of the equity.

The formula for calculating the cost of equity according to this approach is as follows.

Ke = E/ NP (OR) Ke = E/ MP

Where,
Ke = Cost of equity capital
E = Earning per share
NP = Net proceeds of an equity share
MP = Market price of an equity share
PROBLEM NO 7
A firm is considering an expenditure of Rs. 75 lakhs for expanding its operations.
The relevant information is as follows:
Number of existing equity shares =10 lakhs
Market value of existing share =Rs.100
Net earnings =Rs.100 lakhs
i) Compute the cost of existing equity share capital.
ii) Compute new equity capital assuming that new shares will be issued at a price of Rs. 92
per share and the costs of new issue will be Rs. 2 per share.
Solution

i) Cost of existing equity share capital:

Ke = E/ MP
Earnings per share ( E) = Profit after tax / No of shares
E= 100, 00,000/10, 00,000 = Rs 10
MP= Rs 100
Ke = 10/100 = 0.10 Or 10%
ii) Cost of Equity Capital
E = Rs 10
NP = Face value – Issued expenses
NP = 92 – 2 = 90
Ke = 10/90 = 0.1111 Or 11.11%

 COST OF RETAINED EARNINGS

Cost of retained earnings can be calculated with the help of the following formula:

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

Where,
Kr =Cost of retained earnings
Ke =Cost of equity
T =Tax rate
B =Brokerage cost

PROBLEM NO 8
A firm’s Ke (return available to shareholders) is 10%, the average tax rate of shareholders is
30% and it is expected that 2% is brokerage cost that shareholders will have to pay while
investing their dividends in alternative securities. What is the cost of retained earnings?

Solution
Cost of Retained Earnings, Kr = Ke (1 – t) (1 – b)
Where,
Ke = rate of return available to shareholders 10% (OR) 0.10
t = tax rate 30% (OR) 0.30
b = brokerage cost 2% (OR) 0.02
So,
Kr = 10% (1–30%) (1–2%)
Kr = 0.10 (1- 0.30) (1- 0.02)
Kr = 0.10 (0.7) (0.98)
Kr = 0.0686 (OR) 6.86%
WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is the average rate that a business pays to
finance its assets. It is calculated by averaging the rate of all of the company’s sources of
capital (both debt and equity), weighted by the proportion of each component.

PROBLEM NO 9
From the following particulars relating to the capital structure of Bee Ltd, calculate the
overall cost of capital, using i) Book value weights ii) Market Value weights.

Sources of funds Book Value (Rs) Market Value (Rs) After tax (%)
Equity Share Capital 45,000 90,000 14
Preference Capital 10,000 10,000 10
Debentures 30,000 30,000 8
Retained Earnings 15,000 ----- 13
Solution

Computation of Weighted Average Cost of Capital

Book value weights
Sources of funds Amount Proportion After tax (%) Weighted cost in %
(Rs) (w) (x) (w) x (x)

Equity Share Capital 45,000 45,000/100000 =0.45 14 6.30

Preference Capital 10,000 10,000/100000 =0.10 10 1.00
Debentures 30,000 30,000/100000 =0.30 8 2.40
Retained Earnings 15,000 15,000/100000 =0.15 13 1.95
Total 1,00,000 11.65

Computation of Weighted Average Cost of Capital

Market value weights
Sources of funds Amount Proportion After tax (%) Weighted cost in %
(Rs) (w) (x) (w) x (x)

Equity Share Capital 90,000 90,000/130000 = 0.692 14 9.69

Preference Capital 10,000 10,000/130000 = 0.077 10 0.77
Debentures 30,000 30,000/130000 = 0.231 8 1.85
Retained Earnings ---- ---- ---- -----
Total 1,30,000 12.31