COST OF CAPITAL

LEARNING OUTCOMES

➢ Discuss the need and sources of finance to a business entity.

➢ Discuss the meaning of cost of capital for raising capital from different sources of finance.

➢ Measure cost of individual components of capital

➢ Calculate weighted cost of capital and marginal cost of capital, Effective Interest rate.

Cost of
Capital

Cost of Cost of
Cost of Cost of
Preference Retained
Debt Equity
Share Earning of each sources of

Weighted
Average Cost of
Capital (WACC)
Introduction
We know that the basic task of a finance manager is procurement of funds and its effective
utilization. Whereas objective of financial management is maximization of wealth. Here
wealth or value is equal to performance divided by expectations.

Therefore, the finance manager is required to select such a capital structure in which
expectation of investors is minimum hence shareholders’ wealth is maximum. For that
purpose first he need to calculate cost of various sources of finance. In this lecture we will
learn to calculate cost of debt, cost of preference shares, cost of equity shares, cost of
retained earnings and also overall cost of capital.

Meaning of Cost of Capital

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and
the debt-holders) to the business as a compensation for their contribution to the total capital.
When an entity (corporate or others) procured finances from either sources as listed above, it
has to pay some additional amount of money besides the principal amount. The additional
money paid to these financiers may be either one off payment or regular payment at specified
intervals. This additional money paid is said to be the cost of using the capital and it is called the
cost of capital. This cost of capital expressed in rate is used to discount/ compound the cashflow
or stream of cashflows. Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum
rate of return’ etc. It is used as a benchmark for: Framing debt policy of a firm and Taking
Capital budgeting decisions.

Significance of the Cost of Capital

The cost of capital is important to arrive at correct amount and helps the management or an
investor to take an appropriate decision. The correct cost of capital helps in the following
decision making:

a. Evaluation of investment options: The estimated benefits (future cashflows) from

available investment opportunities (business or project) are converted into the present
value of benefits by discounting them with the relevant cost of capital. Here it is
pertinent to mention that every investment option may have different cost of capital
hence it is very important to use the cost of capital which is relevant to the options
available.
b. Financing Decision: When a finance manager has to choose one of the two sources of
finance, he can simply compare their cost and choose the source which has lower cost.
Besides cost he also considers financial risk and control.
c. Designing of optimum credit policy: While appraising the credit period to be allowed
to the customers, the cost of allowing credit period is compared against the benefit/ profit
earned by providing credit to customer of segment of customers. Here cost of capital is

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used to arrive at the present value of cost and benefits received.

Determination of the Cost of Capital

Cost is not the amount which the company plans to pay or actually pays, rather than it
is the expectation of stakeholders. Here Stakeholders include providers of capital
(shareholders, debenture holder, money lenders etc.), intermediaries (brokers,
underwriters, merchant bankers etc.), and Government (for taxes).

For example if the company issues 9% coupon debentures but expectation of investors is
10% then investors will subscribe it at discount and not at par. Hence cost to the company
will not be 9%, rather than it will be 10%. Besides giving return to investors company will
also have to give commission, brokerage, fees etc. To intermediaries for issue debentures.
It will increase cost of capital above 10%. On the other hand payment of interest is a
deductible expense under the Income tax act hence it will reduce cost of capital to the
company. Cost of any sources of finance is expresses in terms of percent per annum. To
calculate cost first of all we should identify various cash flows like:

1. inflow of amount received at the beginning

2. outflows of payment of interest, dividend, redemption amount etc.
3. Inflow of tax benefit on interest or outflow of payment of dividend tax.

Thereafter we can use trial & error method to arrive at a rate where present value of
outflows is equal to present value of inflows. That rate is basically IRR. In investment
decisions IRR indicates income, because there we have initial outflow followed by series of
inflows. In cost of capital chapter this IRR represents cost, because here we have initial
inflow followed by series of net outflows.

Alternatively we can use shortcut formulas. Though these shortcut formulas are easy to
use but they give approximate answer and not the exact answer. We will discuss the cost of
capital of each source of finance separately.
 Cost of
Equity

Weighted
Cost of
Average Cost Cost of Pref.
Retained
of Capital Capital
Earnings
(WACC)

Cost of
Long term
Debt.

Cost of Long Term Debt

External borrowings or debt instruments do no confers ownership to the providers of
finance. The providers of the debt fund do not participate in the affairs of the company
but enjoys the charge on the profit before taxes. Long term debt includes long term loans
from the financial institutions, capital from issuing debentures or bonds etc.
As discussed above the external borrowing or debt includes long term loan from
financial institutions, issuance of debt instruments like debentures or bonds etc. The
calculation of cost of loan from a financial institution is similar to that of redeemable
debentures. Here we confine our discussion of cost debt to Debentures or Bonds only.

Features of debentures or bonds:

I. Face Value: Debentures or Bonds are denominated with some value; this denominated
value is called face value of the debenture. Interest is calculated on the face value of the
debentures. E.g. If a company issue 9% Non- convertible debentures of ₦100 each, this
means the face value is ₦100 and the interest @ 9% will be calculated on this face value.
II. Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) rate (except
Zero coupon bond and Deep discount bond). Interest (coupon) rate is applied to face
value of debenture to calculate interest, which is payable to the holders of debentures
periodically.
III. Maturity period: Debentures or Bonds has a fixed maturity period for redemption.
However, in case of irredeemable debentures maturity period is not defined and it is taken
as infinite.
IV. Redemption Value: Redeemable debentures or bonds are redeemed on its specified

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 maturity date. Based on the debt covenants the redemption value is determined.
Redemption value may vary from the face value of the debenture.
V. Benefit of tax shield: The payment of interest to the debenture holders are allowed as
expenses for the purpose of corporate tax determination. Hence, interest paid to the
debenture holders save the tax liability of the company. Saving in the tax liability is also
known as tax shield. The example given below will show you how interest paid by a
company reduces the tax liability:
Example: There are two companies namely X Ltd. and Y Ltd. The capital of the X Ltd
is fully financed by the shareholders whereas Y Ltd uses debt fund as well. The below is
the profitability statement of both the companies:

X Ltd. Y Ltd.
(₦) (₦)
Earnings before interest and taxes (EBIT) 100 100
Interest paid to debenture holders - (40)
Profit before tax (PBT) 100 60
Tax @ 35% (35) (21)
Profit after tax (PAT) 65 39
A comparison of the two companies shows that an interest payment of ₦40 by the Y
Ltd. results in a tax shield (tax saving) of ₦14 (₦40 paid as interest × 35% tax rate).
Therefore the effective interest is ₦26 only.
Based on redemption (repayment of principal) on maturity the debts can be
categorised into two types (i) Irredeemable debts and (ii) Redeemable debts.

Cost of Irredeemable Debt

Cost of long term Debt
Cost of Redeemable Debt

Cost of Irredeemable Debentures

The cost of debentures which are not redeemed by the issuer of the debenture is
known as irredeemable debentures. Cost of debentures not redeemable during the life

I
Kd= (1- t)
NP
time of the company is calculated as below:

Where,
Kd = Cost of debt after tax
I = Annual interest payment
NP = Net proceeds of debentures or current market price
t = Tax rate
Net proceeds means issue price less issue expenses. If issue price is not given then
students can assume it to be equal to current market price. If issue expenses are not
given simply assume it equal to zero.
Suppose a company issues 1,000, 15% debentures of the face value of ₦100 each at
a discount of ₦5. Suppose further, that the under-writing and other costs are
₦5,000/- for the total issue. Thus ₦90,000 is actually realised, i.e., ₦1,00,000 minus
₦5,000 as discount and ₦5,000 as under-writing expenses. The interest per annum of
₦15,000 is therefore the cost of ₦90,000, actually received by the company. This is
because interest is charge on profit and every year the company will save ₦7,500 as
tax, assuming that the income tax rate is 50%. Hence the after tax cost of ₦90,000 is `
₦7,500 which comes to 8.33%.

Example: Five years ago, Sona Limited issued 12 per cent irredeemable debentures
at ₦103, at ₦3 premium to their par value of ₦100. The current market price of these
debentures is ₦94. If the company pays corporate tax at a rate of 35 per cent
CALCULATE its current cost of debenture capital?

Solution
Cost of irredeemable debenture:
Kd= I /NP(1- t)
12 (1-0.35)/94
= 12(0.65)/94
= 7.8/94
=0.083*100
= 8.3%

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Cost of Redeemable Debentures (using approximation method)
The cost of redeemable debentures will be calculated as below:

(RV-NP)
I (1- t ) +
n
Cost of debenture (Kd) =
(RV+NP)
2
Where,
I = Interest payment
NP = Net proceeds from debentures in case of new issue of debt or
Current market price in case of existing debt.
RV = Redemption value of debentures
t = Tax rate applicable to the company
n = Remaining life of debentures.
The above formula to calculate cost of debt is used where only interest on debt is tax
deductable. Sometime, debts are issued at discount and/ or redeemed at a premium. If
discount on issue and/ or premium on redemption are tax deductible, the following
formula can be used to calculate the cost of debt.
(RV-NP)
I+ n (1- t)
Cost of debenture (Kd) =
(RV+NP)
2
In absence of any specific information, students may use any of the above formulae to
calculate the Cost of Debt (Kd) with logical assumption.
Above formulas give approximate value of cost of debt. In these formulas higher
the difference between RV and NP, lower the accuracy of answer. Therefore one
should not use these formulas if difference between RV and NP is very high. Also
these formulas are not suitable in case of gradual redemption of bonds.

Example: A company issued 10,000, 10% debentures of ₦100 each at a premium of

10% on 1/4/2017 to be matured on 1/4/2022. The debentures will be redeemed on
maturity. COMPUTE the cost of debentures assuming 35% as tax rate
Solution.
The cost of debenture (Kd) will be calculated as below:
(RV-NP)
I (1- t ) + n
Cost of debenture (Kd) =
(RV+NP)
2

I = Interest on debenture = 10% of ₦100 = ₦10

NP = Net Proceeds = 110% of ₦100 = ₦110
RV = Redemption value = ₦100
n = Period of debenture = 5 years
t = Tax rate = 35% or 0.35
(100- 110)
` 10 (1- 0.35)+
5 years
Kd = (100+110)
2
(10×0.65)- 2 4.5
Or, Kd= = = 0.0428 or 4.28%
105 105
=
Example:
A company issued 10,000, 10% debentures of ₦100 each at par on 1/4/2012 to be
matured on 1/4/2022. The company wants to know the cost of its existing debt on
1/4/2017 when the market price of the debentures is ₦80. COMPUTE the cost of
existing debentures assuming 35% tax rate.

Solution
(RV-NP)
I (1- t ) + n
Cost of debenture (Kd) =
(RV+NP)
2
I = Interest on debenture = 10% of ₦100 = ₦10
NP = Current market price = ₦80
RV = Redemption value = ₦100
8
 n = Period of debenture = 5 years
t = Tax rate = 35% or 0.35

I (1- t) + (RV-NP)
Cost of debenture (Kd) = n
RV+NP
2
10(1-0.35) + (100-80)/5 =
100+80/2
Cost of Debt using Present value method [Yield to maturity (YTM)
approach)]
The cost of redeemable debt (Kd) is also calculated by discounting the relevant cash
flows using Internal rate of return (IRR). (The concept of IRR is discussed in the
Chapter- Investment Decisions). Here YTM is the annual return of an investment from
the current date till maturity date. So, YTM is the internal rate of return at which
current price of a debt equals to the present value of all cash-flows.
The relevant cash flows are as follows:

Year Cash flows

0 Net proceeds in case of new issue/ Current market price in case of existing
debt (NP or P0)
1 to n Interest net of tax [I(1-t)]
n Redemption value (RV)

Steps to calculate relevant cash flows:

Step-1: Identify the cash flows
Step-2: Calculate NPVs of cash flows as identified above using two discount rates
(guessing).
Step-3: Calculate IRR
Example: A company issued 10,000, 10% debentures of ₦100 each on 1/4/2013
to be matured on 1/4/2018. The company wants to know the current cost of its
existing debt and the market price of the debentures is ₦80. Compute the cost of
existing debentures assuming 35% tax rate.
Step-1: Identification of relevant cash flows

Year Cash flows

0 Current market price (P0) = ₦80
1 to 5 Interest net of tax [I(1-t)] = 10% of ₦100 (1-0.35) = ₦6.5
5 Redemption value (RV) = Face value i.e. ₦100

Step- 2: Calculation of NPVs at two discount rates

Year Cash Discount Present Discount Present Value

flows (₦) factor @ Value factor @ (₦)
10% 15%
0 80 1.000 (80.00) 1.000 (80.00)
1 to 5 6.5 3.791 24.64 3.352 21.79
5 100 0.621 62.10 0.497 49.70
NPV +6.74 -8.51
Step- 3: Calculation of IRR
NPVL (HR-LR) 6.74
IRR =L+ = 10%+ (15%-10%)= 12.21%
NPVL -NPVH 6.74-(-8.51)

10
YTM or present value method is a superior method of determining cost of debt of
company to approximation method and it is also preferred in the field of finance.
We may keep in mind that in the above formula, higher the difference between
H and L, lower the accuracy of answer.

Examples
Institutional Development Bank (IDB) issued Zero interest deep discount bonds of
face value of ₦100,000 each issued at ₦2500 & repayable after 25 years. COMPUTE
the cost of debt if there is no corporate tax.

Solution
Here,
Redemption Value (RV)=₦100,000
Net Proceeds (NP) = ₦2,500
Interest = 0
Life of bond = 25 years

There is huge difference between RV and NP therefore in place of approximation

method we should use trial & error method.
FV = PV x (1+r)n
100,000 = 2,500 x (1+r)25
40 = (1+r)25
Trial 1: r = 15%, (1.15)25 = 32.919
Trial 2: r = 16%, (1.16)25 = 40.874
Here:
L = 15%, H = 16%
NPVL = 32.919-40 = -7.081
NPVH = 40.874-40 = +0.874
NPVL
IRR=L+ (H-L)
NPVL-NPVH
-7.081
=15%+ ×(16%-15%)= 15.89%
-7.081-(0.874)
Cost of Preference Share Capital
The preference share capital is paid dividend at a specified rate on face value of
preference shares. Payment of dividend to the preference shareholders are not
mandatory but are given priority over the equity shareholder. The payment of
dividend to the preference shareholders are not charged as expenses but treated as
appropriation of after tax profit. Hence, dividend paid to preference shareholders does
not reduce the tax liability to the company. Like the debentures, Preference share
capital can be categorised as redeemable and irredeemable. Accordingly cost of
capital for each type will be discussed here.
Cost of Redeemable
Preference Share Capital
Cost of Preference Share
Capital

Cost of Irredeemable
Preference Share Capital

Cost of Redeemable Preference Shares

Preference shares issued by a company which are redeemed on its maturity is called
redeemable preference shares. Cost of redeemable preference share is similar to the
cost of redeemable debentures with the exception that the dividends paid to the
preference shareholders are not tax deductible. Cost of preference capital is calculated
as follows:

PD +
(RV −NP)
n
Cost of Redeemable Preference Shares Kp = RV +NP)
2

Where,

PD = Annual preference dividend

RV = Redemption value of preference shares
NP = Net proceeds on issue of preference shares
n = Remaining life of preference shares.

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 Net proceeds mean issue price less issue expenses. If issue price is not given then
students can assume it to be equal to current market price. If issue expenses are not
given simply assume it equal to zero.

The cost of redeemable preference share could also be calculated as the discount rate
that equates the net proceeds of the sale of preference shares with the present
value of the future dividends and principal payments.

Examples
XYZ Ltd. issues 2,000 10% preference shares of ₦100 each at ₦95 each. The
company proposes to redeem the preference shares at the end of 10th year from the
date of issue. CALCULATE the cost of preference share?
Solution
(RV-NP)
PD+ n
Kp =
(RV+NP)
2
100 - 95 )
10 + (
10
Kp = (100 + 95)/2 = 0.1077 (approx.) = 10.77%

Cost of irredeemable Preference Shares

The cost of irredeemable preference shares is similar to calculation of perpetuity.
The cost is calculated by dividing the preference dividend with the current market
price or net proceeds from the issue. The cost of irredeemable preference share is
as below:
PD
Cost of Irredeemable Preference Share (KP) =

Where,
PD = Annual preference dividend
P0= Net proceeds in issue of preference shares
Example: XYZ & Co. issues 2,000 10% preference shares of ₦100 each at ₦95
each. CALCULATE the cost of preference shares.

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 Solution

PD
KP =
P
0

K
= 10 (2,000) =10
P 95 (2,000) = 0.1053 = 10.53%
95
Example: If R Energy is issuing preferred stock at ₦100 per share, with a stated dividend of
₦12, and a floatation cost of 3% then, CALCULATE the cost of preference share?

Solution
Preferred stock dividend
Kp =
Market price of preferred stock (1- floatation cost)

12 12
= = = 0.1237 or 12.37%
100(1- 0.03) 97

Cost of Equity Share Capital

Just like any other source of finance, cost of equity is expectation of equity
shareholders. We know that value is performance divided by expectations. If we
know value and performance, then we can calculate expectation as a balancing figure.
Here performance means the amount paid by the company to investors, like
interest, dividend, redemption price etc. In case of debentures and preference
shares amount of interest or dividend is fixed but in case of equity shares it is
uncertain.
Therefore there is no single method for calculation of cost of equity.
1) If dividend is expected to be constant then dividend price approach should be
used.
2) If earning per share is expected to be constant then earning price approach
should be used.
3) If dividend and earning are expected to grow at a constant rate then growth
approach, which is also named as Gordon’s model should be used.
4) If it is difficult to forecast future then realised yield approach should be used,
which looks into past.
5) All above methods calculate cost of equity as a balancing figure. While the cost
of equity or expectation of investors is dependent on risk. Higher the risk higher
the expectations and vice versa. Capital asset pricing model calculates cost of
equity based on risk
Different methods are employed to compute the cost of equity share capital.

Dividend /Price Approach

Earning/ Price Approach

Cost of Equity Share Capital Growth Approach

Realized Yield Approach

Capital Asset Pricing Model

(CAPM)

Dividend Price Approach

This is also known as Dividend Valuation Model. This model makes an assumption
that the dividend per share is expected to remain constant forever. Here, cost of
equity capital is computed by dividing the expected dividend by market price per
share as follows:
D
Cost of Equity (Ke)=
P0

Where,
Ke= Cost of equity
D = Expected dividend

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P0 = Market price of equity (ex- dividend)
Earning/ Price Approach
The advocates of this approach co-relate the earnings of the company with the market
price of its share. Accordingly, the cost of equity share capital would be based upon
the expected rate of earnings of a company. The argument is that each investor
expects a certain amount of earnings, whether distributed or not from the company in
whose shares he invests. Thus, if an investor expects that the company in which he is
going to subscribe for shares should have at least a 20% rate of earning, the cost of
equity share capital can be construed on this basis. Suppose the company is
expected to earn 30% the investor will be prepared to pay ₦150 (30/20 *100) for
each share of ₦100.
Earnings/ Price Approach:
E
Cost of Equity (Ke ) =

Where,
E = Current earnings per share P
P = Market share price
This approach assumes that earning per share will remain constant forever. The
Earning Price Approach is similar to the dividend price approach; only it seeks to
nullify the effect of changes in the dividend policy.

Growth Approach or Gordon’s Model

As per this approach the rate of dividend growth remains constant. Where
earnings, dividends and equity share price all grow at the same rate, the cost of
equity capital may be computed as follows:
D1
Cost of Equity (Ke)= +g
P0

Where,
D1 = [D0 (1+ g)] i.e. next expected dividend
P0 = Current Market price per share
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 g = Constant Growth Rate of Dividend.
In case of newly issued equity shares where floatation cost is incurred, the cost of
equity share with an estimation of constant dividend growth is calculated as below:

P0 -
F
Where, F = Flotation cost per share
Example:
A company has paid dividend of ₦1 per share (of face value of ₦10 each) last year
and it is expected to grow @ 10% next year. CALCULATE the cost of equity if the
market price of share is ₦55.
Solution
D 1(1+0.1)
Ke = 1+ g = + 0.1 = 0.12 = 12%
P0 55
Estimation of Growth Rate
The calculation of ‘g’ (the growth rate) is an important factor in calculating
cost of equity share capital. Generally two methods are used to determine the
growth rate, which are discussed below:
(i) Average Method
It calculated as below:
Current Dividend (D0) =Dn(1+g)n

Dn

Where,
D0 = Current dividend,
Dn = Dividend in n years ago
Growth rate can also be found as follows:
Step-I: Divide D0 by Dn, find out the result, then refer the FVIF table,
Step-II: Find out the result found at Step-I in corresponding year’s row
Step-III: See the interest rate for the corresponding column. This is the growth
rate.

Example: The current dividend (D0) is ₦16.10 and the dividend 5 year ago was
₦10. The growth rate in the dividend can found out as follows:
Step-I: Divide D0 by Dn i.e. ₦16.10 ÷ ₦10 = 1.61
Step-II: Find out the result found at Step-I i.e. 1.61 in corresponding year’s row
i.e. 5th year
Step-III: See the interest rate for the corresponding column which is 10%.
Therefore, growth rate (g) is 10%

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 .
(ii) Gordon’s Growth Model
Unlike the Average method, Gordon’s growth model attempts to derive a
future growth rate. As per this model increase in the level of investment will
give rise to an increase in future dividends. This model takes Earnings retention
rate (b) and rate of return on investments (r) into account to estimate the future
growth rate.
It can be calculated as below:

Where,
r = rate of return on fund invested
b = earnings retention ratio/ rate*

*Proportion of earnings available to equity shareholders which is not

distributed as dividend
(This Model is discussed in detail in chapter 9 i.e. Dividend Decision)

Realized Yield Approach

According to this approach, the average rate of return realized in the past few
years is historically regarded as ‘expected return’ in the future. It computes cost
of equity based on the past records of dividends actually realised by the equity
shareholders. Though, this approach provides a single mechanism of calculating
cost of equity, it has unrealistic assumptions like risks faced by the company
remain same; the shareholders continue to expect the same rate of return; and the
reinvestment opportunity cost (rate) of the shareholders is same as the realised
yield. If the earnings do not remain stable, this method is not practical.

Example
Mr. Mehra had purchased a share of Alpha Limited for ₦1,000. He received dividend
for a period of five years at the rate of 10 percent. At the end of the fifth year, he sold
the share of Alpha Limited for ₦1,128. You are required to COMPUTE the cost of
equity as per realised yield approach.
Solution
We know that as per the realised yield approach, cost of equity is equal to the realised
rate of return. Therefore, it is important to compute the internal rate of return by
trial and error method. This realised rate of return is the discount rate which equates
the present value of the dividends received in the past five years plus the present
value of sale price of ₦1,128 to the purchase price of ₦1,000. The discount rate
which equalises these two is 12 percent approximately. Let us look at the table given
for a better understanding:

Year Dividend Sale Proceeds Discount Factor @ Present

(₦) (₦) 12% Value (`₦)
1 100 - 0.893 89.3
2 100 - 0.797 79.7
3 100 - 0.712 71.2
4 100 - 0.636 63.6
5 100 - 0.567 56.7
6 Beginning 1,128 0.567 639.576
1,000.076
We find that the purchase price of Alpha limited’s share was ₦1,000 and the present
value of the past five years of dividends plus the present value of the sale price at the
discount rate of 12 per cent is ₦1,000.076. Therefore, the realised rate of return may
be taken as 12 percent. This 12 percent is the cost of equity.

Example
Calculate the cost of equity from the following data using realized yield approach:

Year 1 2 3 4 5
Dividend per share 1.00 1.00 1.20 1.25 1.15
Price per share (at the beginning) 9.00 9.75 11.50 11.00 10.60

22
SOLUTION
In this questions we will first calculate yield for last 4 years and then calculate it
geometric mean as follows:

D +P 1+9.75
1+Y1= 1 1 = =1.1944
P0 9
D2+P2 1+11.50
1+Y2= = =1.2821
P1 9.75
D3+P3 1.2+11
1+Y3= = =1.0609
P2 11.5
D4+P4 1.25+10.60
1+Y4= = =1.0772
P3 11
Geometric mean:
Ke=[(1+Y1)×(1+Y2)×……(1+Yn)]1/n-1
Ke=[1.1944×1.2821×1.0609×1.0772]1/4-1=0.15=15%
Note: to calculate power ¼ simply press square root switch, two times on your
calculator.

Capital Asset Pricing Model (CAPM) Approach

CAPM model describes the risk-return trade-off for securities. It describes the
linear relationship between risk and return for securities.
The risks, to which a security is exposed, can be classified into two groups:
(i) Unsystematic Risk: This is also called company specific risk as the risk is
related with the company’s performance. This type of risk can be reduced or
eliminated by diversification of the securities portfolio. This is also known
as diversifiable risk.
(ii) Systematic Risk: It is the macro-economic or market specific risk under which
a company operates. This type of risk cannot be eliminated by the
diversification hence, it is non-diversifiable. The examples are inflation,
Government policy, interest rate etc.
As diversifiable risk can be eliminated by an investor through diversification, the
non-diversifiable risk is the risk which cannot be eliminated; therefore a business
should be concerned as per CAPM method, solely with non-diversifiable risk.

The non-diversifiable risks are assessed in terms of beta coefficient (b or β) through

fitting regression equation between return of a security and the return on a
market portfolio.

Cost of Equity under CAPM

Thus, the cost of equity capital can be calculated under this approach as:
Cost of Equity (Ke)= Rf + ß (Rm − Rf)
Where,

Ke = Cost of equity capital

Rf = Risk free rate of return
ß = Beta coefficient
Rm = Rate of return on market portfolio
(Rm – Rf) = Market risk premium

24
Risk Return relationship of various securities

Therefore, Required rate of return = Risk free rate + Risk premium

 The idea behind CAPM is that investors need to be compensated in two ways-
time value of money and risk.
 The time value of money is represented by the risk-free rate in the formula and
compensates the investors for placing money in any investment over a period of
time.
 The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This is calculated
by taking a risk measure (beta) which compares the returns of the asset to the
market over a period of time and compares it to the market premium.
The CAPM says that the expected return of a security or a portfolio equals the rate on
a risk-free security plus a risk premium. If this expected return does not meet or beat
the required return, then the investment should not be undertaken.
The shortcomings of this approach are:
(a) Estimation of betas with historical data is unrealistic; and
(b) Market imperfections may lead investors to unsystematic risk.
Despite these shortcomings, the CAPM is useful in calculating cost of equity, even
when the firm is suffering losses.
The basic factor behind determining the cost of equity share capital is to measure the
expectation of investors from the equity shares of that particular company. Therefore,
the whole question of determining the cost of equity shares hinges upon the
factors which go into the expectations of particular group of investors in a
company of a particular risk class.
Example
CALCULATE the cost of equity capital of H Ltd., whose risk free rate of return
equals 10%. The firm’s beta equals 1.75 and the return on the market portfolio equals
to 15%.
Solution
Ke = Rf + ß (Rm − Rf)
Ke = 0.10 + 1.75 (0.15 − 0.10)
= 0.10 + 1.75 (0.05)
= 0.1875 or 18.75%

Cost of Retained Earnings

Like another source of fund, retained earnings involve cost. It is the opportunity
cost of dividends foregone by shareholders.
The given figure depicts how a company can either keep or reinvest cash or return
it to the shareholders as dividends. (Arrows represent possible cash flows or
transfers.) If the cash is reinvested, the opportunity cost is the expected rate of return
that shareholders could have obtained by investing in financial assets.

Cost of Retained Earnings

The cost of retained earnings is often used interchangeably with the cost of
equity, as cost of retained earnings is nothing but the expected return of the
26
shareholders from the investment in shares of the company. However, normally
cost of equity remains higher than the cost of retained earnings, due to issue of
shares at a price lower than current market price and floatation cost.
Formulas used for calculation of cost of retained earnings are same as formulas
used for calculation of cost equity:
D
Dividend Price method: K =
r
P
EPS
Earning Price method: K =
r
P
D1
Growth method: K = +g
r
P0
But for the purpose of calculation of Ke : P = net proceeds realized = issue price
less floatation cost. And for the purpose of calculation of Kr : P = current market
price.

Example
Face value of equity shares of a company is ₦10, while current market price is ₦200
per share. Company is going to start a new project, and is planning to finance it
partially by new issue and partially by retained earnings. You are required to
CALCULATE cost of equity shares as well as cost of retained earnings if issue price
will be ₦190 per share and floatation cost will be ₦5 per share. Dividend at the end
of first year is expected to be ₦10 and growth rate will be 5%.

Kr = DI + g = 10/200 + 0.05 = 10%

Po
Ke = DI + g = 10/(190-5) + 0.05 = 10.41%
Po
 If personal tax is also considered then a shortcut formula may be as follows:
Kr = Ke (1-tp)(1-f)
Here tp is rate of personal tax on dividend and “f” is rate of flotation cost.

Here personal income tax means income tax payable on dividend income by
equity shareholders. Currently dividend income is not taxable in the hands of
investors. Only dividend received in excess of Rs.10 lakhs by an Individual, HUF or
firm from domestic company is taxed at the rate of 10%.
Example: Cost of equity of a company is 20%. Rate of floatation cost is 5%. Rate
of personal income tax is 30%. Calculate cost of retained earnings.
Solution:
Kr = Ke (1-tp)(1-f) = 20% x (1-0.30) x (1-0.05) = 13.3%
Floatation Cost: The new issue of a security (debt or equity) involves some
expenditure in the form of underwriting or brokerage fees, legal and
administrative charges, registration fees, printing expenses etc. The sum of all these
cost is known as floatation cost. This expenditure is incurred to make the securities
available to the investors. Floatation cost is adjusted to arrive at net proceeds for
the calculation of cost of capital.

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ILLUSTRATION
ABC Company provides the following details:
D0 = ` 4.19 P0 = ` 50 g = 5%
CALCULATE the cost of retained earnings.
SOLUTION
D1 D0(1+g) +g
Kr = +g
P0 P0
 4.19(1+0.05)
= +0.05
` 50
= 0.088 + 0.05
= 13.8%
ILLUSTRATION
ABC Company provides the following details:
Rf = 7% ß = 1.20 Rm - Rf = 6%
CALCULATE the cost of retained earnings based on CAPM method.
SOLUTION

Kr = Rf + ß (Rm - Rf)
= 7% + 1.20 (6%)
= 7% + 7.20
Kr = 14.2%

Weighted Average Cost o f Capital (WACC)

To balance financial risk, control over the company and cost of capital, a company
usually does not procure entire fund from a single source. Rather than it makes a
mix of various sources of finance. Hence cost of total capital will be equal to
weighted average of cost of individual sources of finance.
WACC is also known as the overall cost of capital of having capitals from the
different sources as explained above. WACC of a company depends on the capital
structure of a company. It weighs the cost of capital of a particular source of capital
with its proportion to the total capital. Thus, weighted average cost of capital is the
weighted average after tax costs of the individual components of firm’s capital
structure. That is, the after tax cost of each debt and equity is calculated separately
and added together to a single overall cost of capital

30
 The steps to calculate WACC is as follows:
Step 1: Calculated the total capital from all the sources.
(i.e. Long term debt capital + Pref. Share Capital + Equity Share Capital

Step 2: Calculated the proportion (or %) of each source of capital to the total
capital.

Step 3: Multiply the proportion as calculated in Step 2 above with the

respective cost of capital.
(i.e. Ke × Proportion (%) of equity share capital (for example) calculated
in Step 2 above)
Step 4: Aggregate the cost of capital as calculated in Step 3 above. This is the
WACC.
(i.e. Ke + Kd + Kp + Ks as calculated in Step 3 above)

Example:
Calculation of WACC

Capital Component Cost of % of total Total

capital capital structure
Retained Earnings 10% (Kr) 25% (Wr) 2.50% (Kr × Wr)
Equity Share Capital 11% (Ke) 10% (We) 1.10%(Ke× We)
Preference Share Capital 9% (Kp) 15% (Wp) 1.35%(Kp× Wp)
Long term debts 6% (Kd) 50% (Wd) 3.00%(Kd× Wd)
Total (WACC) 7.95%
The cost of weighted average method is preferred because the proportions of various
sources of funds in the capital structure are different. To be representative, therefore,
cost of capital should take into account the relative proportions of different
sources of finance.
Securities analysts employ WACC all the time when valuing and selecting
investments. In discounted cash flow analysis, WACC is used as the discount rate
applied to future cash flows for deriving a business's net present value. WACC can be
used as a hurdle rate against which to assess return on investment capital
performance. Investors use WACC as a tool to decide whether or not to invest. The
WACC represents the minimum rate of return at which a company produces value for
its investors. Let's say a company produces a return of 20% and has a WACC of 11%.
By contrast, if the company's return is less than WACC, the company is shedding
value, which indicates that investors should put their money elsewhere.
Therefore, WACC serves as a useful reality check for investors.

Choice of weights
There is a choice weights between the book value (BV) and market value(MV).
Book Value(BV): Book value weights is operationally easy and convenient.
While using BV, reserves such as share premium and retained profits are included in
the BV of equity, in addition to the nominal value of share capital. Here the value of
equity will generally not reflect historic asset values, as well as the future prospects
of an organisation.
Market Value(MV): Market value weight is more correct and represent a firm’s
capital structure. It is preferable to use MV weights for the equity. While using MV,
reserves such as share premium and retained profits are ignored as they are in effect
incorporated into the value of equity. It represents existing conditions and also
take into consideration the impacts of changing market conditions and the current
prices of various security. Similarly, in case of debt MV is better to be used rather
than the BV of the debt, though the difference may not be very significant.
There is no separate market value for retained earnings. Market value of equity
shares represents both paid up equity capital and retained earnings. But cost of
equity is not same as cost of retained earnings. Hence to give market value weights,
market value equity shares should be apportioned in the ratio of book value of paid up
equity capital and book value of retained earnings.

Example: Cost of equity of a company is 10.41% while cost of retained earnings is

10%. There are 50,000 equity shares of ₦10 each and retained earnings of ₦1,500,000.
Market price per equity share is ₦50. Calculate WACC using market value weights if
there is no other sources of finance.

32
Solution
Book value of paid up equity capital = ₦500,000
Book value of retained earnings = ₦1,500,000
Ratio Paid up equity capital & retained earnings = 500000:1500000 = 1:3
Market value of paid equity capital & retained earnings = 50,000 x ₦50 = ₦2,500,000
Market value of paid up equity capital = ₦2,500,000 x ¼ = ₦625,000
Market value of retained earnings = ₦2,500,000 x ¾ = ₦1,875,000
Calculation of WACC using market value weights

Source of capital Market Weights Cost of WAC

Value capital C
(Ko)
(₦) (a) (b) (c) =
(a)×(b)
Equity shares 625,000 0.25 0.1041 0.0260
Retained earnings 1,875,000 0.75 0.1000 0.0750
2,500,000 1.000 0.1010
WACC (Ko) = 0.1010 or 10.10%
Example:
CALCULATE the WACC using the following data by using:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:

(₦)
Debentures (₦100 per debenture) 500,000
Preference shares (₦100 per share) 500,000
Equity shares (₦10 per share) 1,000,000
2,000,000
The market prices of these securities are:
Debentures ₦105 per debenture
Preference shares ₦110 per preference share
Equity shares ₦24 each.
Additional information:
(1) ₦100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs,
10 year maturity.
(2) ₦100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost
and 10 year maturity.
(3) Equity shares has ₦4 floatation cost and market price ₦24 per share.
The next year expected dividend is ₦1 with annual growth of 5%. The firm has
practice of paying all earnings in the form of dividend. Corporate tax rate is 50%.
Assume that floatation cost is to be calculated on face value.
Solution
Cost of Equity (Ke) = D1 +g = 1 + 0.05 == 0.1 *100 or 10%
P0 -F 24 -4

 RV -NP   100 -NP 

I(1- t)+ 10(1- 0.5)+
 n   n 
  =  
Cost of Debt (Kd) =  RV +NP   RV +NP 
 2   2 

I (1- t) + (RV-NP)
Cost of debenture (Kd) = n
RV+NP
2
10(1-0.5) + (100-96)/10 = 0.055
100+96/2

(RV-NP)
PD+ n
Kp =
(RV+NP)
2
(100-98)
5+ 10
Kp =
(100+98 )
2
= 0.053

34
 4.35
(a) Calculation of WACC using book value weights

Source of capital Book Weights After tax cost WACC (Ko)

Value of capital
(₦) (a) (b) (c) = (a)×(b)
10% Debentures 500,000 0.25 0.055 0.0137
5% Preference shares 500,000 0.25 0.053 0.0132
Equity shares 1,000,000 0.50 0.10 0.0500
Total 2,000,000 0.0769

WACC (Ko) = 0.0769 or 7.69%

(b) Calculation of WACC using market value weights

Source of capital Market Weights After WAC

Value tax cost C
of (Ko)
capital
(₦) (a) (b) (c) =
(a)×(b)
10% Debentures (₦105× 5,000) 525,000 0.151 0.055 0.008
5% Preference shares (₦110× 5,000) 550,000 0.158 0.053 0.008
Equity shares (₦24× 100,000) 2,400,000 0.691 0.10 0.069
3,475,000 1.000 0.085
WACC (Ko) = 0.085 or 8.5%