COST OF CAPITAL

KEVIN D. ASENTISTA
This Chapter includes:

• Cost of Capital - Key Concepts

• Importance
• Classification
• Determination of Cost of Capital
• Computation
• Weighted Average Cost of Capital
COST OF CAPITAL - KEY CONCEPTS

• The term cost of capital refers to the

minimum rate of return a firm must earn on
its investments.
• This is in consonance with the firm's overall
object of wealth maximization.
• Cost of capital is a complex, controversial
but significant concept in financial
management.
Meaning of Cost of Capital
• Cost of capital is the rate of return that a
firm must earn on its project investments to
maintain its market value and attract funds.
• Cost of capital is the required rate of return
on its investments which belongs to equity,
debt and retained earnings.
• If a firm fails to earn return at the expected
rate, the market value of the shares will fall
and it will result in the reduction of overall
wealth of the shareholders.
Definitions
• John J. Hampton: The cost of capital may be
defined as “the rate of return the firm requires
from investment in order to increase the value
of the firm in the market place”.
• James C. Van Horne: The cost of capital is “a
cut-off rate for the allocation of capital to
investments of projects. It is the rate return on
a project that will leave unchanged the market
price of the stock.
Definitions
• Solomon Ezra: “Cost of Capital is the
minimum required of earnings of the cut-off
rate capital expenditure”.

• William and Donaldson: “Cost of capital may

be defined as the rate that must be earned on
the net proceeds to provide the cost elements
of the burden at the time they are due”.
There are three basic aspects of the concept of cost of capital:

i. Not a cost as such: In fast the cost of capital is not a

cost as such, it is the rate of return that a firm requires
to earn from its projects.
ii. It is the minimum rate of return: A firm's cost of
capital is that minimum rate of return which at least
maintain the market value of the share.
iii. It comprises three components:
K = ro + b + f
Where, K = cost of capital, ro = return at zero risk
level, b = premium for business risk, which refers to the
variability in operating profit (EBIT) due to changes in
sales, and f = premium for financial risk which is related to
the pattern of capital structure.
IMPORTANCE OF COST OF CAPITAL
• Capital budgeting decisions: The cost of
capital is used for discounting cash flows
under Net Present Value method for
invesment proposals. So, it is very useful in
capital budgeting decisions.
• Capital Structure decisions: An optimal
capital is that structure at which the value of
the firm is Value of the firm is maximum and
cost is the lowest. So, cost of capital is crucial
in designing optimal capital structure.
IMPORTANCE OF COST OF CAPITAL
• Evaluation of final performance: Cost of
capital is used to evaluate the financial
performance of top management. The actual
profitability is compared to the expected and
actual cost of capital of funds and if profit is
greater than the cost of capital the
performance may be said to be satisfactory.
• Other financial decisions: Cost of capital is
also useful in making such other financial
decsions as dividend policy, capitalization of
profits, making the rights issue, etc.
CLASSIFICATION OF COST OF CAPITAL

• Historical Cost and Future Cost: Historical

costs are book costs relating to the past,
while future costs are estimated costs act as
guide for estimation of future costs.
• Specific Costs and Composite Costs:
Specific cost is the cost if a specific source
of capital, while composite costs is
combined cost of various sources of capital.
CLASSIFICATION OF COST OF CAPITAL

– Composite Cost, also known as the

Weighted Average Cost of Capital,
should be considered in capital and
capital budgeting decisions.
CLASSIFICATION OF COST OF CAPITAL

• Explicit and Implicit Cost: Explicit cost of

any source of finance is the discount rate
which equates the present value of cash
inflows with the present value of cash
inflows and with the present value of cash
outflows. It is the internal rate of return and
is calculated with the following formula;
CLASSIFICATION OF COST OF CAPITAL

Io = C1 / (I+K)1 + C2 / (I+K)2 +...+ Cn / (I+K)n

Io = Net cash inflow received at zero of time

C = Cash outflows in the period concerned
K = Explicit cost of capital
N = Duration of time period

– Implicit cost also known as the opportunity cost is the

opportunity foregone in order to take up a particular
project.
CLASSIFICATION OF COST OF CAPITAL

• Average Cost and Marginal Cost: An

average cost is the combined cost or
weighted average cost of various sources of
capital. Marginal cost refers to the average
cost of the capital of new or additional
funds required by a firm. It is the marginal
cost which should be taken into
consideration in an investment decisons.
DETERMINATION OF COST OF CAPITAL

Problems in determination of cost of capital:

• Conceptual controversy regarding the
relationship between cost of capital and
capital structure is a big problem.
• Controversy regarding the relevance or
herwise of historic costs for future costs in
decision making process.
DETERMINATION OF COST OF CAPITAL

• Re-computation of cost of equity capital

depends upon the excepted rate of return by
its investors. But the quantification of
expectations of equity shareholders is
difficult task.
• Retained earnings has the opportunity cost
of dividend forgone by the shareholders.
DETERMINATION OF COST OF CAPITAL

• Since different shareholders may have

different opportunities for reinvesting
dividends, it is very difficult to compute
cost of retained earnings.
• Whether to use book value or market value
weights in determining weighted average
cost of capital poses another problems.
 COMPUTATION OF COST OF CAPITAL

Computation of cost capital of a firm involves the

following steps:

i. Computation of the cost of specific sources

of a capital, viz., debt, preference capital,
equity and retained earnings, and
ii. Computation of weighted average cost of
capital.
Measurment of Cost of Capital
• Cost of Equity
• Cost of Debt
• Cost of Preference Share
• Cost of Retained Earnings
 Cost of Equity
• Cost of equity 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 prices (D/P) approach

• Dividend price plus growth (D/P + g)
approach
• Earning price (E/P) approach
• Realized yield approach.
 Dividend Price Approach

K e = D / Np

Where,

Ke = Cost of equity capital

D = Dividend per equity share
Np = Net proceeds of an equity share
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?
Dividend Price Plus Growth Approach

K e = D / Np + g

Where,

Ke = Cost of equity capital

D = Dividend per equity share
Np = Net proceeds of an equity share
g = Growth in expected dividend
(a) 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%. 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.
The current market price of t shares of A Ltd. is Rs. 95. The floatation
costs are Rs. 5 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 shar capital.
 Earning Price Approach

Ke = E / Np
Where,

Ke = Cost of equity capital

E = Earning per equity share
Np = Net proceeds of an equity share
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. 10
Net earnings = Rs. 100 lakhs
Compute the cost of existing equity share capital and of new equity
capital assuming that new shares will be issued at a price of Rs 92 per
share and the cost of new issue will be Rs. 2 per shares.
 Realized Yield Approach

Ke = PVƒ * D

Where,
Ke = Cost of equity capital.
PV ƒ = Present value of discount factor.
D = Dividend per share.
 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 or redeemable.
Debt Issued at Par
• Debt issued at par means, debt is issued at
the face value of the debt.
Ke = (1 - t) R
Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount
(a) A Ltd. issues Rs. 10,00,000, 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 atation are 2%. The tax rate applicable is
50%. Compute the cost of debt-capital.
Cost of Perpetual Debt and Redeemable Debt
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%.
Cost of Preference Share Capital
– 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
redeemable preference share capital is
calculated with the help of the following
formula:
Redeemable Preference Share Capital

Kp = Dp / Np

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
Irredeemable Preference Share
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) of a
debentures of 6%.
 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.
Formula:

Kr = Ke (1 - t) (1 - b)
Where,
Kr = Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b = Brokerage cost
A firm’s Ke (return available to shareholders) is 10%, the average tax rate
of shareholdersis 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?
Measurement of Overall Cost of Capital

• It is also called as weighted average cost of

capital and composite cost of capital.
• Weighted average cost of capital is the
expected average future cost of funds over
the long run found by weighting the cost of
each specific type of capital by its
proportion in the firms capital structure.
The computation of the overall cost of capital
(Ko) involves the following steps.

(a) Assigning weights to specific costs.

(b) Multiplying the cost of each of the sources

by the appropriate weights.

(c) Dividing the total weighted cost by the

total weights.
Formula:
Ko = Kd Wd + Kp Wp + Ke We + Kr Wr
Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the
following formula also:

Kw =  XW / W

Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of
finance.
Example:
Reference:
• FINANCIAL MANAGEMENT
– C. Paramasivan
– T. Subramanian
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