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THE COST OF CAPITAL

 Centre for Financial Management , Bangalore

 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

 Centre for Financial Management , Bangalore

 COST OF DEBT
n I M
P0 =  +
t = 1 (1 + rD)t (1 + rD)n
P0 = current price of the debenture
I = annual interest payment
n = number of years left to maturity
M = maturity value
rD is computed through trial-and-error. A very close
approximation is:
I + (M – P0)/n
rD =0.6P + 0.4M
0

 Centre for Financial Management , Bangalore

A company has 10% perpetual debt of Rs. 1,00,000
The tax rate is 35%. Calculate the cost of debt
Assuming that the debt is issued at 10% discount, at par
and 10% premium

Cost of Debt = Interest Expense (1 – Tax Rate)

Issue Proceeds

Kd= 10000/90000
Pre tax kd = 11.11%
Post tax kd =11.11 % * .65 = 7. 2%
Unsolved question

A company has issued 10% debentures

aggregating Rs. 100000. The floatation cost is
4%. The company has agreed to repay
debenture at par in 5 equal instalments starting
at the end of year 1. The company’s tax rate is
35%. Find the cost of debt
 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.

 Centre for Financial Management , Bangalore

 ILLUSTRATION
Face value : Rs.100
Dividend rate : 11 percent
Maturity period : 5 years
Market price : Rs.95

Approximate yield :
11 + (100 – 95) / 5
= 12.37 percent
0.6 x 95 + 0.4 x 100

 Centre for Financial Management , Bangalore

 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.

 Centre for Financial Management , Bangalore

 Dividend growth model and cost of equity
The DGM is commonly expressed as a formula in two different forms:
Ke = (D1 / P0) + g
or (rearranging the formula)
P1 = D1 / (Ke - g)
Where:
P0 = net proceeds from share/ market price today.
D1 = expected future dividend at Time 1 period later.
Ke = cost of equity per period.
g = constant periodic rate of growth in dividend from Time 1 to infinity.

Illustration

Suppose that dividend per share of a firm is expected to be Re 1 next year and
is expected to grow at a rate of 6 % annually perpetually.
a. Determine the cost of equity assuming that the market price per share is Rs.
25
b. Determine the price of equity share at the end of year 1 and 2
CAPITAL ASSET PRICING METHOD
APPROACH (CAPM)
CAPM describes the relationship between cost of equity
and the non diversifiable risk of a firm measured by beta
coefficient. So the cost of equity is ascertained as
kE = Rf + E (RM – Rf ]
kE = required return on the equity of the company
Rf = risk-free rate
E = beta of the equity of the company
RM = expected return on the market portfolio

 Centre for Financial Management , Bangalore

 INPUTS FOR THE CAPM
While there is disagreement among finance practitioners, the
following would serve.
• The risk-free rate may be estimated as the yield on long-

term bonds that have a maturity of 10 years or more.

• The market risk premium may be estimated as the
difference between the average return on the market
portfolio and the average risk-free rate over the past 10
years.
• The beta of the stock may be calculated by regressing the
monthly returns on the market index over the past 36
months or so.
 Centre for Financial Management , Bangalore
 ILLUSTRATION

Calculate cost of equity of H Ltd

Risk free rate of return is 10%

Beta is 1.5
Return on market portfolio is 12.5%
 DIVIDEND GROWTH MODEL APPROACH

Cost of equity or kE is 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 the share
 DETERMINING THE
PROPORTIONS OR WEIGHTS
• The appropriate weights are the target capital structure
weights stated in market value terms.
• The primary reason for using the target capital structure
is that the current capital structure may not reflect the
capital structure expected in future.
• Market values are superior to book values because in
order to justify its valuation the firm must earn
competitive returns for shareholders and debt holders on
the current (market) value of their investments.

 Centre for Financial Management , Bangalore

WEIGHTED AVERAGE
COST OF CAPITAL (WACC)

WACC = wErE + wprp + wDrD (1 – tc)

wE = proportion of equity
rE = cost of equity
wp = proportion of preference
rp = cost of preference
wD = proportion of debt
rD = pre-tax cost of debt
tc = corporate tax rate
 Centre for Financial Management , Bangalore
 KEY POINTS

• Only three types of capital (equity; nonconvertible,

non callable preference; and nonconvertible, non callable
debt) are considered.

• Debt includes long-term debt as well as short-term debt.

• Non-interest bearing liabilities, such as trade creditors,

are not included in the calculation of WACC.

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COMPANY COST OF CAPITAL AND
PROJECT COST OF CAPITAL

• The company cost of capital is the rate of return

expected by the existing capital providers.
• The project cost of capital is the rate of return expected
by capital providers for a new project the company
proposes to undertake
• The company cost of capital (WACC) is the right
discount rate for an investment which is a carbon copy
of the existing firm.

 Centre for Financial Management , Bangalore

 WACC

Source of Capital Proportion Cost Weighted Cost

(1) (2) [(1) x (2)]
  Debt 0.60 16.0% 9.60%
Preference 0.05 14.0% 0.70%
Equity 0.35 8.4% 2.94%
  WACC = 13.24%

 Centre for Financial Management , Bangalore

Problem
From the following capital structure of XYZ Ltd,
calculate the weighted average cost of capital
 
Equity shares Rs. 38,00,000
Preference shares Rs. 8,00,000
Debentures Rs. 50,00,000
Bank loan (long term) Rs. 18,00,000
Bank Loan (short term) Rs. 14,00,000
Trade Creditors Rs. 6,00,000
 
Additional information
• Equity shares have a current market price of Rs.
40 per share and the projected DPS is Rs. 5 per
share with a growth of 6.25%
• Dividend indicated on Preference share is 12%
• Pre tax interest on long term Bank Loan is 12 %
& Corporate tax is 35%.
• Pre tax cost of Debenture is 11%
• Market value of Preference share is Rs. 8,50,000