Overview of cost of capital

1. Cost of Capital
Dr. Ankit Jain

2. Cost of Capital
• Cost of capital is the minimum rate of return expected by its investors.
• Cost of capital for a firm may be defined as the cost of obtaining the
funds.
• Cost of capital is that minimum rate of return, which a firm must earn
on its investment in order to satisfy investors and to maintain its
market value.
• It is also known as cut-off rate, target rate, hurdle rate, minimum
required rate of return

3. Various Sources of Funds
• Cost of Debt
• Cost of Preference share capital
• Cost of Equity share capital
• Cost of Retained Earnings

4. Significance of Cost of Capital
• Helpful in designing the capital structure.
• Helpful in Capital Budgeting Decision.
• Helpful in efficiency of top management.
• Helpful in comparative analysis of various sources of finance.

5. Cost of Debt
• Irredeemable debt is debt that has no specific redemption date or
maturity period. The issuing authority or entity pays a specified
interest rate periodically but provides no data on when principal will
be returned.
• Redeemable debt which the company has issued for a limited period of
time. On completion of the time for which they were issued, principal
amount will be returned.

6. Cost of Debt
i) Cost of Irredeemable Debt
Pre tax cost 𝐾 𝐷 =
𝐼
𝑁𝑃
× 100
Post tax cost 𝐾 𝐷 =
𝐼
𝑁𝑃
× 100 (1-t)
ii) Cost of Redeemable Debt
Pre tax cost 𝐾 𝐷 =
I+
(RV−NP)
N
(RV+NP)
2
×100
Post tax cost 𝐾 𝐷 =
I+
(RV−NP)
N
(RV+NP)
2
×100 (1-t)

7. Q.1 A company issued 5000, 8% debenture of Rs. 100 each. Cost of issue is 2%.
Calculate cost of debt if these are issued (a) at par , (b) at 10% premium, and (c)
at 5% discount. Assume tax rate is 40%.
Q.2 Y Ltd issued Rs. 2,00,000, 9% debentures of Rs 100 each at a premium of
10%. The costs of floatation are 2% . The tax rate is 50%. Compute the after tax
cost of debt. (4.17%)
Q.3 A company issued 1,000 10% redeemable debentures of Rs 100 each at a
discount of 5%. The cost of floatation amount to Rs. 3,000. The debentures are
redeemable at par after 5 years. Compute pre tax and post tax cost of debt. The
tax rate is 50%. (6.04%)

8. Cost of Preference Shares
i) Cost of Irredeemable Preference Shares
Post tax cost 𝐾 𝑃 =
𝐷
𝑁𝑃
× 100
Pre tax cost 𝐾 𝑃 =
𝐾 𝑃 (𝑝𝑜𝑠𝑡 𝑡𝑎𝑥)
1−𝑡
ii) Cost of Redeemable Preference Shares
Post tax cost 𝐾 𝑃 = =
D+
(RV−NP)
N
(RV+NP)
2
×100
Pre tax cost 𝐾 𝑃 =
𝐾 𝑃 (𝑝𝑜𝑠𝑡 𝑡𝑎𝑥)
1−𝑡

9. Q.4 A company issued 10,000, 10% preference share of Rs. 10 each, Cost of
issue is Rs. 2 per share. Calculate cost of capital, of these shares are issued (a) at
par (b) at 10% premium and (c) at 5% discount. Assume tax rate is 50%.
(12.5%, 11.11% & 13.33%)
Q.5 A company issues 1,00,000 10% preference share of Rs. 10 each at 5%
discount. Calculate the cost of preference capital if it is redeemable after 10
years. a) At par b) at 5% premium. Assume tax rate is 50%. (10.76% & 11%)
Q.6 XYZ company issued 14% preference share of face value of Rs 100 each to
be redeemed after 10 years at par. It involves brokerage cost 3%, advertising cost
1% and printing expenses 1%.Determine cost of preference share. Assume tax
rate is 50%. (14.87%)

10. Cost of Equity Share Capital
i) Dividend Approach
a. When there is no growth in dividend
Post tax cost 𝐾 𝐸 =
𝐷𝑃𝑆
𝑀𝑃 𝑜𝑟 𝑁𝑃
× 100
b. When there is growth in Dividend
Post tax cost 𝐾 𝐸 =
𝐷𝑃𝑆
𝑀𝑃 𝑜𝑟 𝑁𝑃
× 100 + G
ii) Earning Approach
Post tax cost 𝐾 𝐸 =
𝐸𝑃𝑆
𝑀𝑃 𝑜𝑟 𝑁𝑃
× 100

11. iv) Capital Asset Pricing Model (CAPM)
• CAPM describes the relationship between systematic risk and expected
return for particular stock.. It is widely used for calculating cost of equity
capital.
• Systematic risk cover macroeconomic environmental factors such as inflation,
change in the government policies and political issues. It is an uncontrollable
risk. This risk is measured by Beta.
• Beta is a numeric value that measures the fluctuations of a stock to changes in
the overall stock market.
• Unsystematic risk is a risk related to the company. The problems relating to
management, staff, expenses, losses, strikes etc.

12. Capital Asset Pricing Model
Post tax cost 𝐾 𝐸 = 𝑅 𝐹 + 𝛽(𝑅 𝑀 − 𝑅 𝐹)
𝑅 𝐹 = Rate of Required on a risk free security
𝑅 𝑀 = Expected rate of return on all assets or market portfolio
𝛽 = Beta coefficient
Pre tax cost 𝐾 𝐸 =
𝐾 𝐸 (𝑝𝑜𝑠𝑡 𝑡𝑎𝑥)
(1−𝑡)

13. Interpretation of Beta value
• If beta is greater than 1, the required return of the stock is greater than
the market return.
• If the beta is 1, the stock return would be equal to the market return.
• If less than 1, a stock return would be less than the market return.
• If beta is negative would mean an investment that moves in the
opposite direction from the stock market.

14. Q.7 A company issues, 10,000 equity shares of Rs. 100 each at a premium of
10%. The company has been paying 20% dividend to equity shareholders for the
past five years and expected to maintain the same in the future also. Compute cost
of equity capital. (18.18%)
Q.8 ABC Ltd plans to issued 1,00,000 new equity share of Rs. 10 each at par. The
floatation costs are expected to be 5% of the share price. The company pays a
dividend of Rs. 1 per share at the end of the year and the growth rate in dividend
is expected to be 5%. Compute the cost of new issue share.
(15.53%)
Q.9 XYZ Ltd is planning for an expenditure of Rs. 120 lakhs for its expansion
programme. Number of existing equity shares are 20 lakhs and the market value
of equity shares is Rs. 60. It has net earnings of Rs. 180 lakhs. Compute the cost
of existing equity share. (15%)

15. Q.10 ABC Ltd. Is interested to calculate the cost of equity using CAPM approach. The
following information is provided by the firm’s investment advisors along with the
firm’s own analysis, it is found that the risk free rate of return equals to 6% and the
firms beta equal to 1.6 and the return on market portfolio equals 13%.
(17.2%)
Q.11 Assume that risk free rate of return is 9% and return on market portfolio is 18%. If
the security has a beta factor of a) 1.4, b) 1 and c) 2.3. Calculate cost of equity or
expected return of the security. (21.7%,18% & 29.7%)
Q.12 Assume the risk free rate of return of is 10%. Firms beta value is 1.25 and market
return on portfolio is 12.25%. Find cost of equity through CAPM method.
(12.81%)

16. Q.
Company A Company B Company C
Risk Free Rate 2.50% 2.50% 2.50%
Beta 2.15 1.02 0.647
ERP 6.00% 6.00% 6.00%
Compute cost of equity using CAPM approach? Comment on it ?

17. Cost of Retained Earnings
Kr =
D 1−Tp 1−B
MP
×100
Kr= Cost of Retained Earnings
D= Dividend per share
Tp= Personal or dividend tax rate for shareholder
B= Brokerage
MP= Market price per share

18. Q.13 Calculate cost of retained earning from the following
information:
1.Current Market price of share Rs 140
2.Cost of floatation/Brokerage per share 3% of market price per share
3.Expected dividend per share Rs 14
4. Shareholder personal income tax rate 22% (7.57%)
Q.14 A firm’s cost of equity (Ke) is 18%, the personal income tax rate
of shareholders is 30% and brokerage cost of 2% is excepted to be
incurred while investing their dividends in alternative securities.
Compute the cost of retained earnings. (12.35%)

19. Weighted Average Cost of Capital(WACC) or Overall Cost
of Capital
Ko =
WX
W
Q.15 Following is the capital structure of XYZ ltd:
Amount Cost of Capital
(post tax)
Equity Share capital 3,50,000 12%
Retained Earnings 2,00,000 10%
Preference share cap. 1,50,000 13%
Debentures 3,00,000 09%
You are required to calculate the WACC. (10.85%)

20. Q.16 The capital structure of Ram ltd. is as follows:
Equity Share Capital(100 each) 4,00,000
7%Debenture of Rs 100 each 2,50,000
9% Preference share of Rs 100 each 2,50,000
Retained Earnings 1,00,000
The company has earned 20 per share on equity capital. The
corporate personal tax rate is 50% and personal tax rate is 25%.
Calculate the weighted average cost of capital. (10.725%)

21. Q.17 The capital structure of Shyam ltd. Is as follows:
Equity shares (Rs 10 each) 20,00,000
Retained earnings 10,00,000
9% Preference Shares(Rs 100 each) 5,00,000
12% Debentures (Rs 100 each) 15,00,000
The equity shares of the company sales for Rs 30. It is expected that will
pay dividend of Rs 3 per share this year. Corporate tax rate is 50%. Assume
20% as income tax rate on personal income of share holders. Compute a
weighted average cost of capital. (8.3%)

22. Case Study
Q.18 The capital structure of the company is:
8 % Debenture(100 per debenture) of Rs 8,00,000
10% Preference Shares ( 100 per share) of Rs 2,00,000
Equity Shares (10 per share) of Rs.10,00,000
Anticipated external financing opportunities are:
i)Rs 100 per debenture redeemable at par after 20 years at 4 % flotation cost, sale
price Rs 100.
ii)Rs 100 per preference share redeemable at par after 15 years at 5 flotation cost,
sale price Rs 100.
iii) Equity shares sell at Rs 22 with Rs 2 per share brokerage.

23. Dividend expected on the equity share at the end of the year is Rs 2 per
share, the anticipated growth rate in dividend is 5% and the company
has the practice of paying all its earning in the form of dividends. The
corporate tax rate is 50%.
You are required to calculate weighted average cost of capital using
book value weight and market value weight.
(10.23%,12.02%)

24. Case Study
Q.19 The following is the capital structure of Simons company Ltd. as on 31st
March 2017:
Equity share: 10,000 shares of Rs 100 each at Rs 10,00,000
12% Preference shares of Rs 100 each at Rs 4,00,000
10% Debentures of Rs 100 each at Rs 6,00,000
The market price of the company’s equity share is Rs 110 and it is expected that a
dividend of Rs 10 per share declared at the end of the year. The dividend growth
rate is 6 per cent.

25. (i) If the company is in the 35 per cent tax bracket, compute the
weighted average cost of capital.
(ii) Assuming that in order to finance an expansion plan, the company
intends to borrow a fund of Rs 10 lakh at 12 per cent rate of interest,
What will be the company’s revised weighted average cost of capital?
This financing decision is expected to increase dividend from Rs 10 to
Rs 12 per share. However, the market price of equity share is expected
to decline from Rs 110 to Rs 105 per share.
(11.89%,11.31%)