COST OF CAPITAL

Cost of
Capital

Cost of Cost of Combination of

Cost of Cost of
Preference Retained Cost and Weight
Debt Equity
Share Earning of each sources of
Capital

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
chapter 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.
 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:
(i) Evaluation of investment options: The estimated benefits (future cash flows)
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.
(ii) 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.
(iii) 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 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 Share 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. (In
the next chapter we will discuss in detail about the sources of long term debt.).
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 Rs.100 each, this means the face value is Rs. 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 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.
(Rs. in (Rs. in
lakh) lakh)
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 Rs.14 lakh (Rs. 40 lakh paid as interest × 35% tax
rate). Therefore the effective interest is Rs. 26 lakh 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
time of the company is calculated as below:

K=

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.

Cost of Redeemable Debentures

The cost of redeemable debentures will be calculated as below:

I1- t +
RV-NP
Cost of Redeemable Debenture (Kd) = n
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.
 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 categorized 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
Cost of Redeemable Preference Shares Kp = n
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.
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.
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:
Where,
PD
Cost of Irredeemable Preference Share (KP) =

PD = Annual preference dividend

P0= Net proceeds in issue of preference shares

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:

Where,
Ke= Cost of equity
D = Expected dividend
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 Rs. 150
 30 
×100  for each share of Rs. 100.
 20 
 
Earnings/ Price Approach:
E
Cost of Equity (Ke ) =

Where,
E = Current earnings per share
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
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:

Financial Management Notes by CA Niharika Lakhera

 D1
Cost of Equity (Ke)= +g
P0 -F
Where, F = Flotation cost per share

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.

Financial Management Notes by CA Niharika Lakhera

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

Risk Return relationship of various securities

Financial Management Notes by CA Niharika Lakhera

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.

Financial Management Notes by CA Niharika Lakhera

WEIGHTED AVERAGE COST OF 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

Financial Management Notes by CA Niharika Lakhera

 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
+ Retained Earnings)
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

Financial Management Notes by CA Niharika Lakhera

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.