CHAPTER 5: TIME VALUE OF MONEY Simple interest = $300,000 X 4% X 30 = $360,000

A simple interest rate of 4% annually translates into an annual

Understanding the Time Value of Money interest payment of $12,000. After 30 years, the borrower would have
Time value of money is the concept that money today is worth more made $12,000 x 30 years = $360,000 in interest payments, which
than money tomorrow. That is because money today can be used, explains how banks make their money.
invested, or grown. Therefore, $1 earned today is not the same as $1
earned one year from now because the money earned today can Compound Interest Rate
generate interest, unrealized gains, or unrealized losses. Some lenders prefer the compound interest method, which means
that the borrower pays even more in interest. Compound interest,
What Is the Difference Between Present Value and Future Value? also called interest on interest, is applied both to the principal and
Present value is the time value of money for a series of cash flow that also to the accumulated interest made during previous periods. The
calculates the value of the money today. For example, if you want to bank assumes that at the end of the first year the borrower owes the
find the value of $1,000 to be received one year from now or the principal plus interest for that year. The bank also assumes that at the
value of $2,500 to be received each month for the next two years, you end of the second year, the borrower owes the principal plus the
are trying to find the present value. interest for the first year plus the interest on interest for the first year.
Alternatively, future value is time value of money concept of finding The interest owed when compounding is higher than the interest
the value of a series of cash flows at a point in time in the future. owed using the simple interest method. The interest is charged
You'd be calculating the future value if you want to know what your monthly on the principal including accrued interest from the previous
$500 may be worth in 10 years. You'd also be finding the future value months. For shorter time frames, the calculation of interest will be
if you want to find out what your retirement balance will be if you similar for both methods. As the lending time increases, however, the
contribute $250 every month for 10 years. disparity between the two types of interest calculations grows.

Why Does Time Value of Money Matter? Using the example above, at the end of 30 years, the total owed in
The time value of money helps decision-makers select the best interest is almost $700,000 on a $300,000 loan with a 4% interest
option. Time value of money equalizes options based on timing, as rate.
absolute dollar amounts spanning different time spans should not be The following formula can be used to calculate compound interest:
valued equally. Compound interest = p X [(1 + interest rate)n − 1]
Businesses often use time value of money to compare projects with where:
varying cashflows. Businesses also use time value of money to p = principal
determine whether a project with an initial cash outflow and n = number of compounding periods
subsequent cash inflows will be profitable. Companies may also be
required to use time value of money principles for external reporting What Is Amortization?
requirements. Amortization is an accounting technique used to periodically lower the
Individual investors use time value of money to better understand the book value of a loan or an intangible asset over a set period of time.
true value of their investments and obligations over time. The time Concerning a loan, amortization focuses on spreading out loan
value of money is used to calculate what an investor's retirement payments over time. When applied to an asset, amortization is similar
balance will be in the future. to depreciation.

Understanding Interest Rates Preparing Amortization Schedules

Interest is essentially a charge to the borrower for the use of an asset. Amortization schedules usually have six columns, each
Assets borrowed can include cash, consumer goods, vehicles, and communicating information to the borrower and lender. The six
property. Because of this, an interest rate can be thought of as the columns are often laid out as shown below:
"cost of money" - higher interest rates make borrowing the same
amount of money more expensive. •The period is the timing of each loan payment, often represented on
Interest rates thus apply to most lending or borrowing transactions. a monthly basis. However, each row on an amortization represents a
Individuals borrow money to purchase homes, fund projects, launch payment so if a loan is due bi-weekly or quarterly, the period will be
or fund businesses, or pay for college tuition. Businesses take out the same. This column helps a borrower and lender understand which
loans to fund capital projects and expand their operations by payments will be broken down in what ways. This may either be
purchasing fixed and long-term assets such as land, buildings, and shown as a payment number (i.e., Payment 1, Payment 2, etc.) or a
machinery. Borrowed money is repaid either in a lump sum by a pre- date (i.e. 1/1/2023, 2/1/2023, etc.).
determined date or in periodic installments.
For loans, the interest rate is applied to the principal, which is the •The beginning loan balance is amount of debt owed at the
amount of the loan. The interest rate is the cost of debt for the beginning of the period. This amount is either the original amount of
borrower and the rate of return for the lender. The money to be repaid the loan or the amount carried over from the prior month (last month's
is usually more than the borrowed amount since lenders require ending loan balance equals this month's beginning loan balance).
compensation for the loss of use of the money during the loan period.
The lender could have invested the funds during that period instead •The payment is the monthly obligation calculated above. This will
of providing a loan, which would have generated income from the often remain constant over the term of the loan. Though you usually
asset. The difference between the total repayment sum and the calculate the payment amount before calculating interest and
original loan is the interest charged. principal, payment is equal to the sum of principal and interest.
When the borrower is considered to be low risk by the lender, the
borrower will usually be charged a lower interest rate. If the borrower •The interest portion is the amount of the payment that gets applied
is considered high risk, the interest rate that they are charged will be as interest expense. This is often calculated as the outstanding loan
higher, which results in a higher cost loan. balance multiplied by the interest rate attributable to this period's
portion of the rate. For example, if a payment is owed monthly, this
Simple Interest Rate interest rate may be calculated as 1/12 of the interest rate multiplied
If you take out a $300,000 loan from the bank and the loan by the beginning balance. Always be mindful of how a lender
agreement stipulates that the interest rate on the loan is 4% simple calculates, applies, and compounds your annual percentage rate as
interest, this means that you will have to pay the bank the original this impacts your schedule. As the outstanding loan balance
loan amount of $300,000 + (4% x $300,000) = $300,000 + $12,000 = decreases over time, less interest should be charged each period.
$312,000.
The example above was calculated based on the annual simple •The principal portion is simply the left over amount of the payment.
interest formula, which is: This is the total payment amount less the amount of interest expense
for this period. As the outstanding loan balance decreases over time,
Simple interest = principal X interest rate X time less interest will be charged, so the value of this column should
increase over time.
The individual that took out a loan will have to pay $12,000 in interest
at the end of the year, assuming it was only a one-year lending •The ending loan balance is the difference between the beginning
agreement. If the term of the loan was a 30-year mortgage, the loan balance and the principal portion. This represents the new debt
interest payment will be: balance owed based on the payment made for the new period.
 Companies that plan to go public list their shares on the stock market
and investors purchase those shares, allowing the company to
generate money which they usually use to grow their business. This
type of stock offering is known as an initial public offering (IPO).
Investors can buy and sell their stocks to other investors, and the
stock market will track the performance and set prices depending on
the supply and demand of each stock.

What Is a Stock Cycle?

A stock cycle is the typical evolution of a stock's price from an early
uptrend to price high through to a downtrend and price low.

1.Accumulation: An uptrend starts with the accumulation phase.

This is where institutional investors slowly begin acquiring large
positions in a stock. Investors use support and resistance levels to
find suitable entry points at this stage of the stock cycle. For instance,
investors may start accumulating a security when it nears the lower
end of a well-established trading range.

2.Mark - up: A breakout of the accumulation period starts the mark -

up cycle. Trend and momentum investors make the bulk of their gains
during this phase, as a stock's price continues higher. In this part of
the stock cycle, traders use indicators, such as moving averages
(MA) and trend lines, to help make investment decisions. For
example, an investor may buy a stock if it retraces back to its 20-day
moving average.

3.Distribution: Institutional investors start unwinding their positions at

this stage of the stock cycle. Price action begins to move sideways,
as the bulls and bears fight for control. A bearish technical divergence
between a stock's price and technical indicator often starts to appear
in the distribution phase. For example, a stock's price may make a
higher high while the relative strength index (RSI) makes a lower
high.

4.Markdown: Volatility often increases during this phase, as

investors rush to liquidate their positions. Investors use temporary
retracements to the upside as an opportunity to sell their shares,
while traders look to open short positions to take advantage of falling
prices. Typically, margin calls increase near the conclusion of the
markdown cycle, as stock prices near their lows, which may help
explain the climactic volume often associated with this part of the
CHAPTER 6: BONDS AND STOCKS & THEIR VALUATION stock cycle.

What Are Stocks? BENEFITS OF STOCKS

A stock, also known as equity, is a security that represents the 1. The potential to earn higher returns
ownership of a fraction of the issuing corporation. Units of stock are 2. The ability to protect your wealth from inflation
called "shares" which entitles the owner to a proportion of the 3. The pride of ownership
corporation's assets and profits equal to how much stock they own. 4. Diversification
Stocks are bought and sold predominantly on stock exchanges and 5. Liquidity
are the foundation of many individual investors' portfolios. Stock
trades have to conform to government regulations meant to protect
investors from fraudulent practices. RISKS OF STOCKS
Corporations issue stock to raise funds to operate their businesses 1. You can't stomach the thought of a 10% (or greater) decline in your
and the holder of stock, a shareholder, may have a claim to part of investment.
the company's assets and earnings. 2. You have a lot of high-interest rate debt like credit card debt. Payig
off this debt can often yield higher returns than buying stocks.
Classifications of stocks: 3. You don't have an adequate emergency fund. Having enough cash
There are two main kinds of stocks, common stock and preferred on hand to cover an emergency expense can prevent you from
stock: needing to borrow money with a credit card.

Common stock entitles owners to vote at shareholder meetings and STOCK VALUATION
receive dividends. Stock Valuation in Practice
•The DDM can be calculated through the Gordon growth model
Preferred stockholders usually don’t have voting rights but they (GGM).
receive dividend payments before common stockholders do, and •The GGM assumes that all future dividends will grow at a constant
have priority over common stockholders if the company goes rate.
bankrupt and its assets are liquidated. •The GGM can be calculated through the following formula:
D0 = D1 ÷ (r – g)
Stock Market
The stock market allows buyers and sellers of securities to meet, (Where D0 = current value of the stock, D1 = expected dividend
interact, and transact. The markets allow for price discovery for payment,
shares of corporations and serve as a barometer for the overall r = cost of equity, and g = constant growth rate)
economy. Buyers and sellers are assured of a fair price, high degree
of liquidity, and transparency as market participants compete in the Preferred stock is a type of stock that pays shareholders a specified
open market. dividend and has priority over common stock for receiving dividends.
Despite its name, preferred stock isn’t necessarily preferred by most
How the stock market works investors (though it does have its benefits).
The stock market operates in basically the same way as an auction
house, where buyers and sellers negotiate prices and make trades. FEATURES OF PREFERRED STOCKS
•Equity ownership of a company Bond valuation is a process of determining the fair market price of
•Tradable on public exchanges (for public companies) bond based on factors such as interest rates, bond payments, time
•Have first right to dividends and must be paid before common periods, par value and the time to maturity.
stockholders
•Typically do not have as much capital appreciation
•Typically has no voting rights
•May have the option to be convertible to common stock
•Receives better treatment during liquidations
IMPORTANT FEATURES OF BONDS
Bond Valuation terminologies
Key Features of Bonds 1.Face value – price at which the bond is sold to investors when first
Most bonds have five features when they are issued: issue size, issue issued; it is also the price at which the bond is redeemed at maturity.
date, maturity date, maturity value, and coupon. Once bonds are 2.Coupon rate – percentage of periodic payments
issued, the sixth feature appears, which is yield to maturity. This 3.Coupon payment – amount paid per period; value of periodic
becomes the most important figure for estimating the total yield you payment
will receive by the time the bond matures. 4.Time to maturity – time period until maturity
5.Interest rate – rate of interest applicable in the bond
Issue Size and Date 6.Payment periods – periods that the coupon should be paid
The issue date is simply the date on which a bond is issued and
begins to accrue interest. The issue size of a bond offering is the Method:
number of bonds issued multiplied by the face value. 1.Determine the needed amounts for the valuation, such as the face
value, coupon rate, interest rate, time to maturity and time period.
Maturity Date and Value 2.Calculate the coupon payment for each period until the bond
The maturity date is the date on which you can expect to have your matures, using this formula: CP = face value * coupon rate
principal repaid. It is possible to buy and sell a bond in the open 3.Calculate the price of the bond, using this formula:
market prior to its maturity date. Keep in mind that this changes the
amount of money the issuer will pay you as the bondholder based on
the current market price of the bond.

Coupon and Yield to Maturity

The coupon rate is the periodic interest payment that the issuer
makes during the life of the bond. For instance, a bond with a
$10,000 maturity value might offer a coupon of 5%. Then, you can 4.Identify whether the bond is discounted or premium
expect to receive $500 each year until the bond matures. The term base on its valuation.
“coupon” comes from the days when investors would hold physical
bond certificates with actual coupons; they would cut them off and CHAPTER 7: WORKING CAPITAL MANAGEMENT
present them for payment.
Working Capital Management
TYPES OF BONDS A business technique called working capital
1.Zero coupon bonds - Make no periodic interest payments, but management aims to make sure a firm runs smoothly
instead are offered at a discount from face value, which can be by keeping track of and making the most use of its
redeemed in full at maturity. current assets and liabilities.
2.Convertible bonds - Have typical bond characteristics (maturity Ratio Analysis is mathematical technique for analyzing
date, credit rating) but also include an option to be converted into a company's financial documents, such as the balance
equity of the underlying company. sheet and income statement, to gather knowledge
3.Corporate bonds - Issued by financial institutions or companies to about its liquidity, operational effectiveness, and
fund their operations. profitability.
4.Government bonds - Issued by a government to support spending,
to balance budgets, or even to stimulate the economy. Types of Ratio Analysis
5.High yield / junk bonds - Lower quality bonds which S&P and 1. Liquidity Ratio (current ratio = current asset/ current
Fitch rates BB+ and below and Moody’s Ba1 and below, with a higher liabilities)
yield to compensate for the higher credit risk. 2. Solvency Ratio (Debt ratio = total debt/ total asset)
6.Investment grade bonds - Relatively high quality bonds with a 3. Profitability Ratio (Net margin = Net income/ Sales)
minimum S&P or Fitch rating of BBB-, or a minimum Moody’s rating 4. Efficiency Ratio (Debt ratio= total debt/total asset)
of Baa3. 5. Coverage Ratio
7.Fixed rate bonds - Pay a fixed amount of interest at regular 6. Market prospect Ratio
intervals, hence offer stable return.
8.Floating rate bonds - Pay variable amounts of interest linked to Cash Management
market interest rates, hence the potential for higher, or lower, return Cash management, also known as treasury
as rates rise or fall. management, is the process that involves collecting
and managing cash flows from the operating, investing,
ADVANTAGES OF BONDS and financing activities of a company.
-Legal Protection
-Can generate income through interest or resale The Importance of Cash
-Bonds always pay coupons Cash is the primary asset individuals and companies
-Portfolio diversification use regularly to settle their debt obligations and
operating expenses.
DISADVANTAGES OF BONDS
--Larger investment needed The cash flow statement is divided into three parts:
--Not fully diversified -Investing
--Risks associated -Financing
-Operating activities
RISKS OF BOND INVESTMENT
-Interest rate risk Causes of Problems with Cash Management
-Credit risk 1. Poor understanding of the cash flow cycle
-Inflation risk 2. Lack of understanding of profit versus cash
-Reinvestment risk 3. Lack of cash management skills
-Liquidity risk 4. Bad capital investments

Bond valuation method Accounts receivable management

Accounts receivable management is the process of different types of inventory management, each with its pros and cons,
ensuring that customers pay their dues on time. depending on a company’s needs. 
 
Accounting for Inventory 
Inventory represents a current asset since a company typically
intends to sell its finished goods within a short amount of time,
typically a year. Inventory has to be physically counted or measured
before it can be put on a balance sheet. Companies typically maintain
sophisticated inventory management systems capable of tracking
real-time inventory levels. 
Recording accounts receivable Inventory is accounted for using one of three methods: first-in-first-out
-Establishing the practice of credit transactions (FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average
-Generating invoices for the customer costing. An inventory account typically consists of four separate
-Tracking the payments received and the payment that categories:  
is due to be received
-Accounting for the accounts receivable Raw materials — represent various materials a company purchases
for its production process. These materials must undergo significant
Accounts receivable process work before a company can transform them into a finished good
-Credit rating the paying ability of the customers shall ready for sale. 
be reviewed before agreeing to any terms and Work in process (also known as goods-in-process) — represents
conditions raw materials in the process of being transformed into a finished
-Continuously monitoring any risk of non-payment or product. 
delay in receiving the payments
-Customer relations should be maintained and thus to Finished goods — are completed products readily available for sale
reduce the bad debts to a company’s customers. 
-Addressing the complaints of the customers Merchandise — represents finished goods a company buys from a
-After receiving the payments, the balances in the supplier for future resale. 
particular account receivable should be reduced  
-Preventing any bad debts of the receivables Inventory Management Methods 
outstanding during a particular period. Depending on the type of business or product being analyzed, a
company will use various inventory management methods. Some of
Assessing creditworthiness these management methods include just-in-time (JIT) manufacturing,
-Bank reference materials requirement planning (MRP), economic order quantity
-Trade reference (EOQ), and days sales of inventory (DSI). There are others, but these
-Credit rating/reference agency are the four most common methods used to analyze inventory. 
-Financial statements
-Information from the financial media 1.Just-in-Time Management (JIT) 
-Visit  The method allows companies to save significant amounts of money
and reduce waste by keeping only the inventory they need to produce
Collecting cash and sell products. This approach reduces storage and insurance
-Monthly statement costs, as well as the cost of liquidating or discarding excess
-Chasing letters inventory.
-Chasing phone calls  
-Personal approach 2.Materials Requirement Planning (MRP) 
-Stopping supplies This inventory management method is sales-forecast dependent,
meaning that manufacturers must have accurate sales records to
Payables management-is the handling of a enable accurate planning of inventory needs and to communicate
company’s unpaid debts to third-party vendors for those needs with materials suppliers in a timely manner. 
purchases made on credit. Account payables
management involves tasks such as seeking trade 3. Economic Order Quantity (EOQ) 
credit lines, acquiring favorable terms of purchase, and This model is used in inventory management by calculating the
managing the timing and flow of purchase number of units a company should add to its inventory with each
batch order to reduce the total costs of its inventory while assuming
Importance of management payable constant consumer demand. The costs of inventory in the model
Managing its accounts and staying updated on include holding and setup costs. 
payments and outstanding debts can help a company
control its cash flow and regulate finances. 4. Days Sales of Inventory (DSI) 
This financial ratio indicates the average time in days that a company
• keep payments on time takes to turn its inventory, including goods that are a work in
This may ensure that suppliers deliver products on progress, into sales. DSI is also known as the average age of
time, communicate about delays, offer steady payment inventory, days inventory outstanding (DIO), days in inventory (DII),
plans and continue working with the organization. days sales in inventory or days inventory and is interpreted in multiple
ways. 
•Ensures strategic budget use
If a company develops a gradual payment plan, it can CHAPTER 8: CAPITAL BUDGETING
help it maintain its budget.
Capital Budgeting
Strategies for managing accounts payable  Capital budgeting is a company’s formal process used for
-Centralize your accounts payable evaluating potential expenditures or investments that are significant in
-Automate your accounts payable amount. It involves the decision to invest the current funds for
-Create a supplier portal addition, disposition, modification or replacement of fixed assets. The
-Get to know vendors large expenditures include the purchase of fixed assets like land and
-Pay invoice large batches building, new equipments, rebuilding or replacing existing
equipments, research and development, etc. The large amounts
What Is Inventory Management?  spent for these types of projects are known as capital expenditures.
Inventory management refers to the process of ordering, storing, Capital Budgeting is a tool for maximizing a company’s future profits
using, and selling a company’s inventory. This includes the since most companies are able to manage only a limited number of
management of raw materials, components, and finished products, as large projects at any one time.
well as warehousing and processing of such items. There are
FEATURES OF CAPITAL BUDGETING
1) It involves high risk MODIFIED INTERNAL RATE OF RETURN
2) Large profits are estimated  MIRR or Modified Internal Rate of Return refers to the financial
3) Long time period between the initial investments and estimated metric used to assess precisely the value and profitability of a
returns potential investment or project. It enables companies and investors to
pick the best project or investment based on expected returns.
Nature
 •Long Term Effect
 •High Degree of Risk
 •Huge Funds
 •Irreversible Decision
 •Impact Competitive Strength
 •Impact on Cost Structure

Objectives CHAPTER 10: CONCEPT AND MEASUREMENT OF

-Establishing priorities COST OF CAPITAL
-Cash planning
-Construction planning COST OF CAPITAL
-Eliminating duplication
-Revising plan
Cost of capital is the return (%) expected by investors
Importance of capital budgeting who provide capital for a business. Once this cost is
-Long term effect on profitability paid for, the remaining money is profit. Since it
-Huge investments generates a specific number that determines
-Decision cannot be undone profitability, it’s used to determine the hurdle rate.
-Expenditure control
-Information flow
Cost of capital can be depended upon:
-Helps in investment decision
(a) Demand and supply of capital,
-Wealth maximization
(b) Expected rate of inflation,
-Risk and uncertainty
(c) Various risk involved, and
-Complicacies of investment decisions
(d) Debt-equity ratio of the firm etc.
-National importance
SIGNIFICANCE OF COST OF CAPITAL
Capital Budgeting decision involves two more important
 Maximization of the Value of the Firm
decisions, such as:
 Capital Budgeting Decisions
 Financial Decision
 Decisions Regarding Leasing
 Investment Decision
 Management of Working Capital
 Dividend Decisions
Process and Data Requirements
 Determination of Capital Structure
Step 1-Establishing Investment Goals And objectives
 Evaluation of Financial Performance
Step 2- Determining Risk Tolerance and Appropriate Asset Allocation
Step 3-Creating the Investment Portfolio
FACTORS THAT AFFECT THE COST OF CAPITAL
Step 4-Monitoring and Reporting
1. General Economic Conditions
2. Risk
PAYBACK PERIOD
3. Amount of financed required
The payback period is a method commonly used by investors,
4. Floatation cost
financial professionals, and corporations to calculate investment
5. Taxes
returns. It helps determine how long it takes to recover the initial costs
associated with an investment.
Measurement of Cost of Capital
1. Cost of Debentures
Formula:
2. Cost of Preference Share Capital
Payback = initial investment / Cash flow
3. Cost of Equity or Ordinary Shares
4. Cost of Retained Earnings
CASH FLOW FROM INVESTING
5. Overall or Weighted Average Cost of Capital
Cash flow from investing (CFI) or investing cash flow reports how
much cash has been generated or spent from various investment
Cost of Debentures:
related activities in a specific period. Investing activities include
The capital structure of a firm normally includes the
purchases of speculative assets, investments in securities, or the sale
debt capital. Debt may be in the form of debentures
of securities or assets.
bonds, term loans from financial institutions and banks
etc. The amount of interest payable for issuing
Cash flow for investment Activities formula
debenture is considered to be the cost of debenture or
Free Cash Flow = Net income+ Depreciation/Amortization – Change
debt capital (Kd).
in
Working Capital Expenditure
Cost of debt capital is much cheaper than the cost of
capital raised from other sources, because interest
Operating Cash Flow =Operating Income+ Depreciation- Taxes+
paid on debt capital is tax deductible.
Change in working Capital
(i)When the debentures are issued and redeemable
Cash Flow Forecast = Beginning Cash + Projected Inflows Projected
at par: Kd = r (1 – t)
Outflows = Ending Cash.
(ii) When the debentures are issued at a premium
or discount but redeemable at par: Kd = I/NP (1 – t)
NET PRESENT VALUE
(iii) When the debentures are redeemable at a
 Net present value is the present value of the cash flows at the
premium or discount and are redeemable after ‘n’
required rate of return of your project compared to your initial
period:
investment.
Kd = I(1-t)+1/N(Rv – NP) / ½ (RV – NP)
INTERNAL RATE OF RETURN
Kd = Cost of debenture
 The internal rate of return (IRR) is a metric used in financial
I = Annual interest payment
analysis to estimate the profitability of potential investments.
t = Tax rate
NP = Net proceeds from the issue of debentures
RV = Redeemable value of debenture at the time of This method takes into consideration the earnings per
maturity share (EPS) and the market price of share. Thus, the
cost of equity share capital will be based upon the
COST OF PREFERENCE SHARE CAPITAL expected rate of earnings of a company. The argument
For preference shares, the dividend rate can be is that each investor expects a certain amount of
considered as its cost, since it is this amount which the earnings whether distributed or not, from the company
company wants to pay against the preference shares. in whose shares he invests.
Like debentures, the issue expenses or the If the earnings are not distributed as dividends, it is
discount/premium on issue/redemption are also to be kept in the retained earnings and it causes future
taken into account. growth in the earnings of the company as well as the
increase in market price of the share.
Thus, the cost of equity capital (Ke) is measured by:
Ke = E/P

E = Current earnings per share

(i)The cost of preference shares P = Market price per share.
(KP) = DP / NP
If the future earnings per share will grow at a constant
DP = Preference dividend per share rate ‘g’ then cost of equity share capital (Ke) will be
NP = Net proceeds from the issue of preference Ke = E/P+ g
shares.
This method is similar to dividend/price method. But it
(ii) If the preference shares are redeemable after a ignores the factor of capital appreciation or
period of ‘n’, the cost of preference shares (KP) will depreciation in the market value of shares. Adjustment
be: of Floatation Cost There are costs of floating shares in
market and include brokerage, underwriting
NP = Net proceeds from the issue of preference commission etc. paid to brokers, underwriters etc.
shares These costs are to be adjusted with the current market
RV = Net amount required for redemption of price of the share at the time of computing cost of
preference shares equity share capital since the full market value per
DP = Annual dividend amount. share cannot be realized.
So, the market price per share will be adjusted by (1 –
There is no tax advantage for cost of preference f) where ‘f’ stands for the rate of floatation cost.
shares, as its dividend is not allowed deduction from
income for income tax purposes. The students should Thus, using the Earnings growth model the cost of
note that both in the case of debt and preference equity share capital will be: Ke = E / P (1 – f) + g
shares, the cost of capital is computed with reference
to the obligations incurred and proceeds received. The COST OF RETAINED EARNINGS
net proceeds received must be taken into account The profits retained by a company for using in the
while computing cost of capital. expansion of the business also entail cost.
When earnings are retained in the business,
COST OF EQUITY OR ORDINARY SHARES shareholders are forced to forego dividends. The
The funds required for a project may be raised by the dividends forgone by the equity shareholders are, in
issue of equity shares which are of permanent nature. fact, an opportunity cost. Thus retained earnings
These funds need not be repayable during the lifetime involve opportunity cost.
of the organization. If earnings are not retained, they are passed on to the
Calculation of the cost of equity shares is complicated equity shareholders who, in turn, invest the same in
because, unlike debt and preference shares, there is new equity shares and earn a return on it. In such a
no fixed rate of interest or dividend payment. case, the cost of retained earnings (Kr) would be
Cost of equity share is calculated by considering the adjusted by the personal tax rate and applicable
earnings of the company, market value of the shares, brokerage, commission etc. if any.
dividend per share and the growth rate of dividend or
earnings. Many accountants consider the cost of retained
earnings as the same as that of the cost of equity
(i)Dividend/Price Ratio Method: share capital. However, if the cost of equity share
An investor buys equity shares of a particular company capital i9 computed on the basis of dividend growth
as he expects a certain return (i.e.dividend). The model (i.e., D/P + g), a separate cost of retained
expected rate of dividend per share on the current earnings need not be computed since the cost of
market price per share is the cost of equity share retained earnings is automatically included in the cost
capital. Thus, the cost of equity share capital is of equity share capital.
computed on the basis of the present value of the Therefore, Kr = Ke = D/P + g
expected future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured OVERALL OR WEIGHTED AVERAGE COST OF
by: Ke = D/P CAPITAL

D = Dividend per share

P = Current market price per share.

If dividends are expected to grow at a constant rate of

‘g’ then cost of equity share capital (Ke) will be Ke =
D/P + g. This method is suitable for those entities
where growth rate in dividend is relatively stable. But
this method ignores the capital appreciation in the
value of shares. A company which declares a higher
amount of dividend out of given quantum of earnings
will be placed at a premium as compared to a company
which earns the same amount of profits but utilizes a
major part of it in financing its expansion program.

(ii) Earnings/Price Ratio Method: