COST OF CAPITAL

LEARNING OUTCOMES

 Discuss the need and sources of finance to a business entity.

 Discuss the meaning of cost of capital for raising capital from
different sources of finance.
 Measure cost of individual components of capital
 Calculate weighted cost of capital and marginal cost of
capital, Effective Interest rate.

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)
 4.2 FINANCIAL MANAGEMENT

4.1 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.

4.2 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.

4.3 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 cashflows)
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.
 COST OF CAPITAL 4.3

(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.

4.4 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.
 4.4 FINANCIAL MANAGEMENT

Cost of
Equity

Weighted
Cost of
Average Cost Cost of Pref.
Retained
of Capital Share Capital
Earnings
(WACC)

Cost of
Long term
Debt.

4.5 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.
4.5.1 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 `100 each, this means the face value is ` 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.
 COST OF CAPITAL 4.5

(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.
(` in lakh) (` in 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 `14 lakh (` 40 lakh paid as interest × 35%
tax rate). Therefore the effective interest is ` 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
 4.6 FINANCIAL MANAGEMENT

4.5.2 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:
I
Kd= (1- t)
NP

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.
Suppose a company issues 1,000, 15% debentures of the face value of `100 each
at a discount of `5. Suppose further, that the under-writing and other costs are
` 5,000/- for the total issue. Thus ` 90,000 is actually realised, i.e., ` 1,00,000 minus
` 5,000 as discount and ` 5,000 as under-writing expenses. The interest per annum
of `15,000 is therefore the cost of ` 90,000, actually received by the company. This
is because interest is charge on profit and every year the company will save ` 7,500
as tax, assuming that the income tax rate is 50%. Hence the after tax cost of ` 90,000
is ` 7,500 which comes to 8.33%.
ILLUSTRATION 1
Five years ago, Sona Limited issued 12 per cent irredeemable debentures at ` 103, at
` 3 premium to their par value of ` 100. The current market price of these debentures
is ` 94. If the company pays corporate tax at a rate of 35 per cent CALCULATE its
current cost of debenture capital?
SOLUTION
Cost of irredeemable debenture:
I
Kd = 1- t
NP
` 12
Kd = 1- 0.35 = 0.08297 or 8.30%
` 94
 COST OF CAPITAL 4.7

4.5.3 Cost of Redeemable Debentures (using approximation method)

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.
The above formula to calculate cost of debt is used where only interest on debt is
tax deductable. Sometime, debts are issued at discount and/ or redeemed at a
premium. If discount on issue and/ or premium on redemption are tax deductible,
the following formula can be used to calculate the cost of debt.

I+
RV-NP
n
Cost of Redeemable Debenture ( Kd ) = 1- t
RV+NP 
2
In absence of any specific information, students may use any of the above formulae
to calculate the Cost of Debt (Kd) with logical assumption.
Above formulas give approximate value of cost of debt. In these formulas higher
the difference between RV and NP, lower the accuracy of answer. Therefore one
should not use these formulas if difference between RV and NP is very high. Also
these formulas are not suitable in case of gradual redemption of bonds.
ILLUSTRATION 2
A company issued 10,000, 10% debentures of ` 100 each at a premium of 10% on
1.4.2017 to be matured on 1.4.2022. The debentures will be redeemed on maturity.
COMPUTE the cost of debentures assuming 35% as tax rate.
 4.8 FINANCIAL MANAGEMENT

SOLUTION
The cost of debenture (Kd) will be calculated as below:

I1- t+
RV-NP
Cost of debenture (Kd) = n
RV+NP
2
I = Interest on debenture = 10% of `100 = `10
NP = Net Proceeds = 110% of `100 = `110
RV = Redemption value = `100
n = Period of debenture = 5 years
t = Tax rate = 35% or 0.35

`10 1- 0.35+

`100- `110
5 years
Kd =
 `100+ `110
2
`10×0.65- `2 ` 4.5
Or, Kd = = = 0.0428 or 4.28%
`105 ` 105

ILLUSTRATION 3
A company issued 10,000, 10% debentures of ` 100 each at par on 1.4.2012 to be
matured on 1.4.2022. The company wants to know the cost of its existing debt on
1.4.2017 when the market price of the debentures is ` 80. COMPUTE the cost of
existing debentures assuming 35% tax rate.
SOLUTION

I1- t+
RV-NP
Cost of debenture (Kd) = n
RV+NP
2
I = Interest on debenture = 10% of `100 = `10
NP = Current market price = `80
RV = Redemption value = `100
 COST OF CAPITAL 4.9

n = Period of debenture = 5 years

t = Tax rate = 35% or 0.35

` 10 1- 0.35+
` 100- ` 80

5 years
Kd =
` 100+` 80
2
` 10×0.65+` 4 ` 10.5
Or, = = = 0.1166 or 11.67%
` 90 ` 90
4.5.3.1 Cost of Debt using Present value method [Yield to maturity (YTM)
approach)]
The cost of redeemable debt (Kd) is also calculated by discounting the relevant cash
flows using Internal rate of return (IRR). (The concept of IRR is discussed in the
Chapter- Investment Decisions). Here YTM is the annual return of an investment from
the current date till maturity date. So, YTM is the internal rate of return at which
current price of a debt equals to the present value of all cash-flows.
The relevant cash flows are as follows:

Year Cash flows

0 Net proceeds in case of new issue/ Current market price in case of existing
debt (NP or P0)

1 to n Interest net of tax [I(1-t)]

n Redemption value (RV)

Steps to calculate relevant cash flows:

Step-1: Identify the cash flows
Step-2: Calculate NPVs of cash flows as identified above using two discount rates
(guessing).
Step-3: Calculate IRR
Example: A company issued 10,000, 10% debentures of ` 100 each on 1.4.2013
to be matured on 1.4.2018. The company wants to know the current cost of its
existing debt and the market price of the debentures is ` 80. Compute the cost of
existing debentures assuming 35% tax rate.
 4.10 FINANCIAL MANAGEMENT

Step-1: Identification of relevant cash flows

Year Cash flows

0 Current market price (P0) = `80
1 to 5 Interest net of tax [I(1-t)] = 10% of `100 (1-0.35) = `6.5
5 Redemption value (RV) = Face value i.e. `100

Step- 2: Calculation of NPVs at two discount rates

Year Cash Discount Present Discount Present Value

flows (`) factor @ Value factor @ (`)
10% 15%
0 80 1.000 (80.00) 1.000 (80.00)
1 to 5 6.5 3.791 24.64 3.352 21.79
5 100 0.621 62.10 0.497 49.70
NPV +6.74 -8.51

Step- 3: Calculation of IRR

NPVL 6.74
IRR = L + H-L = 10%+ 15%-10% = 12.21%
NPVL -NPVH 6.74-(-8.51)

YTM or present value method is a superior method of determining cost of debt of

company to approximation method and it is also preferred in the field of finance.
We may keep in mind that in the above formula, higher the difference between
H and L, lower the accuracy of answer.
ILLUSTRATION 4
Institutional Development Bank(IDB) issued Zero interest deep discount bonds of
face value of ` 1,00,000 each issued at ` 2500 & repayable after 25 years. COMPUTE
the cost of debt if there is no corporate tax.
SOLUTION
Here,
Redemption Value (RV)= `1,00,000
Net Proceeds (NP) = ` 2,500
Interest = 0
Life of bond = 25 years
 COST OF CAPITAL 4.11

There is huge difference between RV and NP therefore in place of approximation

method we should use trial & error method.
FV = PV x (1+r)n
1,00,000 = 2,500 x (1+r)25
40 = (1+r)25
Trial 1: r = 15%, (1.15)25 = 32.919
Trial 2: r = 16%, (1.16)25 = 40.874
Here:
L = 15%, H = 16%
NPVL = 32.919-40 = -7.081
NPVH = 40.874-40 = +0.874
NPVL
IRR=L+ (H-L)
NPVL-NPVH
-7.081
=15%+ ×(16%-15%)= 15.89%
-7.081-(0.874)
4.5.3.2 Amortisation of Bond
A bond may be amortised every year i.e. principal is repaid every year rather than
at maturity. In such a situation, the principal will go down with annual payments
and interest will be computed on the outstanding amount. The cash flows of the
bonds will be uneven.
The formula for determining the value of a bond or debenture that is amortised
every year is as follows:
C1 C2 Cn
VB = + + ....... +
1+Kd  1+Kd  1+Kd 
1 2 n

n
Ct
VB=  1+K
 
t
t=1 d

ILLUSTRATION 5
RBML is proposing to sell a 5-year bond of ` 5,000 at 8 per cent rate of interest per
annum. The bond amount will be amortised equally over its life. CALCULATE the
bond’s present value for an investor if he expects a minimum rate of return of 6 per
cent?
 4.12 FINANCIAL MANAGEMENT

SOLUTION
The amount of interest will go on declining as the outstanding amount of bond will
be reducing due to amortisation. The amount of interest for five years will be:
First year: `5,000  0.08 = ` 400;
Second year: (`5,000 – `1,000)  0.08 = ` 320;
Third year: (`4,000 – `1,000)  0.08 = ` 240;
Fourth year: (`3,000 – `1,000)  0.08 = ` 160; and
Fifth year: (`2,000 – `1,000)  0.08 = ` 80.
The outstanding amount of bond will be zero at the end of fifth year.
Since RBML will have to return `1,000 every year, the outflows every year will consist
of interest payment and repayment of principal:
First year: `1,000 + ` 400 = `1,400;
Second year: `1,000 + ` 320 = `1,320;
Third year: `1,000 + ` 240 = `1,240;
Fourth year: `1,000 + ` 160 = `1,160; and
Fifth year: `1,000 + `80 = ` 1,080.
The above cash flows of all five years will be discounted with the cost of capital.
Here the expected rate i.e. 6% will be used.
Value of the bond is calculated as follows:
VB = ` 1, 400 + `1,320 + `1,240 + `1,160 + `1,080
1.06  1.06  1.06  1.06  1.06 
1 2 3 4 5

`1, 400 `1,320 `1,240 `1,160 `1,080

= + + + +
1.06 1.1236 1.1910 1.2624 1.3382
= `1,320.75 + `1,174.80 + `1,041.14 + `918.88 + `807.05 = ` 5,262.62
4.5.4 Cost of Convertible Debenture
Holders of the convertibledebentures has the option to either get the debentures
redeemed into the cash or get specified numbers of companies shares in lieu of
cash. The calculation of cost of convertible debentures are very much similar to the
redeemable debentures. While determining the redemption value of the
debentures, it is assumed that all the debenture holders will choose the option
 COST OF CAPITAL 4.13

which has the higher value and accordingly it is considered to calculate cost of
debt.
Example: A company issued 10,000, 15% Convertible debentures of `100 each
with a maturity period of 5 years. At maturity the debenture holders will have the
option to convert the debentures into equity shares of the company in the ratio
of 1:10 (10 shares for each debenture). The current market price of the equity
shares is `12 each and historically the growth rate of the shares are 5% per annum.
Compute the cost of debentures assuming 35% tax rate.
Determination of Redemption value:
Higher of
(i) The cash value of debentures = `100
(ii) Value of equity shares = 10 shares × `12 (1+0.05)5
= 10 shares × 15.312 = `153.12
`153.12 will be taken as redemption value as it is higher than the cash option and
attractive to the investors.
Calculation of Cost of Convertible debenture (using approximation method):

I1- t+
RV-NP 151- 0.35+
153.12-100
n 5 9.75+10.62
Kd = = = = 16.09%
RV+NP 153.12+100 126.53
2 2
Alternatively:
Using present value method

Year Cash flows Discount Present Discount Present

(`) factor @ Value factor @ Value
15% 20% (`)
0 100 1.000 (100.00) 1.000 (100.00)
1 to 5 9.75 3.352 32.68 2.991 29.16
5 153.12 0.497 76.10 0.402 61.55
NPV +8.78 -9.29
NPVL 8.78
IRR = L + H-L = 15%+ 20%-15% = 0.17429 or 17.43%
NPVL -NPVH 8.78-(-9.29)
 4.14 FINANCIAL MANAGEMENT

4.6 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 categorised 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

4.6.1 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.
 COST OF CAPITAL 4.15

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.
ILLUSTRATION 6
XYZ Ltd. issues 2,000 10% preference shares of ` 100 each at ` 95 each. The
company proposes to redeem the preference shares at the end of 10th year from the
date of issue. CALCULATE the cost of preference share?
SOLUTION

PD+
RV-NP
Kp = n
 RV+NP 
2
 100 - 95 
10 + 
10 
Kp =  100 + 95   = 0.1077 (approx.) = 10.77%

 2 
 
4.6.2 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:
PD
Cost of Irredeemable Preference Share (KP) =
P0
Where,
PD = Annual preference dividend
P0= Net proceeds in issue of preference shares
ILLUSTRATION 7
XYZ & Co. issues 2,000 10% preference shares of ` 100 each at ` 95 each.
CALCULATE the cost of preference shares.
 4.16 FINANCIAL MANAGEMENT

SOLUTION
PD
KP =
P0

10  2,000 10
K   = 0.1053 = 10.53%
p 95  2,000 95

ILLUSTRATION 8
If R Energy is issuing preferred stock at `100 per share, with a stated dividend of
`12, and a floatation cost of 3% then, CALCULATE the cost of preference share?
SOLUTION
Preferred stock dividend
Kp =
Market price of preferred stock (1- floatation cost)
` 12
=
`12
= = 0.1237 or 12.37%
`100(1- 0.03) ` 97

4.7 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.
 COST OF CAPITAL 4.17

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)

4.7.1 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:
D
Cost of Equity (Ke)=
P0
Where,
Ke= Cost of equity
D = Expected dividend
P0 = Market price of equity (ex- dividend)
 4.18 FINANCIAL MANAGEMENT

4.7.2 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
the30company is expected to earn 30% the investor will be prepared to pay ` 150
 
×100  for each share of ` 100.
 20 
 
Earnings/ Price Approach:
E
Cost of Equity (Ke ) =
P
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.
4.7.3 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:
 COST OF CAPITAL 4.19

D1
Cost of Equity (Ke)= +g
P0 -F
Where, F = Flotation cost per share
ILLUSTRATION 9
A company has paid dividend of ` 1 per share (of face value of ` 10 each) last year
and it is expected to grow @ 10% next year. CALCULATE the cost of equity if the
market price of share is ` 55.
SOLUTION
D1 ` 1(1+0.1)
Ke = +g = +0.1 = 0.12 = 12%
P0 ` 55

Dividend Discount Model with variable growth rate is explained in chapter 9 i.e.
Dividend Decision
Estimation of Growth Rate
The calculation of ‘g’ (the growth rate) is an important factor in calculating cost
of equity share capital. Generally two methods are used to determine the growth
rate, which are discussed below:
(i) Average Method
It calculated as below:
Current Dividend (D0) =Dn(1+g)n
or

D0
Growth rate = n -1
Dn
Where,
D0 = Current dividend,
Dn = Dividend in n years ago
Growth rate can also be found as follows:
Step-I: Divide D0 by Dn, find out the result, then refer the FVIF table,
Step-II: Find out the result found at Step-I in corresponding year’s row
 4.20 FINANCIAL MANAGEMENT

Step-III: See the interest rate for the corresponding column. This is the growth
rate.
Example: The current dividend (D0) is `16.10 and the dividend 5 year ago was
`10. The growth rate in the dividend can found out as follows:
Step-I: Divide D0 by Dn i.e. `16.10 ÷ `10 = 1.61
Step-II: Find out the result found at Step-I i.e. 1.61 in corresponding year’s row
i.e. 5th year
Step-III: See the interest rate for the corresponding column which is 10%.
Therefore, growth rate (g) is 10%.
(ii) Gordon’s Growth Model
Unlike the Average method, Gordon’s growth model attempts to derive a
future growth rate. As per this model increase in the level of investment will
give rise to an increase in future dividends. This model takes Earnings retention
rate (b) and rate of return on investments (r) into account to estimate the future
growth rate.
It can be calculated as below:
Growth (g) = b × r
Where,
r = rate of return on fund invested
b = earnings retention ratio/ rate*
*Proportion of earnings available to equity shareholders which is not
distributed as dividend
(This Model is discussed in detail in chapter 9 i.e. Dividend Decision)
4.7.4 Realized Yield Approach
According to this approach, the average rate of return realized in the past few
years is historically regarded as ‘expected return’ in the future. It computes cost
of equity based on the past records of dividends actually realised by the equity
shareholders. Though, this approach provides a single mechanism of calculating
cost of equity, it has unrealistic assumptions like risks faced by the company
remain same; the shareholders continue to expect the same rate of return; and
the reinvestment opportunity cost (rate) of the shareholders is same as the
realised yield. If the earnings do not remain stable, this method is not practical.
 COST OF CAPITAL 4.21

ILLUSTRATION 10
Mr. Mehra had purchased a share of Alpha Limited for ` 1,000. He received dividend
for a period of five years at the rate of 10 percent. At the end of the fifth year, he sold
the share of Alpha Limited for ` 1,128. You are required to COMPUTE the cost of
equity as per realised yield approach.
SOLUTION
We know that as per the realised yield approach, cost of equity is equal to the
realised rate of return. Therefore, it is important to compute the internal rate of
return by trial and error method. This realised rate of return is the discount rate
which equates the present value of the dividends received in the past five years
plus the present value of sale price of ` 1,128 to the purchase price of `1,000. The
discount rate which equalises these two is 12 percent approximately. Let us look at
the table given for a better understanding:
Year Dividend Sale Proceeds Discount Factor @ Present
(`) (`) 12% Value (`)
1 100 - 0.893 89.3
2 100 - 0.797 79.7
3 100 - 0.712 71.2
4 100 - 0.636 63.6
5 100 - 0.567 56.7
6 Beginning 1,128 0.567 639.576
1,000.076
We find that the purchase price of Alpha limited’s share was ` 1,000 and the present
value of the past five years of dividends plus the present value of the sale price at
the discount rate of 12 per cent is `1,000.076. Therefore, the realised rate of return
may be taken as 12 percent. This 12 percent is the cost of equity.
ILLUSTRATION 11
Calculate the cost of equity from the following data using realized yield approach:
Year 1 2 3 4 5
Dividend per share 1.00 1.00 1.20 1.25 1.15
Price per share (at the beginning) 9.00 9.75 11.50 11.00 10.60
 4.22 FINANCIAL MANAGEMENT

SOLUTION
In this questions we will first calculate yield for last 4 years and then calculate it
geometric mean as follows:
D1+P1 1+9.75
1+Y1= = =1.1944
P0 9
D2+P2 1+11.50
1+Y2= = =1.2821
P1 9.75
D3+P3 1.2+11
1+Y3= = =1.0609
P2 11.5
D4+P4 1.25+10.60
1+Y4= = =1.0772
P3 11
Geometric mean:
Ke=[(1+Y1)×(1+Y2)×……(1+Yn)]1/n-1
Ke=[1.1944×1.2821×1.0609×1.0772]1/4-1=0.15=15%
Note: to calculate power ¼ simply press square root switch, two times on your
calculator.
4.7.5 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.
 COST OF CAPITAL 4.23

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

 4.24 FINANCIAL MANAGEMENT

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.
ILLUSTRATION 12
CALCULATE the cost of equity capital of H Ltd., whose risk free rate of return equals
10%. The firm’s beta equals 1.75 and the return on the market portfolio equals to
15%.
SOLUTION
Ke = Rf + ß (Rm − Rf)
Ke = 0.10 + 1.75 (0.15 − 0.10)
= 0.10 + 1.75 (0.05)
= 0.1875 or 18.75%
 COST OF CAPITAL 4.25

4.8 COST OF RETAINED EARNINGS

Like another source of fund, retained earnings involve cost. It is the opportunity
cost of dividends foregone by shareholders.
The given figure depicts how a company can either keep or reinvest cash or return
it to the shareholders as dividends. (Arrows represent possible cash flows or
transfers.) If the cash is reinvested, the opportunity cost is the expected rate of
return that shareholders could have obtained by investing in financial assets.

Cost of Retained Earnings

The cost of retained earnings is often used interchangeably with the cost of
equity, as cost of retained earnings is nothing but the expected return of the
shareholders from the investment in shares of the company. However, normally
cost of equity remains higher than the cost of retained earnings, due to issue of
shares at a price lower than current market price and floatation cost.
Formulas used for calculation of cost of retained earnings are same as formulas
used for calculation of cost equity:
D
Dividend Price method: K =
r
P
EPS
Earning Price method: K =
r
P
D1
Growth method: K = +g
r
P0
 4.26 FINANCIAL MANAGEMENT

But for the purpose of calculation of Ke : P = net proceeds realized = issue price
less floatation cost. And for the purpose of calculation of Kr : P = current market
price.
ILLUSTRATION 13
Face value of equity shares of a company is Rs.10, while current market price is
Rs.200 per share. Company is going to start a new project, and is planning to
finance it partially by new issue and partially by retained earnings. You are required
to CALCULATE cost of equity shares as well as cost of retained earnings if issue price
will be Rs.190 per share and floatation cost will be Rs.5 per share. Dividend at the
end of first year is expected to be Rs.10 and growth rate will be 5%.
SOLUTION
𝐷1 10
𝐾 = +𝑔= + .05 = 10%
𝑟
𝑃0 200
𝐷1 10
𝐾 = +𝑔 = + .05 = 10.41%
𝑒
𝑃0 190 − 5
If personal tax is also considered then a shortcut formula may be as follows:
Kr = Ke (1-tp)(1-f)
Here tp is rate of personal tax on dividend and “f” is rate of flotation cost.
Here personal income tax means income tax payable on dividend income by
equity shareholders. Currently dividend income is not taxable in the hands of
investors. Only dividend received in excess of Rs.10 lakhs by an Individual, HUF or
firm from domestic company is taxed at the rate of 10%.
Example: Cost of equity of a company is 20%. Rate of floatation cost is 5%. Rate
of personal income tax is 30%. Calculate cost of retained earnings.
Solution:
Kr = Ke (1-tp)(1-f) = 20% x (1-0.30) x (1-0.05) = 13.3%
Floatation Cost: The new issue of a security (debt or equity) involves some
expenditure in the form of underwriting or brokerage fees, legal and
administrative charges, registration fees, printing expenses etc. The sum of all these
cost is known as floatation cost. This expenditure is incurred to make the securities
available to the investors. Floatation cost is adjusted to arrive at net proceeds for
the calculation of cost of capital.
 COST OF CAPITAL 4.27

ILLUSTRATION 14
ABC Company provides the following details:
D0 = ` 4.19 P0 = ` 50 g = 5%
CALCULATE the cost of retained earnings.
SOLUTION
D1 D0(1+g)
Kr = +g = +g
P0 P0
`4.19(1+0.05)
= +0.05
` 50
= 0.088 + 0.05
= 13.8%
ILLUSTRATION 15
ABC Company provides the following details:
Rf = 7% ß = 1.20 Rm - Rf = 6%
CALCULATE the cost of retained earnings based on CAPM method.
SOLUTION
Kr = Rf + ß (Rm – Rf)
= 7% + 1.20 (6%)
= 7% + 7.20
Kr = 14.2%

4.9 EFFECTIVE INTEREST RATE (EIR) METHOD:

After the introduction to Effective Interest Rate Method under Ind AS 109, one
should be familiar with this concept as well. Though students will study this concept
and the standard in detail in the subject of Accounting/Financial reporting, a brief
and relevant part of it, is stated here for reference only.
Definition of ‘Effective Interest Method’: It is ‘the rate that exactly discounts
estimated future cash payments or receipts through the expected life of the
financial asset or financial liability to the gross carrying amount of a financial asset
or to the amortised cost of a financial liability. When calculating the effective
 4.28 FINANCIAL MANAGEMENT

interest rate, an entity shall estimate the expected cash flows by considering all the
contractual terms of the financial instrument (for example, prepayment, extension,
call and similar options) but shall not consider the expected credit losses (ECL). The
calculation includes all fees and points paid or received between parties to the
contract that are an integral part of the effective interest rate, transaction costs,
and all other premiums or discounts. There is a presumption that the cash flows
and the expected life of a group of similar financial instruments can be estimated
reliably. However, in those rare cases when it is not possible to reliably estimate
the cash flows or the expected life of a financial instrument (or group of financial
instruments), the entity shall use the contractual cash flows over the full contractual
term of the financial instrument (or group of financial instruments).’
Application of EIR Method: For floating (variable)-rate financial assets or financial
liabilities, periodic re-estimation of cash flows to reflect the movements in the
market rates of interest alters the effective interest rate. If the floating (variable)-
rate financial asset or financial liability is recognized initially at an amount equal to
the principal receivable or payable on maturity, re-estimating the future interest
payments normally has no significant effect on the carrying amount of the asset or
the liability.
So, depending on Materiality an appropriate approach for amortisation can be
determined. If the amount of transaction costs, premiums or discount is not
significant the straight line amortisation can be done .if the amounts are significant
EIR rate, for amortising these amounts may be applied.

4.10 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
 COST OF CAPITAL 4.29

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.
 Equity ShareCapital(for example) 
i.e. 
 Total Capital(ascalculated in Step1above) 

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
 4.30 FINANCIAL MANAGEMENT

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.
4.10.1 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.
ILLUSTRATION 16
Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There
are 50,000 equity shares of Rs.10 each and retained earnings of Rs.15,00,000. Market
price per equity share is Rs.50. Calculate WACC using market value weights if there
is no other sources of finance.
SOLUTION
Book value of paid up equity capital = ` 5,00,000
 COST OF CAPITAL 4.31

Book value of retained earnings = ` 15,00,000

Ratio Paid up equity capital & retained earnings = 500000:1500000 = 1:3
Market value of paid equity capital & retained earnings = ` 50,000 x ` 50 = ` 25,00,000
Market value of paid up equity capital = ` 25,00,000 x ¼ = ` 6,25,000
Market value of retained earnings = ` 25,00,000 x ¾ = `18,75,000
Calculation of WACC using market value weights

Source of capital Market Weights Cost of WACC

Value capital (Ko)
(`) (a) (b) (c) =
(a)×(b)
Equity shares 6,25,000 0.25 0.1041 0.0260
Retained earnings 18,75,000 0.75 0.1000 0.0750
25,00,000 1.000 0.1010

WACC (Ko) = 0.1010 or 10.10%

ILLUSTRATION 17
CALCULATE the WACC using the following data by using:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:

(`)
Debentures (` 100 per debenture) 5,00,000
Preference shares (` 100 per share) 5,00,000
Equity shares (` 10 per share) 10,00,000
20,00,000

The market prices of these securities are:

Debentures ` 105 per debenture
Preference shares ` 110 per preference share
Equity shares ` 24 each.
 4.32 FINANCIAL MANAGEMENT

Additional information:
(1) ` 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs,
10 year maturity.
(2) ` 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost
and 10 year maturity.
(3) Equity shares has ` 4 floatation cost and market price ` 24 per share.
The next year expected dividend is ` 1 with annual growth of 5%. The firm has
practice of paying all earnings in the form of dividend.
Corporate tax rate is 50%. Assume that floatation cost is to be calculated on face value
SOLUTION
D1 `1
Cost of Equity (Ke) = +g = +0.05 = 0.1 or 10%
P0 -F `24 - `4
 RV -NP   100 -NP 
I(1- t)+ 10(1- 0.5)+ 
 n   n 
  =  
Cost of Debt (Kd) =  RV +NP   RV +NP 

 2  

 2


   
(100 - 96) 
10(1- 0.5) +  5 + 0.4 
Cost of debt =Kd = 10 = = 0.055 (approx.)
(100 + 96)  
 98 
2
 2  
5  10   5.2 

Cost of preference shares  K      = 0.053 (approx.)
p  198   99 
 
 2 
(a) Calculation of WACC using book value weights

Source of capital Book Weights After tax cost WACC (Ko)

Value of capital
(`) (a) (b) (c) = (a)×(b)
10% Debentures 5,00,000 0.25 0.055 0.0137
5% Preference shares 5,00,000 0.25 0.053 0.0132
Equity shares 10,00,000 0.50 0.10 0.0500
20,00,000 1.00 0.0769
 COST OF CAPITAL 4.33

WACC (Ko) = 0.0769 or 7.69%

(b) Calculation of WACC using market value weights

Source of capital Market Weights After WACC

Value tax cost (Ko)
of
capital
(`) (a) (b) (c) =
(a)×(b)
10% Debentures (`105× 5,000) 5,25,000 0.151 0.055 0.008
5% Preference shares (`110× 5,000) 5,50,000 0.158 0.053 0.008
Equity shares (`24× 1,00,000) 24,00,000 0.691 0.10 0.069
34,75,000 1.000 0.085
WACC (Ko) = 0.085 or 8.5%

4.1 1 MARGINAL COST OF CAPITAL

The marginal cost of capital may be defined as the cost of raising an additional
rupee of capital. Since the capital is raised in substantial amount in practice,
marginal cost is referred to as the cost incurred in raising new funds. Marginal cost
of capital is derived, when the average cost of capital is calculated using the
marginal weights.
The marginal weights represent the proportion of funds the firm intends to employ.
Thus, the problem of choosing between the book value weights and the market
value weights does not arise in the case of marginal cost of capital computation.
To calculate the marginal cost of capital, the intended financing proportion should
be applied as weights to marginal component costs. The marginal cost of capital
should, therefore, be calculated in the composite sense. When a firm raises funds
in proportional manner and the component’s cost remains unchanged, there will
be no difference between average cost of capital (of the total funds) and the
marginal cost of capital. The component costs may remain constant upto certain
level of funds raised and then start increasing with amount of funds raised.
For example, the cost of debt may remain 7% (after tax) till `10 lakhs of debt is
raised, between `10 lakhs and `15 lakhs, the cost may be 8% and so on. Similarly,
if the firm has to use the external equity when the retained profits are not sufficient,
the cost of equity will be higher because of the floatation costs. When the
 4.34 FINANCIAL MANAGEMENT

components cost start rising, the average cost of capital will rise and the marginal
cost of capital will however, rise at a faster rate.
ILLUSTRATION 18
ABC Ltd. has the following capital structure EXAMINE which is considered to be
optimum as on 31st March, 2017.

(`)
14% Debentures 30,000
11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000

The company share has a market price of ` 23.60. Next year dividend per share is
50% of year 2017 EPS. The following is the trend of EPS for the preceding 10 years
which is expected to continue in future.

Year EPS (`) Year EPS (`)

2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36
The company issued new debentures carrying 16% rate of interest and the current
market price of debenture is ` 96.
Preference share ` 9.20 (with annual dividend of ` 1.1 per share) were also issued.
The company is in 50% tax bracket.
(A) CALCULATE after tax:
(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (assuming new equity from retained earnings)
(B) CALCULATE marginal cost of capital when no new shares are issued.
(C) DETERMINE the amount that can be spent for capital investment before new
ordinary shares must be sold. Assuming that retained earnings for next year’s
investment are 50 percent of 2017.
 COST OF CAPITAL 4.35

(D) COMPUTE marginal cost of capital when the funds exceeds the amount calculated
in (C), assuming new equity is issued at ` 20 per share?
SOLUTION
(A) (i) Cost of new debt
I(1- t)
Kd =
P0
16 (1- 0.5)
= = 0.0833
96
(ii) Cost of new preference shares
PD 1.1
Kp= = = 0.12
P0 9.2
(iii) Cost of new equity shares
D1
Ke = +g
P0
1.18
= +0.10 = 0.05 + 0.10 = 0.15
23.60
Calculation of D1
D1 = 50% of 2013 EPS = 50% of 2.36 = ` 1.18
(B) Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product

(1) (2) (3) (2) × (3) = (4)
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.12 0.0060
Equity Share 0.80 0.15 0.1200
Marginal cost of capital 0.1385

(C) The company can spend the following amount without increasing marginal cost
of capital and without selling the new shares:
Retained earnings = (0.50) (2.36 × 10,000) = ` 11,800
The ordinary equity (Retained earnings in this case) is 80% of total capital
11,800 = 80% of Total Capital
 4.36 FINANCIAL MANAGEMENT

` 11,800
Capital investment before issuing equity = = ` 14,750
0.80
(D) If the company spends in excess of ` 14,750 it will have to issue new shares.
`1.18
Capital investment before issuing equity= + 0.10 = 0.159
20
The marginal cost of capital will be:
Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.0833 0.0125
Preference Shares 0.05 0.1200 0.0060
Equity Shares (New) 0.80 0.1590 0.1272
0.1457

SUMMARY
 Cost of Capital: In simple terms Cost of capital refers to the discount rate that
is used in determining the present value of the estimated future cash proceeds
of the business/new project and eventually deciding whether the business/new
project is worth undertaking or now. It is also the minimum rate of return that a
firm must earn on its investment which will maintain the market value of share
at its current level. It can also be stated as the opportunity cost of an investment,
i.e. the rate of return that a company would otherwise be able to earn at the
same risk level as the investment that has been selected.
 Components of Cost of Capital: In order to calculate the specific cost of each
type of capital, recognition should be given to the explicit and the implicit cost.
The cost of capital can be either explicit or implicit. The explicit cost of any source
of capital may be defined as the discount rate that equals that present value of
the cash inflows that are incremental to the taking of financing opportunity with
the present value of its incremental cash outflows. Implicit cost is the rate of
return associated with the best investment opportunity for the firm and its
shareholders that will be foregone if the project presently under consideration
by the firm was accepted.
 Measurement of Specific Cost of Capital for each source of Capital: The first
step in the measurement of the cost of the capital of the firm is the calculation
of the cost of individual sources of raising funds. From the viewpoint of capital
 COST OF CAPITAL 4.37

budgeting decisions, the long term sources of funds are relevant as they
constitute the major sources of financing the fixed assets. In calculating the cost
of capital, therefore the focus on long-term funds and which are:-
Long term debt (including Debentures)
Preference Shares
Equity Capital
Retained Earnings
 Weighted Average Cost of Capital:- WACC (weighted average cost of
capital) represents the investors' opportunity cost of taking on the risk of
putting money into a company. Since every company has a capital structure
i.e. what percentage of funds comes from retained earnings, equity shares,
preference shares, debt and bonds, so by taking a weighted average, it can
be seen how much cost/interest the company has to pay for every rupee it
borrows/invest. This is the weighted average cost of capital.