COST OF CAPITAL

Unit IV – Cost of Capital

Meaning of cost of capital

Explicit and Implicit costs
Measurement of cost of debt
Cost of debt after tax

Cost of debt when:

1. Issued at par and redeemed at par

2. Issued at par and redeemed at discount
3. Issued at par and redeemed at premium
4. Issued at dis and redeemed at par
5. Issued at par and redeemed at discount
6. Issued at par and redeemed at premium

Cost of perpetual debt

Illustrations

Cost of Preference share

Cost of Preference share issued and redeemed at ….. cost of equity
Dividend approach
Supposed that dividend share of a firm is expected to be Re 1 per share next year and is
expected to grow at 6 per cent per year perpetually. Determine the cost of equity capital,
assuming the market price per share is Rs.25.
Solution: This is a case of constant growth of expected dividends. The ke can be
calculated by using Equation 12.12. Thus
D Rs 1
ke = 1 + g = + 0.06 = 10 per cent
P0 Rs 25
From the under mentioned facts determine the cost of equity shares of company X:
(i) Current market price of a share = Rs.150.
(ii) Cost of floatation per share on new shares, Rs.3.
(iii) Dividend paid on the outstanding shares over the past five years:
Year Dividend per share
1 Rs.10.50
2 11.02
3 11.58
4 12.16
5 12.76
6 13.40

(iv) Assume a fixed dividend pay out ratio.

(v) Expected dividend on the new shares at the end of the current year is
Rs.14.10. per share

Solution: As a first step, we have to estimate the growth rate in dividends. Using the
compound interest table (Table-A-1). The annual growth rate of dividends would be
approximately 5 per cent. (During the five years the dividends have increased from
Rs.10.50 to Rs.13.40, giving a compound factor of 1.276, that is, Rs.13.40/Rs/10.50. The
sum of Re 1 would accumulate to Rs.1.276 in five years @ 5 per cent interest).

Rs.14.10
ke = + 5% = 14.6 per cent
Rs.147( Rs.150 − Rs.3)
Z ltd is foreseeing a growth rate of 12 percent per annum in the next 2 years. The growth
rate is likely to fall to 10 per cent for the third year and the fourth year. After that, the
growth rate is expected to stablise at 8 per cent per annum. If the last dividend was
Rs.1.50 per share and the investors’ required rate of return is 16 per cent, find out the
intrinsic value per share of Z ltd as of date.

Solution
Intrinsic value of Z ltd = the sum of: (i) PV of dividends payments during 1-4 years and
(ii) PV of expected market price at the end of the fourth year based on a constant growth
of 8 per cent.
Present value of dividends, year 1-4.
Years Dividends PVIF(0.16) Total PV
1 Rs.1.68 0.862 Rs.1.45
2 1.88 0.743 1.40
3 2.07 0.641 1.33
4 2.28 0.552 1.26
5.44

Rs.2.28(1.08)
P4 = D5 /(k e − g ) = = Rs.30.78
16% − 8%

PV of Rs.30.78 = Rs.30.78 × 0.522 = Rs.16.99

Intrinsic Value of share = Rs.5.44 + Rs.16.99 = Rs.22.43

Cost of retained earning

Illustration
Session 18
Weighted average cost of capital
Meaning Rationale
Calculation
Application
Historical weights
Marginal weights
Market weight
Illustration

Cost of Capital in Indian context

Capital structure decisions

Relevance
Concept of leverage
Operating
Financial
Operating leverage - Effect of change in roles on EBIT
Degree of operating leverage
Operating risk
Effect
Financial leverage
Effect of various capital structure in EPS
Degree of financial leverage
Financial risk
Illustration
Combined leverage

EBIT/EPS analysis –Relevance

Effects of Various EBIT on EPS

Managerial Implications
Illustrations

Workout the EPS when EBIT is 4%, 5%, 6.5%, 8% and 10%.
14.11

EBIT/EPS analysis continued

Indifference level of EBIT-Meaning
Calculations: For new company
A) Equity Vs debt and equity
B) Equity Vs pref. share and equity
C) Equity vs preference shares and debentures

MM Hypothesis:
Meaning
Assumptions
Proof of MM hypothesis

Q1. Define cost of capital? Explain its significance in financial decision-making.

A1 The project's cost of capital is the minimum required rate of return on funds
committed to the project, which depends on the riskiness of its cash flows. The
firm's cost of capital will be the overall, or average, required rate of return on the
aggregate of investment projects
It is a concept of vital importance in the financial decision-making. It is useful as
a standard for:
1. evaluating investment decisions,
2. designing a firm's debt policy, and
3. appraising the financial performance of top management

Q2. What are the various concepts of cost of capital? Why should they be
distinguished in financial management?
A2 The opportunity cost is the rate of return foregone on the next best alternative
investment opportunity of comparable risk. Thus, the required rate of return on an
investment project is an opportunity cost.
In an all-equity financed firm, the equity capital of ordinary shareholders is the
only source to finance investment projects, the firm's cost of capital is equal to
the opportunity cost of equity capital, which will depend only on the business risk
 of the firm
Viewed from all investors' point of view, the firm's cost of capital is the rate of
return required by them for supplying capital for financing the firm's investment
projects by purchasing various securities. It may be emphasised that the rate of
return required by all investors will be an overall rate of return - a weighted rate
of return. Thus, the firm's cost of capital is the 'average' of the opportunity costs
(or required rates of return) of various securities, which have claims on the firm's
assets. This rate reflects both the business (operating) risk and the financial risk
resulting from debt capital. The opportunity cost of capital is given by the
following formula:
C2
I = C1 + i i Cn

0
(1 + k) (1 + ) k 2 '" (l + ) k n
Where I0 is the capital supplied by investors in period 0 (it represents a net cash
inflow to the firm), Ct are returns expected by investors (they represent cash
outflows to the firm) and k is the required rate of return or the cost of capital.

Q3. How is the cost of debt computed? How does it differ from the cost of preference
capital? A3 The contractual rate of interest or the coupon rate forms the basis
for calculating
the cost of debt. The before-tax cost debt:

kd)n
 The following short-cut method can also be used to calculate the before-tax cost
of debt:
INT+-(F-B )
. _______ n _____0
12F(+B0)
where INT is interest charges, F is face value, B0 is current value of
debenture/debt, and n is maturity of debt in years.
The before-tax cost of debt, kd, should be adjusted for the tax effect as follows:
After - tax cost of debt = k d (1 ) T
Preference shareholders bear more risk than debt-holders. In case of redeemable
preference shares, shareholders get dividends and liquidating value on maturity.
If the company does not have profits, preference shareholders may not get any
dividends. Unlike interest on debt, preference dividend is not tax deductible. The
cost of redeemable preference share:
_± PDIV t Pn
r0 — A . T-
p (l + kp)n
The cost of preference share is not adjusted for taxes because preference dividend
is paid after the corporate taxes have been paid.

Q4. 'The equity capital is cost free.' Do you agree? Give reasons.
A4 It is sometimes argued that the equity capital is free of cost. The reason for such
argument is that it is not legally binding for firms to pay dividends to ordinary
shareholders. Further, unlike the interest rate or preference dividend rate, the
equity dividend rate is not fixed. It is fallacious to assume equity capital to be free
of cost. Equity capital involves an opportunity cost. Ordinary shareholders supply
funds to the firm in the expectation of dividends and capital gains commensurate
with their risk of investment. The market value of the shares, determined by the
demand and supply forces in a well functioning capital market, reflects the return
required by ordinary shareholders. Thus, the shareholders' required rate of return,
which equates the present value of the expected benefits with the current market
value of the share, is the cost of equity.

Q5. The basic formula to calculate the cost of equity is: (DIV1/ Po) + g. Explain its
rationale. A5 The cost of equity is equal to the expected dividend yield
(DIV1/P0) plus capital
gain rate as reflected by expected growth in dividends (g). It may be noted that
formula is based on the following assumptions:
1. The market price of the ordinary share, P , is a function of expected dividends.
2. The dividend, DIV1, is positive (i.e. DIV1 > 0).
3. The dividends grow at a constant growth rate g, and the growth rate is equal to
the return on equity, ROE, times the retention ratio, b (i.e. g = ROE * b).
4. The dividend payout ratio [i.e. (1 - b)] is constant.
 The cost of equity (internal) determined by the dividend-valuation model implies
that if the firm would have distributed earnings to shareholders, they could have
invested it in the shares of the firm or in the shares of other firms of similar risk at
the current market price (P0) to earn a rate of return equal to ke. Thus, the firm
should earn a return on retained funds equal to k to ensure growth of dividends
and share price. If a return less than ke is earned on retained earnings, the market
price of the firm's share will fall.

Q6. Are retained earnings less expensive than the new issue of ordinary shares? Give
your views.
A6 The cost of external equity is greater than the cost of internal equity for one
reason. The selling price of the new shares may be less than the market price. In
India, the new issues of ordinary shares are generally sold at a price less than the
market price prevailing at the time of the announcement of the share issue.

Q7. What is the CAPM approach for calculating the cost of equity? What is the
difference between this approach and the constant growth approach? Which one is
better? Why?
A7 As per the CAPM, the required rate of return on equity is given by the following
relationship:

Equation requires the following three parameters to estimate a firm's cost of

equity:
1. The risk-free rate (Rf):
2. The market risk premium (Rm - Rf):
3. The beta of the firm's share (β):
The dividend-growth approach has limited application in practice because of its
two assumptions. First, it assumes that the dividend per share will grow at a
constant rate, g, forever. Second, the expected dividend growth rate, g, should be
less than the cost of equity, ke, to arrive at the simple growth formula
These assumptions imply that the dividend-growth approach cannot be applied to
those companies, which are not paying any dividends, or whose dividend per
share is growing at a rate higher than ke, or whose dividend policies are highly
volatile. The dividend-growth approach also fails to deal with risk directly. In
contrast, the CAPM has a wider application although it is based on restrictive
assumptions. The only condition for its use is that the company's share is quoted
on the stock exchange. Also, all variables in the CAPM are market determined
and except the company specific share price data, they are common to all
companies. The value of beta is determined in an objective manner by using
sound statistical methods. One practical problem with the use of beta, however, is
that it does not probably remain stable over time.

Q8. 'Debt is the cheapest source of funds.' Explain.

A8 Debt and equity are the two main sources of funds. Debt is cheap because of two
prime reasons:
 1. Risk of the lenders is less as compared to equity holders so cost of debt is less,
2. Interest paid on debt is tax deductible.

Q9. How is the weighted average cost of capital calculated? What weights should be
used in its calculation? A9 The following steps are involved for
calculating the firm's WACC:
1. Calculate the cost of specific sources of funds
2. Multiply the cost of each source by its proportion in the capital structure.
3. Add the weighted component costs to get the WACC.
In financial decision-making, the cost of capital should be calculated on an after-
tax basis. Therefore, the component costs should be the after-tax costs. If we
assume that a firm has only debt and equity in its capital structure, then the
WACC (k0) will be:
k o =k d (l-T)w d +k e w e
D E
k 0o =d k d ( l - T ) D + e k e E
D+E D+E
where k0 is the WACC, kd (1 - T) and ke are, respectively, the after-tax cost of
debt and equity, D is the amount of debt and E is the amount of equity. In a
general form, the formula for calculating WACC can be written as follows:
k0=k1w1 +k2w2 +k3w3 +—
where k1, k2 ... are component costs and w1, w2, ■ ■ ■ weights of various types of
capital employed by the company.
You should always use the market value weights to calculate WACC. In practice,
firms do use the book value weights. Generally, there will be difference between
the book value and market value weights, and therefore, WACC will different.
WACC, calculated using the book-value weights, will be understated if the
market value of the share is higher than the book value and vice-versa.

Q10. Distinguish between the weighted average cost of capital and the marginal cost of
capital. Which one should be used in capital budgeting and valuation of the
firm? Why?
A10 Weighted marginal cost of capital (WMCC): Marginal cost is the new or the
incremental cost of new capital (equity and debt) issued by the firm. The weighted
average cost of capital is the cost of old and new capital. In capital budgeting
decision and valuation, we consider the incremental cash flows. Hence, it
appropriate to use the marginal cost of capital as the discount rate.

Q11. 'Marginal cost of capital is nothing but the average cost of capital.' Explain.
A11 Marginal cost is the new or the incremental cost of new capital (equity and debt)
issued by the firm. We assume that new funds are raised at new costs according to
the firm's target capital structure. Hence, what is commonly known as the WACC
is in fact the weighted marginal cost of capital (WMCC); that is, the weighted
average cost of new capital given the firm's target capital structure
Q12. How would you apply the cost of capital concept when projects with different
risks are evaluated? A12 A simple practical approach to incorporate risk
differences in projects is to adjust
the firm's WACC (upwards or downwards), and use the adjusted WACC to
evaluate the investment project:

Adjusted WACC = WACC ± Risk - adjustment factor

That is, a project's cost of capital is equal to the firm's weighted average cost of
capital plus or minus a risk adjustment factor. The risk adjustment factor would be
determined on the basis of the decision maker's past experience and judgment
regarding the project's risk. It should be noted that adjusting WACC for risk
differences is not theoret ically a very sound met hod; however, this
approach is better than simply using the firm's WACC for all projects without
regard for their risk.
Companies in practice may develop policy guidelines for incorporating the project
risk differences. One approach is to divide projects into broad risk classes, and
use different discount rates based on the decision maker's experience. For
example, projects may be classified as:
1. Low risk projects
2. Medium risk projects
3. High risk projects.
The risk of a project depends on its operating leverage. So you can estimate a
project's beta based on its operating leverage. You may also consider the
variability of the project's earnings to estimate the beta.
Cost of Capital
1. The Ess Kay Refrigerator Company is deciding to issue 2,000,000 of Rs 1,000, 14 per cent 7-year
debentures. The debentures will have to be sold at a discount rate of 3 per cent. Further, the firm will
pay an underwriting fee of 3 per cent of the face value. Assume a 35% tax rate.
Calculate the after-tax cost of the issue. What would be the after-tax cost if the debenture were sold at
a premium of Rs 30?
2. A company issues new debentures of Rs 2 million, at par; the net proceeds being Rs 1.8 million. It has
a 13.5 per cent rate of interest and 7 year maturity. The company’s tax rate is 52 per cent. What is the
cost of debenture issue? What will be the cost in 4 years if the market value of debentures at that time
is Rs 2.2 million?
3. A company has 100,000 shares of Rs 100 at par of preference shares outstanding at 9.75 per cent
dividend rate. The current market price of the preference share is Rs 80. What is its cost?
4. A firm has 8,000,000 ordinary shares outstanding. The current market price is Rs 25 and the book
value is Rs 18 per share. The firm’s earnings per share is Rs 3.60 and dividend per share is Rs 1.44.
How much is the growth rate assuming that the past performance will continue? Calculate the cost of
equity capital.
5. A company has 5,000,000 ordinary shares outstanding. The market price of the share is Rs 96 while
the book value is Rs 65. The firm’s earnings and dividends per share are Rs 10 and Rs 7 respectively.
The company wants to issue 1,000,000 shares with a net proceeds of Rs 80 per share. What is the cost
of capital of the new issue?
6. A company has paid a dividend of Rs 3 per share for last 20 years and it is expected to continue so in
the future. The company’s share had sold for Rs 33 twenty years ago, and its market price is also Rs
33. What is the cost of the share?
7. A firm is thinking of raising funds by the issuance of equity capital. The current market price of the
firm’s share is Rs 150. The firm is expected to pay a dividend of Rs 3.55 next year. The firm has paid
dividend in past years as follows:
Year Dividend per Share (Rs)
2003 2.00
2004 2.20
2005 2.42
2006 2.66
2007 2.93
2008 3.22
The firm can sell shares for Rs 140 each only. In addition, the flotation cost per share is Rs 10.
Calculate the cost of new issue.
8. A company is considering the possibility of raising Rs 100 million by issuing debt, preference capital,
and equity and retaining earnings. The book values and the market values of the issues are as follows:
(Rs in millions)
Book Value Market Value
Ordinary shares 30 60
Reserves 10 —
Preference shares 20 24
Debt 40 36
100 120
The following costs are expected to be associated with the above-mentioned issues of capital. (Assume
a 35 per cent tax rate.)
(i) The firm can sell a 20-year Rs 1,000 face value debenture with a 16 per cent rate of interest. An
underwriting fee of 2 per cent of the market price would be incurred to issue the debentures.
(ii) The 11 per cent Rs 100 face value preference issue fetch Rs 120 per share. However, the firm will
have to pay Rs 7.25 per preference share as underwriting commission.
(iii) The firm’s ordinary share is currently selling for Rs 150. It is expected that the firm will pay a
dividend of Rs 12 per share at the end of the next year, which is expected to grow at a rate of 7 per
cent. The new ordinary shares can be sold at a price of Rs 145. The firm should also incur Rs 5 per
share flotation cost.
Compute the weighted average cost of capital using (i) book value weights (ii) market value weights.
9. A company has the following long-term capital outstanding as on 31 March 2008: (a) 10 per cent
debentures with a face value of Rs 500,000. The debentures were issued in 2003 and are due on 31
March 2010. The current market price of a debenture is Rs 950. (b) Preference shares with a face value
of Rs 400,000. The annual dividend is Rs 6 per share. The preference shares are currently selling at Rs
60 per share. (c) Sixty thousand ordinary shares of Rs 10 par value. The share is currently selling at Rs
50 per share. The dividends per share for the past several years are as follow:
Year Rs Year Rs
2003 2.00 2000 2.80
2004 2.16 2001 3.08
2005 2.37 2002 3.38
2006 2.60 2003 3.70
Assuming a tax rate of 35 per cent, compute the firm’s weighted average cost of capital.
10. A company is considering distributing additional Rs 80,000 as dividends to its ordinary shareholders.
The shareholders are expected to earn 18 per cent on their investment. They are in 30 per cent tax and
incur an average brokerage fee of 3 per cent on the reinvestment of dividends received. The firm can
earn a return of 12 per cent on the retained earnings. Should the company distribute or retain Rs
80,000?
11. The Keshari Engineering Ltd has the following capital structure, considered to be optimum, on 31 June
2008.
Rs in million
14% Debt 93.75
10% Preference 31.25
Ordinary equity 375.00
Total 500.00
The company has 15 million shares outstanding. The share is selling for Rs 25 per share and the
expected dividend per share is Rs 1.50, which is expected to grow at 10 per cent.
The company is contemplating to raise additional funds of Rs 100 million to finance expansion. It can
sell new preference shares at a price of Rs 23, less flotation cost of Rs 3 per share. It is expected that a
dividend of Rs 2 per share will be paid on preference. The new debt can be issued at 10 per cent rate of
interest. The firm pays taxes at rate of 35 per cent and intends to maintain its capital structure.
You are required (i) to calculate the after-tax cost (a) of new debt, (b) of new preference capital, and
(c) of ordinary equity, assuming new equity comes only from retained earnings which is just sufficient
for the purpose, (ii) to calculate the marginal cost of capital, assuming no new shares are sold, (iii) to
compute the maximum amount which can be spent for capital investments before new ordinary shares
can be sold, if the retained earnings are Rs 700,000, and (iv) to compute the marginal cost of capital if
the firm spends in excess of the amount computed in (iii). The firm can sell ordinary shares at a net
price of Rs 22 per share.
12. The following is the capital structure of X Ltd as on 31 December 2008.
Rs in million
Equity capital (paid up) 563.50
Reserves and surplus 485.66
10% Irredeemable Preference shares 56.00
10% Redeemable Preference shares 28.18
15% Term loans 377.71
Total 1,511.05

The share of the company is currently selling for Rs 36. The expected dividend next year is Rs 3.60 per
share anticipated to be growing at 8 per cent indefinitely. The redeemable preference shares were
issued on 1 January 2003 with twelve-year maturity period. A similar issue today will be at Rs 93. The
market price of 10% irredeemable preference share is Rs 81.81. The company had raised the term loan
from IDBI in 2003. A similar loan will cost 10% today.
Assume an average tax rate of 35 per cent. Calculate the weights average cost of capital for the
company using book-value weights.
13. The following capital structure is extracted from Delta Ltd’s balance sheet as on 31 March 2008:
 (Rs ’000)
Equity (Rs 25 par) 66,412
Reserves 65,258
Preference (Rs 100 par) 3,000
Debentures 30,000
Long-term loans 5,360
170,030
The earnings per share of the company over the period 2004–2008 are:

Year Rs Year Rs
2004 2.24 1994 4.40
2005 3.00 1995 5.15
2006 4.21 1996 5.05
2007 3.96 1997 6.00
2008 4.80 1998 6.80

The equity share of the company is selling for Rs 50 and preference for Rs 77.50. The preference
dividend rate and interest rate on debenture respectively are 10 per cent and 13 per cent. The long-term
loans are raised at an interest rate of 14 per cent from the financial institution. The equity dividend is
Rs 4 per share.
Calculate the weighted average cost of capital for Delta Ltd, making necessary assumptions.
14. A company has the following capital structure at the end of 31 March 2008:
(Rs in million)
Share Capital 6,808
Reserve 34,857
Long-term loans 538,220
The company’s EPS, DPS, average market price and ROE for last seven years are given below:
Year EPS DPS AMP ROE
2002 21.55 5.28 143.04 20.9
2003 22.14 5.76 187.52 18.6
2004 26.40 5.76 312.32 11.7
2005 20.16 6.53 587.52 11.0
2006 20.40 7.68 366.72 9.5
2007 23.09 11.53 416.64 10.3
2008 22.00 7.68 355.20 8.4
Note: EPS, DPS and AMP adjusted for bonus issues.
You are required to calculate: (a) growth rate g, using alternative methods; (b) cost of equity, using
dividend – growth model, and (c) weighted average cost of capital, using (i) book-value weights and
(ii) market-value weights. Assume that the interest rate on debt is 11 per cent and the corporate income
tax rate is 35 per cent.
15. Eskayef Limited manufactures human and veterinary pharmaceuticals, bulk drugs, skin care products,
and vaterinary feed supplements and markets bio-analytical and diagnostic instruments. On 31 March
2003, the company has a paid-up share capital of Rs 75 million and reserves of Rs 325.90 million. It
does not employ long-term debt. The following are other financial highlights on the company during
2003–2008:
Year EPS (Rs) DPS (Rs) Book Market
Value (Rs) Value
2003 6.21 2.00 26.03 100.00
2004 10.91 2.50 34.44 205.00
2005 11.57 2.50 43.52 209.38
2006 11.47 2.70 37.98 164.00
2007 10.44 3.00 45.42 138.88
2008 11.23 3.20 53.45 155.00
Note: (1) Years 2003, 2004 and 2005 closed on 30 November while years 2006, 2007 and 2008 on 31
March. (2) Market value is the averages of high and low share prices.
You are required to calculate (a) ROE, (b) dividend payout, (c) retention ratio, (d) growth rate, (e)
dividend yield, (f) earnings yield and (g) cost of equity.