Module-3
COST OF CAPITAL
FORMULAS:
𝑾𝑨𝑪𝑪 (𝒐𝒓)𝑴𝑨𝑪𝑪 (𝒐𝒓)𝑲𝑨 = 𝑾𝑬 𝑲𝑬 + 𝑾𝑫 𝑲𝑫 𝑨𝑻 + 𝑾𝑷 𝑲𝑷 + 𝑾𝑹𝑬 𝑲𝑹𝑬 + 𝑾𝑻𝑳 𝑲𝑻𝑳 𝑨𝑻
Whereas:
𝑾𝑬 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑾𝑫 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
𝑾𝑷 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒
𝑾𝑹𝑬 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝑾𝑻𝑳 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑡𝑒𝑟𝑚 𝑙𝑜𝑎𝑛𝑠
𝑲𝑬 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑲𝑫 𝑨𝑻 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑲𝑷 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒
𝑲𝑹𝑬 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝑲𝑻𝑳 𝑨𝑻 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡𝑒𝑟𝑚 𝑙𝑜𝑎𝑛𝑠 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
1. COST OF DEBT
Irredeemable:
𝑰
𝑲𝑫 (𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙) % = ∗ 𝟏𝟎𝟎
𝑵𝑷
𝑰
𝑲𝑫 (𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙) % = (𝟏 − 𝒕) ∗ 𝟏𝟎𝟎
𝑵𝑷
Redeemable:
(𝑹𝑽 − 𝑵𝑷)
𝑰+
𝑲𝑫 (𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙) % = 𝒏 ∗ 𝟏𝟎𝟎
(𝑹𝑽 + 𝑵𝑷)
𝟐
(𝑹𝑽 − 𝑵𝑷)
𝑰(𝟏 − 𝒕) +
𝑲𝑫 (𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙) % = 𝒏 ∗ 𝟏𝟎𝟎
(𝑹𝑽 + 𝑵𝑷)
𝟐
2. COST OF PREFERENCE
Irredeemable:
𝑫
𝑲𝑷 % = ∗ 𝟏𝟎𝟎
𝑵𝑷
Redeemable:
(𝑹𝑽 − 𝑵𝑷)
𝑫+
𝑲𝑷 % = 𝒏 ∗ 𝟏𝟎𝟎
(𝑹𝑽 + 𝑵𝑷)
𝟐
3. COST OF TERM LOAN
𝑰
𝑲𝑻𝑳 (𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙) % = ∗ 𝟏𝟎𝟎
𝑵𝑷
𝑰
𝑲𝑻𝑳 (𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙) % = (𝟏 − 𝒕) ∗ 𝟏𝟎𝟎
𝑵𝑷
Whereas:
t = Tax rate
I = Interest in Rs
RV = Redemption value
n = No. of years
D = Dividend in Rs
NP = Net proceedings
Net Proceedings can be calculated with the effects of Discount, Issue Premium, Flotation
cost to the Par Value.
Redemption value can be calculated with the effects of Redemption Premium to the Par
Value.
4. COST OF EQUITY
a) Dividend Yield Method or Dividend/Price Ratio Method:
𝑫 𝑫
𝑲𝑬 % = ∗ 𝟏𝟎𝟎 = ∗ 𝟏𝟎𝟎
𝑵𝑷 𝑴𝑷
Whereas:
𝐷 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑀𝑃 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑁𝑃 = Net proceedings
Dividend growth model:
𝑫𝟏
𝑲𝑬 % = + 𝒈 ∗ 𝟏𝟎𝟎
𝑵𝑷
𝑫𝟏
𝑲𝑬 % = + 𝒈 ∗ 𝟏𝟎𝟎
𝑴𝑷
Whereas:
𝐷 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝑜𝑟) 𝑫𝟎 (𝟏 + 𝒈)
𝐷 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑀𝑃 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑁𝑃 = Net proceedings
𝑔 = 𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
b) Earnings – Price Ratio & Cost of Equity
𝑬𝑷𝑺
𝑲𝑬 % = ∗ 𝟏𝟎𝟎
𝑴𝑷
Whereas:
𝐸𝑃𝑆 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝑀𝑃 = 𝑃 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
5. COST OF RETAINED EARNINGS
If there is no tax rate and brokerage cost
KRE = KE
If there is tax rate and brokerage cost
KRE = KE (1 – t) (1 – b)
Whereas:
KE = Cost of Equity
t = tax rate
b = brokerage cost
1. Y ltd. issues Rs. 1,00,000 9% debentures at a premium of 10%. The costs of floatation is
2%. The tax rate applicable is 60%. Compute cost of debt capital.
2. A company issues 25,000, 14% debentures of ₹1,000 each. The debentures are redeemable
after the expiry period 5 years. Tax rate applicable to the company is 35%. Calculate the
cost of debt after tax if debentures are issued at 5% discount with 2% flotation cost.
3. A company issued 40,000, 12% Redeemable Preference Shares of ₹100 each at a premium
of ₹5 each, redeemable after 10 years at a premium of ₹10 each. The flotation cost of each
share is ₹2. You are required to calculate cost of preference share capital ignoring dividend
tax.
4. JC Ltd. is planning an equity issue in the current year. It has an earnings per share (EPS)
of ₹20 and proposes to pay 60% dividend at the current year end with a P/E ratio 6.25, it
wants to offer the issue at market price. The flotation cost is expected to be 4% of the issue
price. You are required to determine rate of return for equity share (cost of equity) before
the issue and after the issue.
5. A firm’s Kₑ (return available to shareholders) is 10%, the average tax rate of shareholders
is 30% and it is expected that 2% is brokerage cost that shareholders will have to pay while
investing their dividends in alternative securities. What is the cost of retained earnings?
6. ABC Company’s equity share is quoted in the market at ₹25 per share currently. The
company pays a dividend of ₹2 per share and the investor’s market expects a growth rate
of 6% per year. You are required to:
(i) Calculate the company’s cost of equity capital.
(ii) If the anticipated growth rate is 8% per annum, calculate the indicated market price
per share.
(iii) If the company issues 10% debentures of face value of ₹100 each and realises ₹96
per debenture while the debentures are redeemable after 12 years at a premium of
12%, what will be the cost of debenture?
(iv) Assume Tax Rate to be 50%.
7. Beeta Ltd. has furnished the following information:
Earnings per share (EPS) : ₹4.00
Dividend payout ratio : 25%
Market price per share : ₹40.00
Rate of tax : 30%
Growth rate of dividend : 8%
The company wants to raise additional capital of ₹10 lakhs including debt of ₹4 lakhs. The
cost of debt (before tax) is 10% up to ₹2 lakhs and 15% thereafter.
Compute the after-tax cost of equity and debt, and the weighted average cost of capital.
8. Assuming that a firm pays tax at a 50 % rate, compute the after-tax cost of capital in the
following cases:
(i) A 8.5% preference share sold at par.
(ii) A perpetual bond sold at par, coupon rate of interest being 7 per cent.
(iii) A ten-year, 8 per cent, ₹1000 par bond sold at ₹950 less 4 %underwriting commission.
(iv) A preference share sold at ₹100 with a 9 % dividend and a redemption price of ₹110 if
the company redeems it in five years.
(v) An ordinary share selling at a current market price of ₹120, and paying a current
dividend of ₹9 per share, which is expected to grow at a rate of 8 per cent.
(vi) An ordinary share of a company, which engages no external financing, is selling for
₹50. The earnings per share are ₹7.50 of which sixty % is paid in dividends. The company
reinvests retained earnings at a rate of 10 per cent.
9. A firm finances all its investments by 40 % debt and 60 % equity. The estimated required rate
of return on equity is 20 % after-taxes and that of the debt is 8 %after-taxes. The firm is
considering an investment proposal costing ₹40,000 with an expected return that will last
forever. What amount (in rupees) must the proposal yield per year so that the market price of
the share does not change? Show calculations to prove your point.
10. The capital structure of Adamus Ltd. in book value terms is as follows:
Equity capital (20 million shares, Rs.10 par) - Rs.200 million
Preference capital, 12 % (500,000 shares, Rs.100 par) Rs.50 million
Retained earnings - Rs.350 million
Debentures 14 % (1,200,000 debentures, Rs.100 par)- Rs.120 million
Term loans, 13 % - Rs.80 million
Total - Rs.800 million
The next expected dividend per share is Rs.2.00. The dividend per share is expected to grow at
the rate of 12 %. The market price per share is Rs.50.00. Preference stock, redeemable after 10
years, is currently selling for Rs.85.00 per share. Debentures, redeemable after 5 years, are
selling for Rs.90.00 per debenture. The tax rate for the company is 30 %. Calculate the average
cost of capital.
11. Ivy Ltd. has the following capital structure and after tax costs for the different sources of
funds used:
Source of funds Amount Proportion % After-tax cost %
Debt 15,00,000 25 5
Preference sh. 12,00,000 20 10
Equity shares 18,00,000 30 12
Retained earnings 15,00,000 25 11
Total 60,00,000 100
You are required to compute the weighted average cost of capital.
12. The following information is available for Cowboy Synergy Ltd.
Source Amount (Rs.) Specific COC
Equity Share Capital [2,00,000 shares of Rs. 10 each] 20,00,000 11%
Preference share capital [50,000 shares of Rs. 10 each] 5,00,000 8%
Retained earnings 10,00,000 11%
7.5% Debentures of Rs. 1,000 each 15,00,000 4.5%
Presently, the debentures are being traded at 94%, preference shares at par and the equity shares at
Rs. 13 per share. Find out the WACC based on book weights and market value weights.
13. ABC ltd. has the following capital structure:
Particulars Book Value Market Value
Equity capital (25,000 shares of Rs.10 each) Rs.2,50,000 Rs.4,50,000
13% Preference capital (500 shares of Rs.100 each) Rs.50,000 Rs.45,000
Reserves & Surplus Rs.1,50,000 -
12% Debentures (1500 debentures of Rs.100 each) Rs.1,50,000 Rs.1,45,000
Total 6,00,000 6,40,000
The expected dividend per share is Rs.1.40 and the dividend per share is expected to grow at a rate
of 8% forever. Preference shares are redeemable after 5 years at par whereas debentures are
redeemable after 6 years at par. The tax rate for the company is 40%. You are required to compute
the weighted average cost of capital for the existing capital structure using market value as weights.
14. A company has on its books the following amounts and specific costs of each type of capital.
Type of Capital Book Value Rs. Market Value Rs. Specific Costs (%)
Debt 4,00,000 3,80,000 5
Preference 1,00,000 1,10,000 8
Equity 6,00,000 9,00,000 15
Retained Earnings 2,00,000 3,00,000 13
Total 13,00,000 16,90,000
Determine the weighted average cost of capital using:
(a) Book value weights, and
(b) Market value weights.
How are they different? Can you think of a situation where the weighted average cost of capital
would be the same using either of the weights?