SUMMARY
1. 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. Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc.
2. Components of Cost of Capital: COMPONENTS OF
3. Cost
of
Debt
(
Kd
):
COST OF DEBTS (Kd)
Irredeemable Redeemable
Kd = () ⎡⎤ ⎣⎦ × 11-t 100 NP
Here,
I = Amount of Interest
NP = Net Proceeds
Alternatively: When FV = NP
Kd = Rate of Interest (1 - t)
In Lump-sum In Instalments
(1) Approximation Method:
(a) Kd =
× 100 or (b) Kd =
× 100
(2) YTM Method; Kd = L + L LH
(a) Cost of Irredeemable Debenture:
Kd = I(1t) NP × 100
Where,
I = Amount of Interest
t = Tax rate
× (H - L)
YTM Method only : Kd = L+ L LH
× (H – L)
NP = Net Proceeds of Debenture or Current Market Price
Note: If Face Value of Debenture equal to Net Proceeds then Kd = Rate of Interest (1 – t)
(b) Cost of Redeemable Debenture (in Lump sum):
Approximation Method:
Kd = () ⎛⎞ −+ ⎜⎟ ⎝⎠ + I1tRVNP n RVNP 2 × 100 Or =
Where, I = Amount of Interest.
RV = Redemption value of Debenture
NP = Net Proceeds of Debenture or Current Market Price
n = Remaining Life of Debenture
Present Value Method (PV)/Yield to Maturity Method (YTM):
Kd = IRR = L + L LH NPV NPVNPV × (H - L)
(c) Cost of Redeemable Debenture (in Instalments):
Kd = IRR = L + L LH
(d) Cost of Zero Coupon Bonds (ZCB):
Kd = n RV1 IP
Where, I = Amount of Interest.
RV = Redemption value of Debenture
IP = Issue Price of Bond
n = Life of Bond
Note:
× (H - L)
In case of convertible debenture use convertible value in place of redemption value of debenture.
If nothing is specified, issue price, redemption value etc. assumed to be equal to face value.
If nothing is specified, flotation cost assumed to be linked with “face value or issue price whichever is higher”.
4. Cost of Preference Share Capital (K p):
(a) Cost of Irredeemable Preference Share:
K p = PD NP × 100
Where,
PD = Amount of Preference Dividend
NP = Net Proceeds of Preference Share or Current Market Price of Preference Share
Note: If Face Value of Preference Share equal to Net Proceeds then
K p = Rate of Preference Dividend
(b) Cost of Redeemable Preference Share (in Lump sum):
Approximation Method:
Where,
PD = Amount of Preference Dividend
RV = Redemption value of Preference Share
NP = Net Proceeds of Preference Share or Current Market Price of Preference Share
n = Remaining Life of Preference Share
Present Value Method (PV)/Yield to Maturity Method (YTM): K p = IRR = L + L
× (H - L)
(c) Cost of Redeemable Preference Share (in Instalments):
= IRR = L +
Note:
In case of convertible preference share use convertible value in place of redemption value.
If nothing is specified, issue price, redemption value etc. assumed to be equal to face value.
If nothing is specified, flotation cost assumed to be linked with “face value or issue price whichever is higher”.
5. Cost of Equity Share Capital (K e):
COST OF EQUITY SHARE CAPITAL (Ke)
Dividend Price Approach
K e = 0 D P × 100 or In Case of New Issue :
K e = D NP × 100
(a) Dividend Price/Yield Approach:
K e = 0 D P × 100
Where,
D = Expected/Current Dividend
P0 = Current Market Price of Equity Share
Assumption: Constant Dividend
(b) Earning Price/Yield Approach:
K e = 0 E P × 100 Where,
E = Expected/Current EPS
P0 = Current Market Price of Equity Share
Assumption: Constant EPS
(c) Growth Approach or Gordon’s Model:
Where,
D1 = D0 (1 + g) = Expected DPS
P0 = Current Market Price of Equity Share
g = Constant Growth Rate of Dividend
Note:
In case of fresh issue of Equity shares (New Shares), Net Proceeds from equity share {(Issue price - Issue expenses/Flotation cost) or (P - F)} is used in place of current price of share.
If nothing is specified, flotation cost assumed to be linked with “face value or issue price whichever is higher”.
Estimation of Growth Rate:
(a) Average Method: Growth rate = 0 n n D D - 1
D0 = Current Dividend
D n = Dividend in n years ago
(b) Gordon’s Growth Model: g = b × r
r = Rate of return on fund invested
b = Earning retention ratio
(c) Realised Yield Approach:
K e = Average rate of return realised in past few years = IRR or Geometric mean
(d) Capital Asset Pricing Model (CAPM):
K e = Rf + ß (Rm - Rf)
Rf = Risk Free Rate of Return
R m = Rate of Return on Market Portfolio
R m - Rf = Market Risk Premium
ß = Beta coefficient
6. Cost of Retained Earnings (K r): After tax return to shareholder if he invest elsewhere.
Formulae:
K r = K e (of existing investors)
K r = K e (1 - tp) (In case of personal tax)
K r = K e (1 - tp) (1 - f) (f is rate of flotation cost)
7. Weighted Average Cost of Capital (K0): 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. 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. It can be calculated by using either Book Value weights or Market Value weights.
Note: Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings when Market Value weights are used.
8. Marginal Cost of Capital (MCC): The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Marginal cost of capital is derived, when the average cost of capital is calculated using the marginal weights.
THEORY QUESTIONS THEORY
Q1. Explain the significance of cost of capital. (Nov. 2019, 4 Marks)
Ans. The cost of capital is one of the most important component to take financial decisions. The correct calculation of cost of capital helps in the following decision making:
(1) Evaluation of investment options: Present value of all future benefit is calculated by discounting them with the relevant cost of capital. Different investment options have different cost of capital so we have to calculate cost of capital related to every project and then present value of future benefits related to these projects.
(2) Financing Decision: Finance managers obtains funds from various sources with consideration of cost, risk and control. Finance manager can easily compare cost of different sources and select source with lowest cost.
(3) Designing of optimum credit policy: In modern world firm has to sell its products or services on credit. For evaluation of credit period cost of capital is used, benefit though credit should be higher than cost of funds blocked in credit.
Q2. Distinguish between Unsystematic Risk & Systematic Risk. (Nov. 2020, 2 Marks)
Ans. Unsystematic Risk : Risk which is associated with performance of company is known as company specific risk or unsystematic risk. This risk can be reduced or eliminated by diversification of the securities portfolio. This is also known as diversifiable risk.
Systematic Risk : Risk which is associated with macro-economic or market under which a firm is doing business is known as unsystematic risk. This risk cannot be eliminated by the diversification of the securities portfolio, it is also known as non-diversifiable risk. The examples are Centre and State government policies, inflation, GDP, per capita income, interest rate, etc. This risks are assessed in terms of beta coefficient (b or ) and calculated through regression equation between return of a security and the return on a market portfolio.
PRACTICAL PROBLEMS
COST OF DEBT
Q1. 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. (Nov. 2015, 5 Marks)
Ans.
= 10.88%
Net Proceeds = 1,000 – 5% Discount – 2% Flotation cost = 930
Note: Flotation cost has been calculated on the basis of face value (i.e. 2% of `1,000 or `950 whichever is higher).
Q2. TT Ltd. issued 20,000, 10% 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 1:5 (5 shares for each debenture). The current market price of the equity shares is `20 each and historically the growth rate of the shares are 4% per annum. Assuming tax rate is 25%.
Compute the cost of 10% debentures using Approximation Method and Internal Rate of Return Method.
PV Factor are as under: Year12345
(Nov. 2020, 5 Marks)
Ans.
(a) Calculation of Cost of Convertible debenture using Approximation Method:
(b) Calculation of Cost of Convertible debenture using IRR Method
Calculation of NPV at two discount rates:
= 11.09%
Determination of Convertible value:
Higher of:
(i)The cash value of debentures= `100
(ii)Value of equity shares=5 shares × `20 (1 + 0.04)5 =5
× `24.333= `121.67 `121.67 will be taken as redemption value as it is higher than the cash option and attractive to the investors.
COST OF PREFERENCE SHARE CAPITAL
Q3. 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. (May 2013, 5 Marks)
Ans.
COST OF EQUITY
Q4. JC Ltd. is planning an equity issue in current year. It has an earning 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.
(May 2018, 5 Marks)
Ans.
Market price of share (MPS/P0) =EPS × PE= `20 × 6.25= `125 Net proceeds=125 – 4%= `120 Return on Equity (ROE)
Q5. 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? Assume Tax Rate to be 50%. (Nov. 2016, 5 Marks)
Ans.
(i)Ke
0.06 =14%
Note: The cost of equity can be calculated with taking the effect of growth on dividend (i.e. D1 = 2.12).
(ii)Po
WEIGHTED AVERAGE COST OF CAPITAL
Q6. Beeta Ltd. has furnished the following information:
per share (EPS): `4.00
The company wants to raise additional capital of ` 10 lakhs including debt of ` 4 lakhs. The cost of debt (before tax) is 10% upto ` 2 lakhs and 15% beyond that.
Compute the after tax cost equity and debt and the weighted average cost of capital. (Nov. 2011, 4 Marks)
Ans. K
Assumption: DPS `1.00 is treated at D o .
Q7. The following details are provided by GPS Limited:
The cost of equity capital for the company is 16.30% and Income Tax Rate for the company is 30%.
You are required to calculate the Weighted Average Cost of Capital (WACC) of the company. (May 2014, 5 Marks)
