cost of capital

Meaning of cost of capital
Importance of cost of capital
Classification of cost Computation of Cost of capital
Computation of specific cost
•Cost of Debt
•Cost of Preference share
•Cost of Equity share
•Cost of Retained Earnings
•Overall cost of capital
Meaning of Cost of Capital
 In other words, COC means that rate which is paid for
the use of capital. Each source of funds has different
cost, such as cost of equity share capital, cost
of preference share capital, cost of debt, cost
of retained earning
 From the view point of investor:-COC is the reward for
the amount he is investing which could have other
wise been used for consumption or for investment at
some other place
Importance of Cost of Capital
 COC is very important in the area of financial
management:Capital Budgeting
Capital Structure Decision
Dividend Policy Decision
Efficiency of Top mgt
Comparative Analysis
Classification of Cost
 Specific or component cost :-refers to the cost of
individual components of capital viz. equity share,
preference share ,debentures, retained earning.
 Combined cost/WACC : refers to the combined cost (or weighted avg COC) of
the various individual components. It is also called the
average /weighted cost of capital or overall cost of
Computation of Cost of Capital
 Computation of cost of specific source
of finance.
Cost of Debt
Cost of Preference share capitalCost of Equity share capitalCost of Retained Earnings
 combined cost
 Computation of weighted average cost
of capital
Cost of Debt
 Debt fund can be in the form of debentures or loans
from financial institution. Debt can be of 2 types: Irredeemable or perpetual Debt
 Redeemable Debt
Cost of Irredeemable Debt
 Calculation of Irredeemable Debt, before tax : Kd = I / NP
 Kd = Cost of Debt before tax
 I = Interest
 NP = Net Proceeds
Example of Cost of Debt, before
tax: X Ltd. issues Rs 1000 , 8%debentures face value 100
(a) at par,
(b) at a discount of 7 % and
( c) at a premium of 10%
You are required to calculate the cost of Debt to the
Cost of Irredeemable debt,after tax
 Formula:-Kda = Int/NP(1-t) * 100
 Example:-X Ltd has 8% perpetual debt of Rs20 Lakh.
The tax applicable to the company is 40%. Determine
the cost of capital after tax assuming the debt is issued
 (a) at par,
 (b) at 10% discount,
 © at 10% premium
 X ltd issues 50000 8% debentures at par the tax rate
applicable to the company is 50%
 Yltd issues 50000 8% debentures at a premium of 10%
the tax rate applicable to the company is 60%
 Altd issues 50000 8% debentures at a discount of 5%
the tax rate applicable to the company is 50%
 Bltd issues 100000 9% debentures at a premium of 10%
the floatation costs are 2% the tax rate applicable to the
company is 60%
Example of Cost of Irredeemable
 X Ltd. issues 40,000, 8% debentures of Rs 100each and
incurred the following expenditure : Underwriting
Commission 2% of issue price Brokerage 0.5% of issue
price Printing and other expense Rs 20,000Calculate
cost of Debt assuming debt is issued
 At 10% premium
 At 10% discount
 Tax rate is 40%
Cost of Redeemable Debt
 Before tax :- Kd = I + ( RV-NP) /n
½(RV+ NP)
RV: Redeemable value
NP: Net proceeds
N: Net proceeds
I: Interest
 After tax :-Kda = kd X (1-t)
Example of Redeemable debt
 A company issues Rs 5,00,000 , 10%redeemable
debentures redeemable at par after 5 years .The cost of
Floatation amount to 4% of face value. Tax rate is
35% You are required to calculate before tax and after
tax cost of debt
if debentures are issued
at par,
at a discount of 10%,
at a premium of 5%
 A company issues 20,000, 7%debentures of Rs. 100
each at a discount of 2% t be redeemed after 10years at
a premium of 5% .The cost of floatation amount to Rs
50,000..Calculate cost of debt assuming tax rate at 40%
Cost of Preference Share Capital
 Irredeemable Preference share
 Redeemable Preference share
 Kp=D/NP
 D = Dividend
Redeemable Preference share
 Formula of computing:-Kpr = D+ (MV-NP)/ n
--------------------½ ( MV + NP )
 where:-Kpr= cost of redeemable preference
 D = Dividend
 MV = Market value
 n = no of years
Example of preference share
 A company issues 10,000, 10%preference share of Rs
100 each. Cost of issue is Rs 2 per share. Calculate
cost of preference capital if these are issued at par, at a
premium of 10 % , at a discount of 5%
 A company issues 10,000 , 10%preference share of Rs
100 each redeemable after 10 years at a premium of 5%.
The cost of issue is Rs2 per share. Calculate the cost
of preference capital.
Cost of Equity share capital
 The cost is difficult to measure, as therate of return
fluctuates every year
 Its not legally binded to pay dividend to equity share
 As the future earning and dividend are expected to
grow overtime.
Cost of Equity Share Capital
Formula of computing Cost of Equity
Ke=D/MP +G
where:ke=cost of equity
D=Dividend Per share
MP=Market Price
X Ltd pays a dividend of Rs 12 per share initially and
the growth in dividend is expected to be 5 % .
Compute the cost of equity share if the current market
price of anequity share is Rs 150.
Cost of Retained Earnings
 Kr=Ke (1-t)(1-B)
 Ke: cost of retianed earnings
 T:tax rate of shareholders
 B:brokerage or commission
 The A company has net earnings of Rs100lakhs and all
of its shareholders are in 40% tax bracket. The mgt
estim,ates the under present conditions stock holders
required rate of return is 10%. The brokerage @3% is
paid on investment compute the cost of retained
The Weighted Average Cost
of Capital
 The weighted cost of capital is just the
weighted average cost of all of the
financing sources
 Equity shares 200000 share
7% Preference shares
8% Debentures
The company sells equity shares at 20 and it will pay
dividend of 2 per share which will grow at 7% for ever
Tax rate 50%compute weighted average cost of captial
 Compute new weighted average cost of capital if
company raises additional debentures at 9% 2000000
 This would result in increasing equity divided to 3 per
share and growth rate unchanged price of share will
fall to 15 per share