CHAPTER 4

COST OF CAPITAL
LEARNING OUTCOMES
r Discuss the need and sources of finance to a business entity.
r Discuss the meaning of cost of capital for raising capital
from different sources of finance.
r Measure cost of individual components of capital
r Calculate weighted cost of capital and marginal cost of
capital, Effective Interest rate.

CHAPTER OVERVIEW

Cost
of
Capital

Cost of Cost of Combination of

Cost of
Cost of Debt Preference Retained Cost and Weight
Equity
Share Earning of each sources
of Capital

Weighted
Average Cost of
Capital (WACC)

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 4.2 FINANCIAL MANAGEMENT

4.1 INTRODUCTION
The cost of capital i.e. cost of having capital for long period from different sources
of finance. Generally the sources of finance for non corporate entity could be either
internal (savings, investments in current and non-current assets etc.) or external
borrowings (loan from financial institutions, local borrowings etc.).

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.
• Educating 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. Here Internal Rate of Return (IRR) is treated
as cost of capital for evaluation of two options (projects).
(ii) Performance Appraisal: Cost of capital is used to appraise the performance
of a particulars project or business. The performance of a project or business
in compared against the cost of capital which is known here as cut-off rate or
hurdle rate.
(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

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 COST OF CAPITAL 4.3

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

The cost of capital can either be explicit or implicit. The cash outflow of an entity
towards the utilization of capital which is clear and obvious is termed as explicit
cost of capital. These outflows may be interest payment to debenture holders,
repayment of principal amount to financial institution or payment of dividend
to shareholders etc. On the other hand Implicit cost is the cost which is actually
not a cash outflow but it is an opportunity loss of foregoing a better investment
opportunity by choosing an alternative option. An entrepreneur for example, uses
its bank deposits which earns interest @ of 9% p.a. for the business purpose. Using
its bank deposits for business purpose means forgoing interest earnings from the
bank on this deposit. The cost of capital in this case will be 9% interest that could
have been earned by not investing the deposit for the business purpose. This
opportunity loss of 9% is called implicit cost capital or opportunity cost.
The two factors which are considered to determine the cost of capital are:
(i) Source of Finance
(ii) Reciprocal payment of the using finance.
We will discuss the cost of capital of each source of finance separately.

Cost of
Equity

Cost of Weighted Cost of

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

Cost of
Long term
Debt.

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 4.4 FINANCIAL MANAGEMENT

4.5 COST OF LONG TERM DEBT

External borrowings or debt instruments do not 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.
(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:

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 COST OF CAPITAL 4.5

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.

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
Cost of Irredeemable Debenture ( 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
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 a 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%.
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 4.6 FINANCIAL MANAGEMENT

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 what is 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
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 deb or Current
market price in case of existing debt.
RV = Redemption value of debentures
t = Tax rate applicable to the company
n = 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.

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 COST OF CAPITAL 4.7

I+
(RV-NP )
Cost of Redeemable Debenture (Kd) = n (1- t)
(RV+NP)
2
In absence of any specific information, students may use any of the above formu-
lae to calculate the Cost of Debt (Kd) with logical assumption.

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.
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 on 1.4.2017 to be matured on
1.4.2022. 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.

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 4.8 FINANCIAL MANAGEMENT

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
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 cashflows.
The relevant cash flows are as follows:
Year Cash flows
Net proceeds in case of new issue/ Current market price in case of
0
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

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 COST OF CAPITAL 4.9

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.
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 flows Discount Present Discount Present
factor @ Value factor @ Value
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

company to approximation method and it is also preferred in the field of finance.
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:

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 4.10 FINANCIAL MANAGEMENT

C1 C2 Cn
VB = + +.......+
(1+Kd) (1+Kd)
1 2
(1+Kd)n
n
Ct
VB = ∑
(1+K )
t=1 d
t

ILLUSTRATION 4
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. What is the bond’s
present value for an investor if he expects a minimum rate of return of 6 per cent?
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 x 0.08 = ` 400;
Second year : (`5,000 – `1,000) x 0.08 = ` 320;
Third year : (`4,000 – `1,000) x 0.08 = ` 240;
Fourth year : (`3,000 – `1,000) x 0.08 = ` 160; and
Fifth year : (`2,000 – `1,000) x 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:
` 1, 400 ` 1,320 ` 1,240 ` 1,160 ` 1,080
VB = + + + +
(1.06)1 (1.06)2 (1.06)3 (1.06)4 (1.06)5
` 1, 400 ` 1,320 ` 1,240 ` 1,160 ` 1,0
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

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 COST OF CAPITAL 4.11

4.5.4 Cost of Convertible Debenture

Holders of the convertibel debentures has the option to either get the debentures
redeemed into the cash or get specified numbers of companies shares in leiu of
cash. The calculation of cost of convertible debentures are very much similar to the
redeemable debentures. While determining the redeemable value of the debentures, it
is assumed that all the debenture holders will choose the option 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 @ 15% Value factor @ 20% Value
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)

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 4.12 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.

4.5.1 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 Reedemable Preference Share (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 = Life of preference shares.
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.

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 COST OF CAPITAL 4.13

ILLUSTRATION 5
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 = = 0.1077 (approx.) = 10.77%
 100 + 95 
 
2

4.5.2 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 6
XYZ & Co. issues 2,000 10% preference shares of ` 100 each at ` 95 each. Calculate
the cost of preference shares.
SOLUTION
PD
KP =
P0
(10 × 2,000) 10
Kp =
(95 × 2,000) = 95 = 0.1053 = 10.53%
ILLUSTRATION 7
If R Energy is issuing preferred stock at `100 per share, with a stated dividend of `12, and
a floatation cost of 3% then, what is the cost of preference share?

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 4.14 FINANCIAL MANAGEMENT

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

It may prima facie appear that equity capital does not carry any cost. But this is not
true. The market share price is a function of return that equity shareholders expect and
get. If the company does not meet their requirements, it will have an adverse effect on
the market share price. Also, it is relatively the highest cost of capital. Due to relative
higher risk, equity shareholders expect higher return hence, the cost of capital is also
high.
In simple words, cost of equity capital is the rate of return which equates the present
value of expected dividends with the market share price. In theory, the management
strives to maximize the position of equity holders and the effort involves many
decisions.
Different methods are employed to compute the cost of equity share capital.

4.7.1 Dividend Price Approach

This is also known as Dividend Valuation Model. This model makes an assumption that
the market price of a share is the present value of its future dividends stream. As per
this approach the cost of equity is the rate which equates the future dividends to the
current market price. Here, cost of equity capital is computed by dividing the expected
dividend by market price per share.
Dividend Price Approach with Constant Dividend: In this approach dividend is
constant, which means there is no-growth or zero growth in dividend. The cost of
equity can be calculated as follows:

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 COST OF CAPITAL 4.15

D
Cost of Equity (K e ) =
P0
Where,
Ke = Cost of equity
D = Expected dividend
P0 = Market price of equity (ex- dividend)
This model assumes that dividends are paid at a constant rate to perpetuity. It ignores
taxation.
Dividend Price Approach with Constant Growth: 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 (K e )= +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:

D1
Cost of Equity (K e )= +g
P1 -F
Where, F = Flotation cost per share.

ILLUSTRATION 8
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
D ` 1(1+0.1)
K e = 1 +g= +0.1 = 0.12 = 12%
P0 ` 55

Dividend Discount Model with variable growth rate is explained in chapter 10 i.e.
Dividend Decision

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 4.16 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
the company is expected to earn 30% the investor will be prepared to pay ` 150
 30 
 ×100 for each share of ` 100.
20 

Earnings/ Price Approach with Constant Earnings:

E
Cost of Equity (K e )=
P
Where,
E = Current earnings per share
P = Market share price
Since practically earnings do not remain constant and the price of equity shares is
also directly influenced by the growth rate in earnings. The above formula need to
be modified to reflect the growth element.
Earnings/ Price Approach with Growth in Earnings:
E
Cost of Equity (K e )= +g
P
Where,
E = Current earnings per share
P = Market price per share
g = Annual growth rate of earnings.
The Earning Price Approach is similar to the dividend price approach; only it seeks to
nullify the effect of changes in the dividend policy.
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:

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 COST OF CAPITAL 4.17

(i) Average Method

It calculated as below:
Current Divident (D0) = Dn(1+g)n
or

D0
Growth rate (g) = n -1
Dn
Where,
D0 = Current dividend,
Dn = Dividend in n years ago
Trick: 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
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 10 i.e. Dividend Decision )

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 4.18 FINANCIAL MANAGEMENT

4.7.3 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.
ILLUSTRATION 9
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 @ 12% Present 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.
4.7.4 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.

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 COST OF CAPITAL 4.19

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.
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 )

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 4.20 FINANCIAL MANAGEMENT

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 premium

Risk Return relationship of various securities

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.

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 COST OF CAPITAL 4.21

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 10
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%

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

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 4.22 FINANCIAL MANAGEMENT

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, sometime cost of retained
earnings remains below the cost of equity due to saving in floatation cost and
existence of personal tax.
The Cost of Retained Earnings (Ks) is calculated as below:
In absence of any information on personal tax (tp):
Cost of Retained Earnings (Ks) = Cost of Equity Shares (Ke)
If there is any information on personal tax (tp):
Ks = Ke -tp
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.
ILLUSTRATION 11
ABC Company provides the following details:
D0 = ` 4.19 P0 = ` 50 g = 5%
Calculate the cost of retained earnings.
SOLUTION
D1 D0(1+g)
Ks = +g= +g
P0 P0
` 4.19(1+0.05)
= +0.05
`50

= 0.088 + 0.05 = 13.8%

ILLUSTRATION 12
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
Ks = Rf + ß (Rm – Rf )
= 7% + 1.20 (6%) = 7% + 7.20
Ks = 14.2%

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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
related 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 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)
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. The weighted average cost of capital for a firm is of
use in two major areas:-
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 4.24 FINANCIAL MANAGEMENT

1. In consideration of the firm’s position;

2. Evaluation of proposed changes necessitating a change in the firm’s capital. Thus,
a weighted average technique may be used in a quasi-marginal way to evaluate a
proposed investment project, such as the construction of a new building.
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.
The steps to calculate WACC is as follows:
Step 1: Calculate the total capital from all the sources.
(i.e. Long term debt capital + Pref. Share Capital + Equity Share Capital +
Retained Earnings)
Step 2: Calculate the proportion (or %) of each source of capital to the total capital.
 Equity Share Capital (for example) 
 i.e. Total Capital (as calculated in Step 1 above) 

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 capital Total
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.

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 COST OF CAPITAL 4.25

Securities analysts employ WACC all the time when valuing and selecting investments.
In discounted cash flow analysis, WACC is used as the discount rate 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.
But there are problems in determination of weighted average cost of capital. These
mainly relate to:-
1. Computation of equity capital and;
2. Assignment of weights to the cost of specific source of financing. Assignment of weights
can be possible either on the basis of historical weighting or marginal weighting.
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.
ILLUSTRATION 13
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
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 4.26 FINANCIAL MANAGEMENT

The market prices of these securities are:

Debentures ` 105 per debenture
Preference shares ` 110 per preference share
Equity shares ` 24 each.
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%.
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 (Ke) = =
 RV + NP   RV + NP 
   
2 2 
(100 - 96)
10(1 - 0.5) +
Cost of debt = (Kd) =
10  5 + 0.4 
= = = 0.055 (approx.)
(100 + 96)  98 
2
 2 
5+
 10   5.2 
Cost of preference shares =Kp =  198  =  99  =0.053 (approx.)
 
2 
(a) Calculation of WACC using book value weights
Source of capital Book Value Weights After tax cost WACC (Ko)
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
WACC (Ko) = 0.0769 or 7.69%
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 COST OF CAPITAL 4.27

(b) Calculation of WACC using market value weights

Source of capital Market Weights After tax WACC (Ko)
Value cost 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%

4.11 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 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 14
ABC Ltd. has the following capital structure which is considered to be optimum as on
31st March, 2017.

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 4.28 FINANCIAL MANAGEMENT

(`)
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 (consuming new equity from retained earnings)
(B) Calculate marginal cost of capital when no new shares are issued.
(C) How much 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.
(D) What will the 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

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 COST OF CAPITAL 4.29

(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
` 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

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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
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.

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TEST YOUR KNOWLEDGE

MCQs based Questions
1. Which of the following is not an assumption of the capital asset pricing model
(CAPM)?
(a) The capital Market is efficient
(b) Investors lend or borrow at a risk-free rate of return
(c) Investors do not have the same expectations about the risk and return
(d) Investor’s decisions are based on a single-time period
2. Given: risk-free rate of return = 5 % market return = 10%, cost of equity = 15%
value of beta (β) is:
(a) 1.9
(b) 1.8
(c) 2.0
(d) 2.2
3. Which of the following sources of funds is related to Implicit Cost of Capital?
(a) Equity Share Capital,
(b) Preference Share Capital,
(c) Debentures,
(d) Retained earnings.
4. Which of the following cost of capital require to adjust tax?
(a) Cost of Equity Shares,
(b) Cost of Preference Shares,
(c) Cost of Debentures,
(d) Cost of Retained Earnings.
5. Marginal Cost of capital is the cost of:
(a) Additional Revenue,
(b) Additional Funds,
(c) Additional Interests,
(d) None of the above.
6. In order to calculate Weighted Average Cost of Capital, weights may be based on:
(a) Market Values,
(b) Target Values
(c) Book Values,
(d) Anyone.
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7. Firm’s Cost of Capital is the average cost of :

(a) All sources of finance,
(b) All Borrowings,
(c) All share capital,
(d) All Bonds & Debentures.
Theoretical based Questions
1. What is meant by weighted average cost of capital? Illustrate with an example.
2. Discuss the dividend-price approach, and earnings price approach to estimate
cost of equity capital.
3. What is the difference between Book Value and Market Value?
4. What is Marginal Cost of Capital?
5. Explain YTM approach of calculating Cost of Debt.
6. What is the meaning of Amortisation of Bond?
Practical Problems
1. Determine the cost of capital of Best Luck Limited using the book value (BV)
and market value (MV) weights from the following information:
Sources Book Value Market Value
(`) (`)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 —
Preference shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000
Additional information :
I. Equity : Equity shares are quoted at ` 130 per share and a new issue priced at
` 125 per share will be fully subscribed; flotation costs will be ` 5 per share.
II. Dividend : During the previous 5 years, dividends have steadily increased from
` 10.60 to ` 14.19 per share. Dividend at the end of the current year is expected
to be ` 15 per share.
III. Preference shares : 15% Preference shares with face value of ` 100 would realise
` 105 per share.
IV. Debentures : The company proposes to issue 11-year 15% debentures but
the yield on debentures of similar maturity and risk class is 16% ; flotation
cost is 2%.
V. Tax : Corporate tax rate is 35%. Ignore dividend tax.

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2. Gamma Limited has in issue 5,00,000 ` 1 ordinary shares whose current

ex-dividend market price is ` 1.50 per share. The company has just paid a dividend of
27 paise per share, and dividends are expected to continue at this level for some time.
If the company has no debt capital, what is the weighted average cost of capital?
3. Masco Limited wishes to raise additional finance of ` 10 lakhs for meeting its
investment plans. It has ` 2,10,000 in the form of retained earnings available
for investment purposes. Further details are as following:
(1) Debt / equity mix 30%/70%
(2) Cost of debt
Upto ` 1,80,000 10% (before tax)
Beyond ` 1,80,000 16% (before tax)
(3) Earnings per share `4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate in dividend 10%
(6) Current market price per share ` 44
(7) Tax rate 50%
You are required:
(a) To determine the pattern for raising the additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity, and
(d) Compute the overall weighted average after tax cost of additional finance.
4. The following details are provided by the GPS Limited :
(`)
Equity Share Capital 65,00,000
12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000
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.
ANSWERS/SOLUTIONS
Answers to the MCQs based Questions
1. (c) 2. (c) 3. (d) 4. (c) 5. (b) 6. (d)
7. (a)

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 4.34 FINANCIAL MANAGEMENT

Answers to the Theoretical Questions

1. Please refer paragraph 4.10
2. Please refer paragraph 4.7.1
3. Please refer paragraph 4.10.1
4. Please refer paragraph 4.11
5. Please refer paragraph 4.5.3.1
6. Please refer paragraph 4.5.3.2
Answers to the Practical Problems
D1 ` 15
1. (i) Cost of Equity (Ke) = +g= +0.06 (refer to workingnote)
P0 -F `125-`5

Ke = 0.125 + 0.06 = 0.185

Working Note: Calculation of ‘g’
14.19
` 10.6(1+g)5 = ` 14.19 Or, (1+g)5 = = 1.338
10.6

Table (FVIF) suggests that `1 compounds to `1.338 in 5 years at the

compound rate of 6 percent. Therefore, g is 6 per cent.
D1 ` 15
(iii) Cost of Retained Earnings (Ks) = +g= +0.06 = 0.18
P0 `125
PD `15
(iv) Cost of Preference Shares (Kp) = = = 0.1429
P0 `105
 RV -NP 
I(1- t)+ 
 n 
(iv) Cost of Debentures (Kd) =
RV+NP
2

 ` 100-` 91.75 * 
` 15(1- 0.35)+  
 11 years
= ` 100+` 91.75 *
2
` 15×0.65+ ` 0.75 ` 10.5
= = = 0.1095
` 95.875 ` 95.875
*Since yield on similar type of debentures is 16 per cent, the company would be
required to offer debentures at discount.

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 COST OF CAPITAL 4.35

Market price of debentures (approximation method) = Coupon rate ÷ Market rate

of interest
= ` 15 ÷ 0.16 = ` 93.75
Sale proceeds from debentures = `93.75 – ` 2 (i.e., floatation cost) = `91.75
Market value (P0) of debentures can also be found out using the present
value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF
(16%, 11 years)
P0 = `15 × 5.029 + `100 × 0.195
P0 = `75.435 + `19.5 = ` 94.935
Net Proceeds = `94.935 – 2% of `100 = ` 92.935
Accordingly, the cost of debt can be calculated
Cost of capital (amount in lakh of rupees)
[BV weights and MV weights]
Weights Specific Total cost
Source of capital Cost (K)
BV MV (BV × K) (MV × K)
Equity Shares 120 160* 0.1850 22.2 29.6
Retained Earnings 30 40* 0.1800 5.4 7.2
Preference Shares 9 10.4 0.1429 1.29 1.49
Debentures 36 33.75 0.1095 3.94 3.70
Total 195 244.15 32.83 41.99
*Market Value of equity has been apportioned in the ratio of Book Value of
equity and retained earnings
Weighted Average Cost of Capital (WACC):
` 32.83
Using Book Value = ` 195 = 0.1684 or 16.84%

` 41.99
Using Market Value = = 0.172 or 17.2%
` 244.15
2. Market value of equity, E = 5,00,000 shares x `1.50 = `7,50,000
Market value of debt, D = Nil
D1 ` 0.27
Cost of equity capital, Ke = = = 0.18
P0 ` 1.50
Since there is no debt capital, WACC = Ke = 18 per cent.

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 4.36 FINANCIAL MANAGEMENT

3. (a) Pattern of raising additional finance

Equity 70% of ` 10,00,000 = ` 7,00,000
Debt 30% of ` 10,00,000 = ` 3,00,000
The capital structure after raising additional finance:
(`)
Shareholders’ funds
Equity Capital (7,00,000–2,10,000) 4,90,000
Retained earnings 2,10,000
Debt (Interest at 10% p.a.) 1,80,000
(Interest at 16% p.a.) (3,00,000–1,80,000) 1,20,000
Total Funds 10,00,000
(b) Determination of post-tax average cost of additional debt
Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate
On ` 1,80,000 = 10% (1 – 0.5) = 5% or 0.05
On ` 1,20,000 = 16% (1 – 0.5) = 8% or 0.08
Average Cost of Debt
(` 1,80,000×0.05)+(` 1,20,000×0.08)
= ×100 = 6.2%
` 3,00,000
(c) Determination of cost of retained earnings and cost of equity applying
Dividend growth model:
D
Ke = 1 + g
P0

Where,
Ke = Cost of equity
D1 = DO(1+ g)
D0 = Dividend paid (i.e., 50% of EPS = 50% × ` 4 = ` 2)
g = Growth rate
P0 = Current market price per share
` 2(1.1) ` 2.2
Then, K e = +0.10 = +0.10 = 0.05+0.10 = 0.15 = 15%
` 44 ` 44

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 COST OF CAPITAL 4.37

(d) Computation of overall weighted average after tax cost of additional

finance
Particular (`) Weights Cost of Weighted
funds Cost (%)
Equity (including retained 7,00,000 0.70 15% 10.5
earnings)
Debt 3,00,000 0.30 6.2% 1.86
WACC 10,00,000 12.36
4. Calculation of Weighted Average Cost of Capital (WACC)
Source Amount (`) Weight Cost of Capital WACC
after tax
Equity Capital 65,00,000 0.619 0.163 0.1009
12% Preference Capital 12,00,000 0.114 0.120 0.0137
15% Redeemable 20,00,000 0.190 0.105* 0.020
Debentures
10% Convertible 8,00,000 0.076 0.07** 0.0053
Debentures
Total 1,05,00,000 1.0000 0.1399
* Cost of Debentures (after tax) = 15 (1 – 0.30) = 10.5% = 0.105
** Cost of Debentures (after tax) = 10 (1 – 0.30) = 7% = 0.07
Weighted Average Cost of Capital = 0.1399 = 13.99%
(Note: In the above solution, the Cost of Debentures has been computed in the
above manner without considering the impact of special features i.e. redeemability
and convertibility in absence of requisite information.)

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