003. COST OF CAPITAL

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COST OF CAPITAL The cost of capital to a company is the minimum required rate of return that it must Earn on its investments in order to satisfy the various categories of investors, who Have made investments in the form of shares, debentures & term loans. SOURCE OF FINANCE: Equity share capital; Preference share capital; Debt amount if it is new organization. In case of existing organization in addition to above Reserve & Surplus also the one source.

COMPUTATION OF COST OF DEBT {Kd} : 

COMPUTATION OF COST OF DEBT {Kd}

IRREDEMABLE DEBT FORMULA : 

IRREDEMABLE DEBT FORMULA 1. Kd, before tax = I ------------ NP/Mpo 2. Kd, after tax = I [ 1- T ] ------------ NP Were: Kd = Cost of debt, I = Interest Amount, T = Tax Rate, Rv = Redemption value, Np = Net Proceedings [ issue price-flotation cost ] N = No of years, Mpo = Current Market Price.

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Example: 1. A 10% debentures, face value of Rs 100 each issued at [a] 100; [b] 90; [c] 110 compute cost of debt, before tax @ 50% (1) With tax rate (2) with out tax rate ? Solution: With tax rate With out tax rate Formula Kd = I Kd = I (1-T) -------- ------------ NP NP Kd = 10/100 = 10% Kd = 10 (1-0.5)/100 = 5% Kd = 10/90 = 11.11% Kd = 10 (1-0.5)/90 = 5.5% Kd = 10/110 = 9.09% Kd = 10 (1-0.5)/110 = 4.54% Note:- Tax shield on interest = Interest Tax Rate Net interest = Interest – Tax shield on interest

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Example:- 2 10% debentures, face value of Rs 100 each issued at 100 but repayable After 5 years with Rs 10 assume tax rate 40%. Compute cost of debt ? Solution: Kd = I (1-T) + Rv-NP/n ----------------------------- Rv + Np/2 I = Interest amount = 10 T = Tax rate = 40% Rv = Redemption value = 110 Np = Net proceeds = 100 n = No of years = 5 Kd = 10 (1-40%) + (110-100)/5 ----------------------------------- = 7.6% 110+100/2 If FV, IP, RV = 100 Then Kd = CR(1-T) Were:- FV = Face Value IP = Issue Price RV = Redemption Value CR = Coupon Rate Kd = Cost of Debt [ OR ] REEDEMABLE PREFERENCE SHARE Formula

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By using Internal Rate of Return [ IRR ] method Internal Rate of Return [ IRR ], Formula IRR = Li + NPVLi --------------------------- Di NPVLi - NPVHi Were:- IRR = INTERNAL RATE OF RETURN Li = LOWER INDEX NPVLi = NET PRESENT VALUE OF LOWER INDEX NPVHi = NET PRESENT VALUE OF HIGHER INDEX Di = DIFFERENCE IN INTEREST RATE = 8 + 14.7 -------------- 4 16.33 = 8 + 3.6 = 11.60

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PREFERENCE SHARE CAPITAL [ Kp ] IRREDEMABLE PREFERENCE SHARE REEDEMABLE PREFERENCE SHARE

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IRREDEMABLE PREFERENCE SHARE FORMULA Kp = Pd ------------- NP/MPo REEDEMABLE PREFERENCE SHARE FORMULA Kp = Pd + [ Rv – Np ] ------------ n --------------------------- Rv+Np/2 Kp = Cost of preference share Pd = Preference Dividend Rv = Redemption value Np = Net proceedings [ issue price – floatation cost ] Mpo = Current market value n = No of years Were:

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Example: 1. 10% preference share face value of Rs 100 each issued at 100, 90 & 110 ? Solution: Kp = Pd/NP 1. Kp = 10/100 = 10% 2. Kp = 10/90 = 11.11% 3. Kp = 10/110 = 9.09% 10% preference share of Rs 100 each issued at 100 but redeemable after 5 years @ 120 Rs ? Compute KP ? Solution: KP = Pd + [ Rv – Np ] -------------- n ------------------------------ Rv + Np/2 = 10 + [ 120-100 ] --------------- 5 -------------------------- 120 + 100/2 = 10 + 4 ----------- = Kp = 12.72% ; This formula gives only approximate answer. 110

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By Using IRR Method Internal Rate of Return [ IRR ], Formula IRR = Li + NPVLi --------------------------- Di NPVLi - NPVHi = 13 + 0.21 ---------------- 1 0.21 + 3.39 = 13 + 0.058 = 13.058% Note: 1. At IRR = NET PRESENT VALUE OF = TOTAL PRESENT VALUE OF CASH IN FLOW OUT FLOW 2. At IRR ------- NET PRESENT VALUE { NPV } = 0

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COST OF EQUITY [ Ke ] 1. Dividend Yield Model = Ke = D/MPo Formula’s 2. Dividend Yield + Growth Model = Ke = d1 ------- + g MPo = d0 ( 1+g ) -------------- + g MPo Ke = Cost of Equity; D = Dividend Per Share; MPo = Current Market Value d1 = Dividend at the end of current year; MPo = Current Market Value; g = Growth Rate in Dividend; b = Retention Rate = E – D/D r = Required Rate of Return = E/CE Were: E = EARNINGS D = DIVIDENDS CE = CAPITAL EMPLOYED

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3. Dividend Net Worth Model = Ke = D ------------------------- Average Net Worth D = Dividend Per Share Avg Net Worth = Opening + Closing Net Worth/2 Price Earning Approach [ PEA ], Ke = 1 1 EPS ------------- = --------------- --------- PER MPS/EPS MPS PER = Price Earning Ratio EPS = Earning Per Share PER = MPS/EPS MPS = Market Price Per Share 5 . Price Earning + Growth Model, Ke = EPS ---------- + g MPS g = Growth in Earning Per Share

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6 . CAPITAL ASSET PRICING MODEL [ CAPM ] Ke = Rf + β [ Rm – Rf ] Rp = Rm - Rf Were: Rf = Risk free rate of return Rm = Return on market Portfolio β = Beta Factor Rp = Risk Premium Note: 1. If floatation cost was given in problem then reduce floatation cost from market price. { Mpo – Floatation cost } 2. If issue price differs with market price use issue price rather than market price in the formula.

COST OF RETAINED EARNINGS [ Kr ] { Opportunity Cost Approach } : 

COST OF RETAINED EARNINGS [ Kr ] { Opportunity Cost Approach } Kr = Ke Note:- If there is involvement of floatation cost, cost of retained earnings are slighter cheaper than cost of equity.

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WEIGHTED AVERAGE COST OF CAPITAL [ WACC / Ko ] A company cost of capital is nothing but the weighted arithmetic average of The cost of various sources of finances that have been used by it. WACC / Ko = [ Ko is also known as overall cost of capital ] Source of Cost of Weighted Average Fund Amount Weights Capital Cost of Capital ------------------------------------------------------------------------------------------------------------ Equity Capital 50 0.50 15% 7.5% Preference Capital 25 0.25 14% 3.5% Debt 25 0.25 8% 2% ----------- ----------- ------------- 100 1 WACC 13 ----------- ----------- -------------- { OR }

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WACC / Ko = Kd D + Kp P + Ke E ------ ------ ----- V V V = 8% {25/100} + 14% {25/100} + 15% {50/100} = 2% + 3.5% + 7.5% = 13%

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If you really want to judge of the character of a man, look not at his great performance. Every fool may become a hero at one time or another. Watch a man do his most common actions; those are indeed the things which will tell you the real character of a great man. - Swami Vivekananda