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.

Slide 4:

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

Slide 5:

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

Slide 6:

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

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:

Slide 9:

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

Slide 10:

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

Slide 11:

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

Slide 12:

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

Slide 13:

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 } Kr = Ke Note:- If there is involvement of floatation cost, cost of retained earnings
are slighter cheaper than cost of equity.

Slide 15:

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 }

Slide 16:

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%

Slide 17:

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

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