UNIT V

Cost of Capital

5.1 Introduction

The cost of capital is an important financial concept. It links the

company's long- term decisions with the wealth of the shareholders as
determined in the market place. Whenever, a business organization
raises funds, it has to keep in mind its cost. Hence computation of cost
of capital is very important and finance managers must have a close
look on it. In this unit, we shall discuss the concept, classification, and
importance of cost of capital the process of computing cost of capital
of individual components, weighted cost of capital, importance of cost
of capital and a few misconceptions.

5.2 Meaning and Importance

The term cost of capital refers to the minimum rate of return which a
firm must earn on its investments so that the market value of the
company's equity shares does not fall.

5.2.1 Meaning of Cost of Capital

Hampton, John defines the term as "the rate of retur n the firm requires
from investment

in order to increase the value of the firm in the market place". The
following are the basic characteristics of cost of capital :
i) Cost of capital is a rate of return, It is not a cost as such.

ii) This return, however, is calculated on the basis of actual

cost of different components of capital.
iii) A firm's cost of capital represents minimum rate of return that
will result in at least maintaining (If not increasing) the value of its
equity shares.
iv) It is related to long term capital funds.
v) Cost of capital consists of three components:
a) Return at Zero Risk Level.(r0)
b) Premium for Business Risk (b)
c) Premium for Financial Risk (f)

vi) The cost of capital may be put in the form of the following
equation : K = ro + b + f
Where

K = Cost of Capital
ro = Return at Zero Risk Level b = Premium for Business Risk f =
Premium for Financial Risk

A firm's cost of capital has mainly three risks :

Return at Zero Risk Level : This refers to the expected rate of

return when a project involves no risk whether business or financial.
Premium for Business Risk : Business risk is possibility where in
the firm will not be able to operate successfully in the market. Greater
the business risk, the higher will be the cost of capital.
Premium for Financ ial Risk : It refers to the risk on account of
pattern of capital structure. In other words, a firm having a higher
debt content in its capital structure is more risky as compared to a
firm which has a comparatively low debt content.

5.2.2 Importance
The determination of the firm's cost of capital is important from the
point of view of the following :
i) It is the basis of appraising new capital expenditure proposals.
This gives the acceptance / rejection criterion for capital expenditure
projects.
ii) The financ e manager must raise capital from different sources
in a way that it optimizes the risk and cost factors. The source of funds
which have less cost involve high risk. Cost of capital helps the
managers in determining the optimal capital structure.
iii) It is the basis for evaluating the financial performance of top
management.
iv) It helps in formulating appropriate dividend policy.
v) It also helps the organization in developing an appropriate
working capital policy.

5.3 Classification of Cost of Capital

There is no fixed base of classification of cost of capital. It varies
according to need, process and purpose. It may be classified as follows
:
Explicit Cost and Implicit Cost : Explicit cost is the discount rate
that equates the present value of the funds received by the firm net of
underwriting costs, with the present value of expected cash outflows.
Thus, it is `the rate of return of the cash flows of financing opportunity.
On the other hand, the 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 were accepted . In the other words, explicit
cost relate to raising of funds and implicit costs relate to usage of funds.
Average Cost and Marginal Cost : The average cost is the
weighted average of the costs of each components of funds. After
ascertaining costs of each source of capital, appropriate weights are
assigned to each component of capital. Marginal cost of capital is the
weighted average cost of new funds raised by the firms.
Future Cost and Historical Cost : In financial decision making, the
relevant costs are future costs. Future cost i.e expected cost of funds
to finance the projects is ascertained with the help of historical costs.

Specific Cost and Combined Cost : The costs of individual

components of capital are specific costs of capital. The combined cost
of capital is the average cost of capital as it is inclusive of cost of
capital from all sources. In capital budgeting decisions, combined cost
of capital is used for accepting / rejecting the proposals.

5.4 Computing Cost of Capital of Individual components

There are four basic sources of long term funds for a business firm : (i)
Long-term Debt and Debentures (ii) Preferences share capital, (iii)
Equity share capital, (iv) Retained Earnings. Through all of these
sources may not be tapped by the firm for funding its activities, each
firm will have some of these sources in its capital structure.

5.4.1 Cost of Long Term Debt

Debt may be issued at par, or at premium or at of discount. It may be

perpetual or redeemable. The technique of computation of cost in each
case has been explained in the following paragraphs.

(a) The formula for computing the Cost of Long Term debt at par
is
 Kd = (1 T) R
where
Kd = Cost pf long term debt
T = Marginal Tax Rate
R = Debenture Interest Rate

For example, if a company has issued 10% debentures and the

tax rate is 50%, the cost of debt will be
(1 - .5) 10 = 5%

(b) In case the debentures are issued at premium or discount,

the cost of debt should be calculated on the basis of net proceeds
realised. The formula will be as follows :
I
Kd = ------ (1 T) NP

wher
e

Kd = Cost of debt after tax

I = Annual Interest Payment

NP = Net Proceeds of Loans

T = Tax Rate

Illustration No. 1 : A company issue 10% irredeemable debentures

of Rs. 10,000. The company is in 50% tax bracket. Calculate cost of
debt capital at par, at 10% discount and at 10% premium
Solution :

Rs. 1,000
Cost of debt at par = ----------------- * (1 - .50)
Rs. 10,000

= 5%

Rs. 1,000
Cost of debt issued at = ----------------- * (1 - .50)
10% discount Rs. 9,000
 = 5.55%

Rs. 1,000
Cost of debt issued at = ----------------- * (1 - .50)
10% premium Rs. 11,000

= 4.55%
(c) For computing cost of redeemble debts, the period of
redemption is considered. The cost of long term debt is the investors
yield to maturity adjusted by the firms tax rate plus distribution cost.
The question of yield to maturity arises only when the loan is taken
either at discount or at premium. The formula for cost of debt will be

Discount Premium
I + --------------- (In case of Premium, --------------- will be
subtracted)
mp mp
---------------------- * 100 (1 T)
p + np
-----------
2
wher
e

mp = maturity period

p = nominal or par value

np = net proceeds i.e. (Par value Discount + Premium)

Illustration No. 2 : A firm issued 100 10% debentures, each of Rs.

100 at 5% discount. The debentures are to be redeemed at the end of
10th year. The tax rate is 50%. Calculate cost of debt capital.
Solution :

500
1,000 + --------
10 1,050
Cost of Debt Capital = ---------------------- * ------------ * .50
10,000 + 9,500 9,750
----------------------
2
= 5.385%

Or
10 (1-.50) + (100-95)/10
.... (As discussed in class)
(100 + 95)/2
Activity 2
1. A firm in tends to issue 10,000 10% debentures each of Rs. 10.
What is the cost of capital if the firm desires to sell at 5% premium. The
tax rate is 50%.

2. A firm issued 10,000, 10% debentures of Rs,. 10 each at a premium

of .5% with a

maturity period of 20 years. The tax rate is 50%. Find the cost of capital.

3. A company raised loan of Rs. 25,000 by 10% debentures at 10%

discount for a period

of ten years, underwriting costs are 3% and tax rate is 50%

5.4.2 Cost of Preference Capital

The preference share represents a special type of ownership interest in

the firm. Preference shareholders must receive their stated dividends
prior to the distribution of any earnings to the equity shareholders. In
this respect preference shares are very much like bonds or debentures
with fixed interest payment. The cost of preference shares can be
estimated by dividing the preference dividend per share by the current
price per share,
as the dividend can be considered a continuous level payment.
 Dividend
Cost of Preference Capital = ---------------------------------
Market Price Issue Cost

For example, A company is planning to issue 9% preference shares

expected to sell at Rs.

85 per share. The costs of issuing and selling the shares are expected
to be Rs. 3 per share.

The first step in finding out the cost of the preference capital is to
determine the rupee amount of preference dividends, which are stated
as 9% of the share of Rs. 85 per share. Thus 9% of Rs. 85 is Rs.
7.65. After deducting the floatation costs, the net proceeds are Rs.
82 per share.
Thus the cost of preference capital :

Dividend per share

= ---------------------------------
Net proceeds after selling

Rs. 7.65
= ----------- = 9.33 % Rs. 82

Cost of Reedemable Preference Share as discussed in

class

5.4.3 Cost of Equity Capital

Cost of equity capital is the cost of the estimated stream of net

capital outlays desired from equity sources E.W. Walker.
James C. Van Horne defines the cost of equity capital can be thought
of as the

rate of discount that equates the present value of all expected future
dividends per share, as perceived by investors.
The cost of equity capital is the most difficult to measure. A few
problems in this regard are as follows :
i) The cost of equity is not the out of pocket cost of using equity
capital.
ii) The cost of equity is based upon the stream of future dividends
as expected by shareholders (very difficult to estimate).
iii) The relationship between market price with earnings is known.
Dividends also affect the market value (which one is to be considered).
The following are the approaches to computation of cost of equity
capital :

(a) E / P Ratio Method : Cost of equity capital is measured by

earning price ratio. Symbolically
Eo (current earnings per share)
----- * 100
Po (current market price per share)

(b) E / P Ratio + Growth Rate Method : This method considers growth

in earnings. A

period of 3 years is usually being taken into account for growth. The
formula will be as

follows
:
3
Eo (1 + b)
-------------
Po
Where (1 + b) 3 = Growth factor where b is the growth rate as a
percentage and estimated for a period of three years.

For example , A firm has Rs. 5 EPS and 10% growth rate of earnings
over a period of 3 years. The current market price of equity share is Rs.
50
3
Rs. 5 (1+.10)
------------------ * 100
Rs. 50

Rs. 5 (1.331) 6.655

------------------ * 100 = --------------- * 100
Rs. 50 50

= 13.31%

(c) D / P Ratio Method : Cost of equity capital is measured by

dividends price ratio. Symbolically

Do (Dividend per share)

----- * 100
Po (Market price per share)
If a firm is playing a dividend of 20% on a share with a par value of
Rs. 10 as a level perpetual dividend, and its market price is Rs. 20,
then
D
P = -------- Ke

2
20 = -------- Ke

2
Ke = -------- = 10%
20

(d) D / P + Growth Rate Method : The method is comparatively more

realistic as i) it considers future growth in dividends, ii) it considers the
capital appreciation.
Thus
 D1
Ke = ------- + g
Po

wher
e,
Po = the current price of the equity share

D1 = the per share dividend expected at the end of year 1.

G = the constant annual rate growth in dividends and earnings.

The equation indicate that the cost of equity share can be found by
dividing the dividend expected at the end of the year 1 by the current
price of the share and adding the expected growth rate.

(f) Securitys Beta Method : An investor is concerned with the risk of his
entire portfolio, and that the relevant risk of a particular security is the
effect that the security has on the entire portfolio. By diversified
portfolio we mean that each investors portfolio is representative if
the market as a whole and that the portfolio Beta is 1.0. A securitys
Beta indicate how closely the securitys returns move with from a
diversified portfolio. A beta of 1.0 for a given security means that, if
the total value of securities in the market moves up by 10 percent,
the stocks price will also move up, on the average by 10 percent. If
security has a beta of 2.0, its price will, on the whole, rises or falls by
20 percent when the market rises or falls by 10 percent. A share with
0.5 percent beta will rises by 10 percent, when the market falls by 20
percent.
A beta of any portfolio of securities is the weighted average of the
betas of the securities, where the weights are the proportions of
investments in each security. Adding a high beta (beta greater than
1.0) security to a diversified portfolio increase the portfolios risk,
and adding a low beta (beta less than zero) security to a diversified
security reduces the portfolios risk.

How is beta determined ? The beta co-efficient for a security (or asset)
can be found by examining securitys historical returns rela tive to the
return of the market. As it is, not feasible to take all securities, a
sample of securities is used. The Capital Asset Pricing Model (CAPM)
uses these beta co-efficients to estimate the required rate of return on
the securities. The CAPM, specifies that the required rate on the share
depends upon its beta. The relationship is :
Ke = riskless rate + risk premium x beta
where, Ke = expected rate of return.

The current rate on government securities can be used as a riskless

rate. The difference between the long-run average rate of returns
between shares and government securities may represent the risk
premium. During 1926-1981, this was estimated in USA to be 6
percent. Beta co-efficient are provided by the published date or
can be independently estimated.
The beta for Pan Ams stock was estimated by Value Line to be 0.95 in
1984. Long-term government bond rates were about 12 percent in
November 1984. Thus the required rate of return on Pan Ams stock in
November 1984 was
Required Rate = 12% + 6% * 0.95 = 17.7 %

The use of beta to measure the cost of equity capital is

definitely a better approach. The major reason is that the method
incorporates risk analysis, which other methods do not. However, its
application remains limited perhaps because it is tedious to calculate
Beta value.

Activity 3
1. A firm has Rs. 3 EPS and 10% growth rate of earnings over a period
of 3 years. The current market price of equity share is Rs. 100. Compute
the cost of equity capital.

2. The current dividend paid by the company is Rs. 5 per share, the
market price of the equity share is Rs. 100 and the growth rate of
dividend is expected to remain constant at
10%. Find out the cost of capital.
5.4.4 Cost of Retained Earnings

Some authors do not consider it necessary to calculate separately

cost of retained earnings. They say that the cost of retained earnings is
included in the cost of equity share capital. They say that the existing
share price is used to determine cost of equity capital and this price
includes the impact of dividends and retained earnings. There
are authorities who also suggest that cost of retained earnings is to be
determined separately. Two alternative approaches are there :
i) One is to regard cost of equity capital as the cost of retained
earnings.

ii) The concept of external yields as suggested by Ezra

Soloman. It assures investment of retained earnings in another firm.
Symbolically
Cost of Retained Earnings =

D1
( -------- + G ) ( 1 TR ) (1-B) Po

= Ke ( 1 TR) ( 1 B )
wher
e
Ke = Cost of equity capital based on dividends growth method

TR = Shareholders Tax Rate

B = Percentage Brokerage Cost

For example, A firms cost of equity capital is 12% and tax rate
of majority of shareholders is 30%. Brokerage is 3%
= 12% ( 1 30% ) ( 1 3% )

= 12 * .70 * .97 = 8.15%

5.5 Weighted Cost of Capital

Weighted cost of capital is also called as composite cost of capital,

overall cost of capital, weighted marginal cost of capital, combined
cost of debt and equity etc. It comprises the costs of various
components of financing. These components are weighted according to
their relative proportions in the total capital.

5.5.1 Choice of Weights

The weights to be employed can be book value, market values, historic

or target. Book value weights are based on the accounting values to
assess the proportion of each type of capital in the firms structure.
Market value weights measure the proportion of each type of financing
at its market value. Market value weights are preferred because they
approximate the curre nt value of various instruments of finance
employed by the
company.
Historic weights can be book or market weights based on actual
data.

Activity 4

1. How is the cost of retained earnings computed ?

5.5.2 Calculating The Weighted Cost of Capital : A Few Examples

In this subsections, two problems are solved :

Illustration No. 8 : A firm has the following capital structure and after
tax costs for the different sources of funds used :

Source of Funds Amount Proportion After tax cost

Rs. % %
Debt 40,00,000 20 4.50
Preference Shares 20,00,000 10 9.00
Equity Shares 60,00,000 30 11.00
Retained Earnings 80,00,000 40 10.00
2,00,00,000 100

Calculate cost of weighted capital by using book value method.

Solution :

Method of Financing Proportion Cost Weighted cost

% %
Debt 20 4.50 0.90
Preference Shares 10 9.00 0.90
Equity Shares 30 11.00 3.30
Retained Earnings 40 10.00 4.00
9.10%