CMS Business School Corporate finance

Module 4 – Financing decisions

INTRODUCTION:

Capital is the money or wealth needed to produce goods and services. In the most basic terms, it is
money. All businesses must have capital in order to purchase assets and maintain their operations.
Business capital comes in two main forms: debt and equity. Debt refers to loans and other types of
credit that must be repaid in the future, usually with interest. Equity, on the other hand, generally
does not involve a direct obligation to repay the funds. Instead, equity investors receive an ownership
position in the company.

SOURCES OF CAPITAL

Debt Capital

Small businesses can obtain debt capital from a number of different sources. These sources can be
broken down into two general categories, private and public sources. Private sources of debt
financing include friends and relatives, banks, credit unions, consumer finance companies,
commercial finance companies, trade credit, insurance companies, factor companies, and leasing
companies. Public sources of debt financing include a number of loan programs provided by the state
and central governments to support small businesses.

Basic concept of Cost of Capital:

"Capital is a necessary factor of production and, like any other factor, it has a cost . "The Cost of
Capital is the minimum rate of return, which enables a company to make an amount of profit on
its investment so as to ensure that the market value of the company’s equity shares either
increases or remains at the same level. This is in conformity with any company’s goal of “Wealth
Maximization” for its shareholders.

Wealth Maximization for the shareholders of a company is feasible only when the projects
financed by the company (shareholders’ money) generate revenues at a rate equal to or more than
the rate expected by the shareholders.
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Two major schools of thought have emerged having basic difference on the relevance of cost of
capital. In one camp, Modigline Miller argued that a firm’s cost of capital is constant and it is
independent of the method and level of financing. In another camp (traditional theorists), cost of
capital is variable and dependent on cost of capital structure. In both the camps, the optimal
policy is taken as the policy that maximizes the value of the company.

The cost of capital of a firm is the minimum rate of return expected by its investors. It is the
weighted average cost of various sources of finance used by a firm. The capital used by a firm may be
in the form of debt, preference shares, equity shares and retained capital. A decision to invest in a
particular project depends upon the cost of capital of the firm or the cutoff rate, which is the minimum
rate of return expected by the investors. In case a firm is not able to achieve even the cut off rate, the
market value of its shares will fall. Generally, higher the risk involved in a firm, higher the cost of
capital.

In the worlds of Hunt, William and Donaldson, “Cost of Capital may be defined as the rate that must
be earned on the net proceeds to provide the cost elements of the burden at the time they are due”.

Tim Hindle defines it as “an average of cost of a company’s various types of capital; ordinary
shares, preference shares, debentures, bonds, loans, retained profit and so on.

COST OF CAPITAL – CONCEPT:

The term Cost of Capital is a concept having many different meanings. Three viewpoints,
regarding the cost of capital are given below;

1. FROM INVESTORS’ POINT OF VIEW:

The cost of capital may be defined it as “the measurement of the sacrifice made by him in
capital formation. For example, Mr. A, an investor invested in a company’s equity shares,
amount Rs 1,00,000, instead of investing in a bank at the rate of 7% interest. Here, he had
sacrifices 7% interest for not having invested in the bank.
2. FIRMS’ POINT OF VIEW:

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It is the minimum required rate of return needed to justify the use of capital. For example, a
firm raised Rs 50 lakhs through the issue of 10% debentures, for justifying this issue, a
minimum rate of return it must earn is 10%.
3. CAPITAL EXPENDITURE POINT OF VIEW:
The cost of capital is the minimum required rate of return, the hurdle or target rate of return or
the cut off rate or any discounting rate used to value cash flows.

For example, Firm A is planning to invest in a project that requires Rs 20 lakh as initial
investment and provides cash flows for a period of 5 years. So for the conversion of future 5
years cash inflows into present value, the cost of capital is needed.

MEANING AND DEFINITION OF COST OF CAPITAL:

The three basic aspects of the concept of Cost of Capital are:

1. Cost of Capital is not a cost as such. In fact, it is the rate of return that a firm
requires to earn from its projects.
2. It is the minimum rate of the firm. Cost of capital of a firm is that minimum rate of return
which would at least maintain the market value of the shares.
3. It comprises three components. As there is always some business and financial risk in
investing funds in a firm, cost of capital comprises of three components;
A. The expected normal rate of return at zero risk level, say the rate of interest allowed by
banks.
B. The premium for business risk; and
C. The premium for financial risk on account of pattern of capital structure.

K o =r o +b +f
K o =Cost of Capital
r o =Normal Rate of return at zero risk levelo
b = premium for business risk
r = premium for financial risk

SIGNIFICANCE OF THE COST OF CAPITAL:

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The concept of cost of capital is very important in the financial management. It plays a crucial role
in both capitals budgeting as well as decisions relating to planning of capital structure. Cost of
capital concept can also be used as a basis for evaluating the performance of a firm and it further
helps management in taking so many other financial decisions.

AS AN ACCEPTANCE CRITERION IN CAPITAL BUDGETING: According to the present

value method of capital budgeting, if the present value of expected returns from investment is greater
than or equal to the cost of investment, the project may be accepted; otherwise; the project may be
rejected

AS A DETERMINANT OF CAPITAL MIX IN CAPITAL STRUTURE: While designing an

optimal capital structure, the management has to keep in mind the objective of maximizing the value
of the firm and minimizing the cost of capital.

AS A BASIS FOR EVALUATING THE FINANCIAL PERFORMANCE:The actual profitability

of the project is compared to the projected overall cost of capital and the actual cost of capital of
funds raised to finance the project if the actual profitability of the project is more than the projected
and the actual cost of capital, the performance may be said to be satisfactory.

AS A BASIS FOR TAKING OTHER FINANCIAL DECISIONS:The cost of capital is also used
in making other financial decisions such as dividend policy, capitalization of profits, making the right
issue and working capital.

PROBLEMS IN DETERMINATION OF COST OF CAPITAL:

1. CONCEPTUAL CONTROVERSIES REGARDING THE REALTIONSHIP BETWEEN

THE COST OF CAPITAL AND THE CAPITAL STRUCTURE:
It has already been stated that the cost of capital plays a crucial role in the decisions relating to
financial management. However, the determination of the cost of capital of a firm is not an
easy task because of conceptual problems as well as uncertainties of proposed investments and
the pattern of financing.
Different theories have been propounded by different authors explaining the relationship
between capital structure, cost of capital and the value of the firm. This has resulted into

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various conceptual difficulties. According to the Net Income Approach and the Traditional
Theories both the cost of capital as well as the value of the firm have a direct relationship with
the method and level of financing? In their opinion, a firm can minimize the weighted average
cost of capital and increase the value of the firm by using debt financing. On the other hand,
Net Operating Income and Modigliani and Miller Approach prove that the cost of capital is not
affected by changes in the capital structure or say that the debt equity mix is irrelevant in the
determination of cost of capital and the value of a firm. However, the M & M approach is
based upon certain unrealistic assumption such as, there is a perfect market or the expected
earnings of all the firms have an identical risk characteristic, etc.,
2. HISTORIC COST AND FUTURE COST:
Another problem in the determination of cost of capital arises on account of the difference of
opinion as regards the concept of cost itself. It is argued that historic costs are book cost which
are related to the past and are irrelevant in the decision making. In the same manner,
arguments are given in favour of specific costs and composite cost as well as explicit cost and
implicit cost and the marginal cost.
3. PROBLEMS IN COMPUTATION OF COST OF EQUITY:
The computation of cost of equity capital depends upon the expected rate of return by its
investors. But the quantification of expectations of equity shareholders is a very difficult task
because there are many factors which influence their valuation about a firm.
4. PROBLEMS IN COMPUTATION OF COST OF RETAINED EARNINGS:
It is sometimes argued that retained earnings do not involve any cost. But in reality, it is the
opportunity cost of dividends foregone by its shareholders. Since, different shareholders may
have different opportunities for investing their dividends, it becomes very difficult to compute
the cost of retained earnings.
5. PROBLEMS IN ASSIGNING WEIGHTS:
For determining the weighted average cost of capital, weights have to be assigned to the
specific cost of individual sources of finance. The choice of using the book value of the source
or the market value of the source poses another problem in the determination of cost of capital.

COMPUTATION OF COST OF CAPITAL:

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Computation of overall cost of capital of a firm involves:

A. Computation of cost of specific source of finance, and

B. Computation of Weighted Average Cost of Capital.

COMPUTATION OF SPECIFIC SOURCE OF FINANCE:

A. COMPONENTS OF COST OF CAPITAL:

Cost of Capital (Ko ). The most important components of Cost of Capital (K o ) are listed
below:

A. Cost of Equity (Ke )

B. Cost of Preference Shares (Kp )
C. Cost of Debt (debentures and bonds) (Kd )
D. Cost of Retained Earnings (Kre)

Computation of each specific source of finance, viz., debt, preference, equity share capital and
retained earnings is discussed below;

A. Computation of Cost of Retained Earnings (Kre):

It is sometimes argued that retained earnings do not involve any cost because a firm is not
required to pay dividends on retained earnings. However, the shareholders expect a return on
retained profits. Retained earnings accrue to a firm only because of some sacrifice made by the
shareholders in not receiving the dividends out of the available profits.
The cost of retained earnings may be considered as the rate of return which the existing
shareholders can obtain by investing the after tax dividends in alternative opportunity of equal
qualities. It is, thus, the opportunity cost of dividends foregone by the shareholders.

Retained earnings are one of the internal sources to raise equity finance. Retained earnings are
those part of (amount) earnings that are retained by the form of investing in capital budgeting
proposals instead of paying them as dividends to shareholders. Corporate executives and some
analysts too normally consider retained earnings as cost free, because there is nothing legally
binding the firm to pay dividends to equity shareholders and the company has its own entity
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different from its stockholders. But it is not so, they involve opportunity cost. The opportunity
cost of retained earnings is the rate of return that shareholder foregoes by not putting his/her
funds elsewhere, because the management has retained the funds. The opportunity cost can be
well computed with the following formula;

(1−T i)
K ℜ=k e X
(1−T b)

Where Ke = cost of equity capital (D/P or E/P +g)

Ti = marginal tax rate applicable to the individual concerned

Tb = cost of purchase of new securities / brokers
D = expected dividend per share
NP = Net Proceeds of equity shares / market price
g = growth rate in %
Illustration:
A firm’s k e ( return available ¿ s h are h olders ) is15%, the average tax rate of shareholders is 40% and it
is expected that 2% is brokerage cost that shareholders will have to pay while investing their
dividends in alternative securities. What is the cost of retained earnings?

Solution:
(1−T i)
K ℜ =k e X
(1−T b)

(1−0 . 4)
K ℜ=15 X
(1−0 . 02)

(0 .60)
K ℜ=15 X
(0 .98)

K ℜ=9 .18 %

Illustration:
Excellent Fans Limited needs Rs 5, 00,000 for the expansion of its activities and it is expected to earn
a rate of return of 10% on its investment. The management of the company is considering this
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amount by retaining profits which otherwise shall be distributed to the shareholders. The
shareholders, on an average are in 60% tax bracket. If the shareholders reinvest their dividends, they
will earn 12% on new investment but have to incur a 2% brokerage cost on the purchase of new
securities. What is your recommendation to the management keeping in view the shareholders?
Solution:

(1−T i)
K ℜ=k e X
(1−T b)

(1−0 . 60)
K ℜ=12% X
(1−0 . 02)

( 0. 4)
K ℜ=12% X
(0 . 98)

K ℜ=0 .12 X 0 . 408

K ℜ=0 .0489 X 100=4 .89 %

Note: The cost of retained earnings as calculated above is 4.89%. It means if divided is paid to
shareholders; they will earn a return of 4.89% by investing in some other securities. On the other
hand, if the amount is retained, the firm will earn a rate of return of 10%. Hence, the firm should not
distribute dividend rather it should retain the amount for further expansion.

B. COMPUTATION OF COST OF EQUITY:

The cost of capital is the minimum rate of return that the company must earn on equity share
capital portion of its investment in order to leave unchanged the market price of its shares. The cost of
equity capital is a function of the expected return by its investors. The cost of equity is not the out of
pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed rate every
year. Moreover, payment of dividend is not a legal binding. It may or may not be paid. But it does not
mean that equity share capital is a cost free capital. Shareholders invest money in equity shares on the
expectations of getting dividend and the company must earn this minimum rate so that the market price of
the shares remains unchanged. Whenever, a company wants to raise additional funds by the issue of new
equity shares, the expectations of the shareholders have to be evaluated.
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Calculation of Cost of Equity (K e) capital cost brings forth, a host of problems. It is difficult and
controversial cost to measure because there is no one common basis for computation. For calculation of
cost of debt (Kd) interest charge is the base and preference dividend is the base for calculation of cost of
preference shares (Kp). Interest of debentures / debt and dividend on preference shares is fixed in terms of
the stipulations following the issues of such debentures and shares. In contrast, the return on equity
shareholders solely depends upon the discretion of the company management. A part from this, there is no
stipulation for payment of dividend to equity shareholders. They are ranked at the bottom as claimants on
the assets of the company at the time of liquidation. Though, it is quite evident from the above discussion
that equity capital does not carry any cost. However, this is not true, equity capital has some cost.
The cost of equity capital (Ke), may be defined as the minimum rate of returns that a firm must earn
on the equity financed portion of an investment project in order to leave unchanged the market price of the
shares. The cost of equity is not the out – of – pocket cost of using equity capital as the equity shareholders
are not paid dividend at a fixed rate every year.
It is the annual cost payable by the company on the equity shares. Originally, it was considered to be
dividend per share dividend by the face value of the shares. The dividend is declared at a certain
percentage on the face value of the shares. Therefore, this was a dividend divided by face value of shares.
Subsequently, this was factors entered into its computation. The simplicity and certainty of computation
are lost in the process of considering these different factors. We have three different models of
computation of cost of equity
APPROACHES TO CALCUALTE THE COST OF EQUITY (Ke):
There are six approaches available to calculate the cost of equity capital, they are;
1. Dividends Capitalization Approach / Dividend Yield Method (D/Mp Approach)
2. Dividend Capitalization Plus Growth Rate Approach (D/Mp) + g
3. Earnings Capitalization Approach/ Earnings Price Method (E/Mp Approach)
4. Capital Asset Pricing Model Approach

1. DIVIDEND CAPITALIZATION APPROACH (Dividend Yield Approach): (D/Mp

Approach)

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According to this method, the cost of equity capital is the discount rate that equates the present
value of expected future dividend per share with the net proceeds (or current market price of a
share)
This method involves dividing the dividend per share by the market price of the equity shares.
The cost of equity capital can be measured by the given formula;
DPS
Ke=
CMP orNP
Where Ke = Cost of Equity
D = Dividend per share
CMP = Current Market Price
NP = Net Proceeds
Market price exists for a company that has already listed the shares on the stock exchange.
When a company is issuing the shares (IPO), the shares are not listed. Hence, there is no
market price. In such a case, Net Proceeds received on the issue of shares would be considered.
Total Proceeds−Issue Expenses
Net Proceeds per Share¿
No of Equity Shares issued
This method assumes that investor give prime importance to dividends and risk in the firm
remains unchanged and it does not consider the growth in dividend.
Issue expenses include underwriting commission, fee of merchant banker, brokerage, printing
expenses, banker’s commission and all other expenses.
Problems:
1. A company issues 1,000 equity shares of Rs1000 each at a premium of 10%. The company
has been paying 20% dividend to equity shareholders for the past five years and expects to
maintain the same in the future also. Compute the cost of equity capital? Will it make any
difference if the market price of equity share is Rs1600? (Ans:-18.18% and 12.5%)
Solution:
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
200
Ke= X 100=18.18 %
1100
Suppose if the market price is Rs160

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200
Ke= X 100=12. 5 %
1600

2. Calculate the Cost of Equity shares; Showoff Limited issued 1 lakh ordinary shares of Rs 10
each at a discount of 10%. Share issue expenses amounted to Rs 50,000. It expected to pay
dividend @ 17% for the current year. (Ans: 20%)
Solution:
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds

( 1,00,000 @10 ) X 17
Ke= X 100
( 1,00,000 X 9 ) −50,000

1,70,000
Ke= X 100
( 9,00,000 )−50,000
1,70,000
Ke= X 100
8,50,000
Ke=20 %

3. Confidence Limited issued 50,000 equity shares of Rs 10 each at a premium of 20%. The share
issue expenses are estimated to be 10% of total sale proceeds. Calculate the cost of equity
share if the company is planning to declare a dividend @ 13.5% for the current year.
(Ans:12.5%)
Solution:
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds

( 50,000 X 10 ) X 13.5
Ke= X 100
( 50,000 X 12 )−(50,000 X 12 X 10/100)
( 5,00,000 ) X 13.5
Ke= X 100
( 6,00,000 ) −(6,00,000 X 10/100)

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67,500
Ke= X 100
( 6,00,000 ) −(60,000)
67,500
Ke= X 100
( 5,40,000 )
67,500
Ke= X 100=12.5 %
( 5,40,000 )

4. In December, 2005, ICICI Bank Limited issued equity shares through the book building route.
The cut off price was determined at Rs 500 per share for an equity share of Rs 10 face value. It
is planning to declare 85% dividend for the year 2005 -06. Calculate the cost of equity shares
assuming issue expenses at 30% of issue price (cutoff price) (Ans:2.43%)
Solution:
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
(10 X 0.85)
Ke= ¿¿
(8.5)
Ke= X 100
(500−150)
(8.5)
Ke= X 100=2.42 %
(350)

5. Repro India Limited issued 26,20,000 equity shares of Rs 10 each through book building
process open between Nov 28, 2005 to Dec 1st , 2005. The price band was Rs 145 to Rs 165.
After the closure of book running, the cut off price was fixed at Rs 150/-. It expected to pay
dividend at 100% for the year 2005 – 06. If share issue expenses amounted to 20% of the cut
off price, calculate the cost of equity shares. (Ans: 8.33%)
Solution:

Dividend Per Share

Ke= X 100
Current Market Price orNet Proceeds

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10
Ke= X 100
150−(150 X 0.20)
10
Ke= X 100
150−(30)
10
Ke= X 100
120
10
Ke= X 100=8.33 %
120

6. The details of four companies that accessed the primary capital market during 2005 – 06 are
given below. Calculate their cost of equity.
S.No Name of the Company Face Value (Rs) Issue Price (Rs) Issue ExpensesEstimated % of
(as a % of Issue Price) Dividend
1 Union Bank of India 10 100 10% 35%
2 Prathibha Industries 10 110 20% 20%
3 Malu Paper Mills 10 30 20% 30%
4 Gitanjali Gems 10 190 30% 40%

(Ans: 3.9%, 2.27%, 12.5%, 3.01%)

Solutions
Union Bank of India
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds

3.5
Ke= X 100
100−10
3.5
Ke= X 100=3.88 %
90
Prathibha Industries Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds

2
Ke= X 100
110−22
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2
Ke= X 100=2.27 %
88
Malu Papers Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
3
Ke= X 100
30−6
3
Ke= X 100=12.5 %
24
Gitanjali Gems Limited

Dividend Per Share

Ke= X 100
Current Market Price orNet Proceeds
4
Ke= X 100
190−(0.30 X 190)
4
Ke= X 100
190−57
4
Ke= X 100=3 %
133

Existing Companies:
For this existing companies, sale proceeds of issue are irrelevant. Price represents the price at
which the shares are traded in the stock exchange. This computation is based on Walter’s
Dividend Model, where the dividend determines the market price. In other words, cost of
equity capital is the rate of return the investors are expecting on their investment in the shares
of the company in the form of dividend.
1. From the following data relating to three steel companies, calculate their cost of equity
form the year 2004 – 05.
S.No Name of the Company Face Value (Rs)Dividend (%) Market Price (Rs)
1 Jindal Steel Limited 2 120 78
2 SAIL 10 33 67
3 TATA Steel Ltd 10 130 510

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Ans: 3.08%, 4.93%, 2.55%

Solution:
Jindal Steels Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
2.4
Ke= X 100=3.076 %
78

SAIL
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
3.3
Ke= X 100=4.92%
67
TATA Steels Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
13
Ke= X 100=2.54 %
510

2. The relevant data relating to certain Indian Pharmaceutical companies are given below.
Calculate the cost of equity shares;

S.No Name of the Company Face Value (Rs)Dividend (%) Market Price (Rs)
1 Cadila Health Care Ltd 5 120 620
2 Cipla 2 175 225
3 Dr. Reddy’s Lab 5 100 1100
4 Matrix Laboratories 2 60 228
5 Nicholas Piramal 2 150 177
6 Ranbaxy Laboratories 5 50 431
7 Wockhardt 5 100 390
8 Zandu Pharma 100 50 2800
9 Dabur Pharma 1 10 59
9 Amruthanjan 10 35 211
(Ans:- 0.97%, 1.56%, 0.45%, 0.53%, 1.69%, 0.58%, 1.28%, 1.79%, 0.17%, 1.66)
Solution
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Cadila Health Care Limited

Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
6
Ke= X 100=0.967 %
620
Cipla Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
3.5
Ke= X 100=1.55 %
225
Reddy’s Laboratory Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
5
Ke= X 100=0.45 %
1100
Matrix Laboratories
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
1.2
Ke= X 100=0.052 %
228
Nicholas Piramal Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
3
Ke= X 100=1.69 %
177
Ranbaxy Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
2.5
Ke= X 100=0.58 %
431
Wockhardt Limited
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
5
Ke= X 100=1.28 %
390
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Zandu Pharma
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds

50
Ke= X 100=1.78 %
2800
Dabur Pharma
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
0.10
Ke= X 100=0.169 %
59

Amruthanjan
Dividend Per Share
Ke= X 100
Current Market Price orNet Proceeds
3.5
Ke= X 100=1.65 %
211

Criticism of Dividend Yield Method:

The main limitation of this method is that it believes dividend alone determines the market
value of shares. In reality, plenty of factors contribute to the market value of the shares.
There is a serious operational weakness in this method. If the company does not declare a
dividend, cost of equity becomes zero. But, the shareholders expect a capital appreciation in
the form of bonus shares. In one respect, all the earnings of the company belong to the
shareholders ultimately. Therefore, the cost is the highest even for non dividend paying
companies.
EARNINGS CAPITALIZATION APPROACH (Earnings Price Ratio Method)(E/MP
Approach):

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Both Dividend Yield Method and Dividend Growth Method suffer when dividend declared is zero.
Many a time, dividend is totally ignored by the investors. The shareholder is more interested in
knowing the Earnings Per Share (EPS). He is indifferent to the percentage of it declared as dividend.
Therefore, EPS is compared with market price to arrive at cost of equity shares. This is nothing but
reciprocal of PE Ratio.
This method is superior in that even if dividend declared is zero. We calculate either the cost of
equity shares or market price.
A. According to this approach, the cost of equity (K e) is the discount rate that equates the present
value of expected future earnings per share with the net proceeds (or current market price) or a
share. The advocates of this approach establish a relationship between earnings and market
price of the share. They say that, it is more useful than the dividend capitalization approach,
due to two reasons, one, the earnings capitalization approach acknowledges that all earnings of
the company, after payment of fixed dividend to preference shareholders, legally belong to
equity shareholders whether they are paid as dividend or retained for investments, secondly,
and most importantly, determining the market price of equity shares is based on earnings and
not dividends. The company satisfies the requirements through equity shares and does not
employ debt. Cost of equity can be calculated with the following formula;
EPS
K e= X 100
CMP orNP

Where Ke = Cost of Equity

E = Earnings per share
CMP = Current Market Price
NP = Net Proceeds (Face Value +/- Premium or discount – floatation cost)
This method of computing cost of equity capital may be employed in the following cases;
1. When the earnings per share are expected to remain constant.
2. When the dividend payout ratio is 100 percent or when the retention ratio is zero, i.e., all
the available profits are distributed as dividend.
3. When a firm is expected to earn an amount on new equity capital, which is equal to the
current rate of earnings.
4. The market price of the share is influenced only by earnings per share.
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Limitations:
Earnings capitalization approach has the following limitations;
 All earnings are not distributed to the equity shareholders as dividend.
 Earning per Shares may not be constant.
 Share Price also does not remain constant.
Illustration:
1. A firm is considering an expenditure of Rs 60 lakh for expansion of its operations. The
relevant information is as follows;
Number of existing equity shares 10,00,000
Market value of a share Rs 60
Net Earnings 90,00,000
Compute the cost of existing equity shares and of new equity capital if new shares will be
issued at a price of Rs. 52 per share and the costs of new issue will be Rs 2 per share.
Solution:
Cost of existing equity shares;
EPS
K e= X 100
CMP
9
K e= X 100 = 15%
60
cost of New Equity Share Capital

EPS
K e= X 100
NP
9
K e= X 100
52−2
K e =18 %

Problems:
2. For the year ending 31st March, 2006, Bilpower Limited achieved an EPS of Rs 8.30. The
market price was Rs 170.30. Calculate the cost of equity shares.
(Ans:- 4.87%)

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Solution
EPS
K e= X 100
CMP orNP
8.3
K e= X 100=4.87 %
170.3

3. The EPs and Market Price of the four companies comprising the abrasive industry in India are
given below;
S.No Name of the Company EPS (Rs) Market Price (Rs) Face Value (Rs)
1 Carborandum Universal 3.90 144.25 2
2 Grindwell Norton 25.60 590 10
3 Orient Abrasives 3.30 19.75 1
3 Wendt India 35.8 692.40 10
(Ans:- 2.7%, 4.3%, 16.71%, 5.17)
Solution
EPS
K e= X 100
CMP orNP
Carborandum Universal Limited
3.9
K e= X 100=2.7 %
144.25
Grindwell Norton Limited
25.6
K e= X 100=4.33 %
590
Orient Abrasives Limited
3.3
K e= X 100=16.7 %
19.75

Wendt India Limited

35.8
K e= X 100=5.17 %
692.40

4. The EPS for the year 2004 – 05 and Market Price as on 22 nd May, 2006 of eight Tata Group
Companies are given below. Calculate the cost of equity shares of each company.
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S.No Name of the Company EPS (Rs) Market Price (Rs) Face Value (Rs)
1 Tata Chemicals 13.9 222.50 10
2 Tata Coffee 16.1 299.85 10
3 Tata Tea 21.8 683.00 10
4 Tata Elxsi 11 206.65 10
5 Tata Metaliks 18.2 160.25 10
6 Tata Sponge 14.4 109.60 10
7 Indian Hotels 14.9 1024.90 10
8 Voltas 13.1 991.95 10
(Ans:-6.25%, 5.37%,3.19%, 5.32%, 11.35%,13.14%, 1.45%, 1.32%)
Illustration:
The EPS for the year 2004 – 05 and Market price as on 22 nd May, 2006 of eight TATA Group of
Companies are given below. Calculate the Cost of Equity Shares of Each Company.
S.No Name of the
Face Value (Rs) EPS (Rs) Market Price as on
Company 22nd May, 06 (Rs)
1 TATA Chemicals 10 13.90 222.5
2 TATA Coffee 10 16.10 299.85
3 TATA Tea 10 21.80 683
4 TATA Lexis 10 11.00 206.65
5 TATA Metaliks 10 18.20 160.25
6 TATA Sponge 10 14.40 109.60
7 Indian Hotels 10 14.90 1024.90
8 Voltas 10 13.10 991.95

DIVIDEND CAPITALIZATION PLUS GROWTH RATE APPROACH (Dividend Growth

Method) (D/Mp +g):
When the dividends of the firm are expected to grow at a constant rate and the dividends
payout ratio is constant this method may be used to compute the cost of equity capital.
According to this method, the cost of equity capital is based on the dividends and the growth
rate.
This is based on Gordon’s Dividend Growth Model. If there is a constant growth in the
earnings and dividend, it is reasonable to expect it in the future also. Therefore, to the usual
cost of capital as a percentage, we add growth in earning or dividends as a percentage.
Computation of cost of equity capital based on a fixed dividend rate may not be appropriate,
because the future dividend may grow. The growth in dividends may be constant perceptually

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or may vary over a period of time. It is the best method over dividend capitalization approach,
since it considers the growth in dividends. Generally, investors invest in equity shares on the
basis of the expected future dividends rather than on current dividends. Growth in dividends
will have positive impact on share prices.
A. Cost of Capital under Constant Growth Rate Perceptually:
The formula for computation of cost of equity under constant growth rate is;

D1
Ke= +g
CMP orNP

Or

D 0 (1+ g)
Ke= +g
CMP orNP

Where Ke = cost of Equity capital

D 1= expected Dividend per share at the end of the year
NP = Net proceeds per share
CMP = Current Market Price
g = growth rate (%)
D 0= previous year dividend
Further, in case Cost of Existing Equity Share Capital is to be calculated, the NP should be
changed with MP (Market Price Per Share) in the above equation.
PROBLEMS
1. Nippo Batteries Limited declared 200% dividend for the year 2005 – 06 on its equity shares
of Rs 10 face value. The price of the share was Rs 340. If it’s expecting a growth in the
earnings for the next year at 12%, calculate the cost of equity shares for the company. (ANs:
17.88%)
Solution:
D0 (1+ g)
Ke= +g
CMP orNP

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20(1+ 0.12)
Ke= + 0.12
340

20(1.12)
Ke= + 0.12
340

22.4
Ke= +0.12
340

Ke=0.0658+0.12

Ke=0.1858(18.58 %)

2. Asian Paints Limited declared 95% dividend on its equity shares of Rs 10 for the year 2004 –
05. The market price rules at Rs 410 per share. It expected a growth rate of 8%. On the
other hand, Berger Paints Limited for the same year declared 70% dividend on its equity
shares of Rs 2 face value. The market price ruled at Rs 68. It expected a growth rate of 10%.
Calculate the cost of equity shares of each of the companies. (ANs: 10.32%, 12.06%)
Asian paints limited

D 0 (1+ g)
Ke= +g
CMP orNP

9.5 (1+ 0.08)

Ke= +0.08
410

10.26
Ke= +0.08
410

Ke=0.025+0.08

Ke=0.1050(10.5 %)

Berger Paints Limited

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D0 (1+ g )
Ke= +g
CMP orNP

1.40(1+ 0.1)
Ke= + 0.1
68
1.54
Ke= +0.1
68
Ke=0.0226+0.1
Ke=0.1226(12.26 %)

3. The following four companies were engaged in polyester packaging. They furnish the details
for the year 2004 – 05. Calculate their cost of equity shares.
S.No Name of the Company Face Value (Rs) Dividend (%) Market Price (Rs) Expected Growth Rate
(%)
1 Cosmo Films 10 40 83 3
2 Ecoplast 10 15 19 6
3 Garware Polyster 10 10 40 5
4 Polyplex Corporation 10 80 115 8

(Ans: 7.82%, 13.89%, 7.5%, 14.96)

Solutions
Cosmo Films Limited
D0 (1+ g )
Ke= +g
CMP orNP
4 ( 1+0.03 )
Ke= + 0.03
83
4 ( 1+0.03 )
Ke= + 0.03=7.96 %
83
Ecoplast Limited
1.5 ( 1+0.06 )
Ke= +¿0.06
19

1.59
Ke= +¿0.06
19
Ke=0.0836+¿0.06
Ke=0.1436(14.36 %)

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Garware Polyester Limited

1 ( 1+ 0.05 )
Ke= + 0.05
40
1.05
Ke= +0.05
40
Ke=0.026+0.05

Ke=0.07625(7.625 %)
Polyplex Corporation
8 ( 1+0.08 )
Ke= +0.08
115

8.64
Ke= + 0.08
115
Ke=0.0751+ 0.08
Ke=0.1551(15.51% )

4. The financial details of 8 Fertilizer Companies for the year 2004 – 05 are given below along
with expected growth rates. Calculate their cost of equity shares.
S.No Name of the Company Face Value (Rs) Dividend (%) Market Price (Rs) Expected Growth Rate
(%)
1 Chambal Fertilizers 10 18 34 4
2 Coromandel Fertilizers 2 85 77 6
3 EID Parry 2 225 281 8
4 Gujarath Narmada Fertilizers 10 38 103 5
5 Godavari Fertilizers 10 20 78 5
6 Gujarat State Fertilizers 10 15 190 6
7 National Fertilizers 10 10 34 4
8 Zuari Industries 10 18 234 7

Ans: (9.28%, 8.21%, 9.6%, 8.69%, 7.56%, 6.79%, 6.94%, 7.77%)

5. A company plans to issue 1,000 new shares of Rs100 each at par. The floatation costs are
expected to be 5% of the share price. The company pays a dividend of Rs 10 per share
initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of

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equity shares? If the current market price of an equity share is Rs 150, calculate the cost of
Equity? (Ans:-15.53% and 11.67%)
6. The shares of a company are selling at Rs 40 per share and it had paid a dividend of Rs 4 per
share last year. The investor’s market expects a growth rate of 5% per year. (A) Compute the
company’s equity cost of capital and (B) if the anticipated growth rate is 7% per annum,
calculate the indicated market price per share? (Ans:-15.55% and Rs 50.35)

CRITICISM OF DIVIDEND GROWTH MODEL:

The growth model attracts the same criticism as Dividend Yield Method. Dividend alone
does not determine the market price. Adding the growth percentage to the yield does not make
the method a drastically new one.
If the market price is determined for the given other factors, an operational difficulty is created
under this method also. If dividend is not declared for any reason, market value will become
zero. However, it would not be zero for many non dividend paying companies.
Again, both Dividend Yield Method and Dividend Yield Growth Method do not take into
account earning per share (EPS). EPS is an important measure as an analytical tool. However,
this is not taken to account.

COST OF EQUITY USING CAPITAL ASSET PRICING MONDEL (CAPM):

The value of an equity share is a function of cash inflows expected by the investor and the
risk associated with the cash outflows. It is calculated by discounting the future stream of dividends
at the required rate of return called the “Capitalization Rate”. The required rate of return depends
upon the element of risk associated with investment in shares. It will be equal to the risk – free rate
of interest plus the premium for risk, the required rate of return Ke for a share is;
Cost of Equity K e =Risk Free Rate of Return+ Premium for Risk

According to CAPM, the premium for risk is the difference between market return from diversified
portfolio and the risk free rate of return. It is indicated in terms of Beta Coefficient (β);
Risk Premium=Market Returnof a Diversified Portfolio−Risk Free Rate of Return ( βi ) =β i ¿ - R f ¿
Thus, Cost of Equity, according to CAPM, can be calculated as below;

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K e =R f + β i ¿ - R f ¿
K e = Cost of Equity
R f = Risk Free Rate of Return
β i = Beta Coefficient of the firm’s portfolio
Rm = Market return of a diversified portfolio

Illustration:
You are given the following facts about a firm;
1. Risk free rate of return is 11%
2. Beta – Coefficient, β i of the firm is 1.25
Compute the cost of equity capital using Capital Asset Pricing Model (CAPM) assuming a market
return of 15% next year. What would be the cost of equity if β i rises ¿1.75
Solution:
When β i is 1 .25
K e =R f + β i ¿ - R f ¿
K e =11 %+ 1. 25 ¿- 11 % ¿
K e =11 %+ 1. 25 ¿
K e =11 %+ 5 %
K e =16 %
When β i is 1 .75
K e =R f + β i ¿ - R f ¿
K e =11 %+ 1. 75 ¿- 11 % ¿
K e =11 %+ 1. 75 ¿
K e =11 %+ 7 %
K e =18 %

B. COMPUTATION OF COST OF DEBT: (Kd)

Debt which comprises debentures essentially represents borrowed funds. Interest is payable
compulsorily, even if the company is incurring losses. As the interest paid is treated as a
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business expense, there is a benefit accruing out of tax benefit. This reduces the cost of debt.
Cost of debt can be classified as:

1. Cost of Irredeemable Debentures

2. Cost of Redeemable Debentures (not for exam)

The cost of debt (Kd) is the rate of interest payable on debt. For example, a company issues Rs
1,00,000, 10% debentures at par; the before tax cost of this debt issue will also be 10%.

A. Cost of Irredeemable Debentures:

Companies are not allowed to issue irredeemable debentures. All the debentures are
redeemable within a maximum period of 5 years. When Basel – II norms applied to the
banks requiring higher capital computation based on risk weightage assigned to the assets,
most of the Indian Banks needed to raise capital. As pure equity or pure debt securities
have problems of their own, RBI allowed them to raise hybrid securities in the form of
perpetual bonds or debentures. These debentures can continue forever on the balance sheet
of the bank. They are redeemable at the option of the bank. The debenture holder has no
option to demand the redemption. Therefore, such bonds get the status of irredeemable
debt.

I (1−T )
K da = X100
NP

Where K da = Cost of debentures after tax

I = Interest payable on per debenture

T = Marginal rate of tax

NP = Net Proceeds received from the issue of debentures

In case the debt is raised at premium or discount, we should consider P as the amount of net
proceeds received from the issue and not the face value of securities.

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Further, when debt is used as a source of finance, the firm saves a considerable count in
payment of tax as interest is allowed as a deductible expense in the computation of tax. Hence,
the effective cost of debt is reduced.

I
Kda = Kdb (1-t) = (1-t)
NP

Illustration:1’

A. X limited issues Rs 50,000, 8% debentures at par. The tax rate applicable to the company
is 50%. Compute the cost of debt?
B. Y Limited issues Rs 50,000, 8% debentures at a premium of 10%. The tax rate applicable
to the company is 60%. Compute the cost of debt?
C. A Limited issues Rs 50,000, 8% debentures at a discount of 5%. The tax rate applicable
is 50%. Compute the cost of debt?
D. B Limited issues Rs 1, 00,000, 9% debentures at a premium of 10%. The cost of
floatation is 2%. The tax rate applicable is 60%. Compute the cost of debt capital?

Solution:

In all the cases, we have computed the after tax cost of debt as the firm saves on account of
tax by using debt as a source of finance.

I (1−T )
K da= X 100
NP
4,000 I (1−0.5)
A. K da= X 100=4 %
50,000
4,000 (1−0.6)
B. K da= X 100 = 2.91%
55,000
4,000 (1−0.5)
C. K da= X 100 = 4.21%
47,500
9,000 I (1−0.60)
D. K da= X 100=3.34 %
1,10,000−2,200

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C. COST OF PREFERENCE SHARES

A fixed rate of dividend is payable on preference shares. Though dividend is payable at
the discretion of the Board of Directors and there is no legal binding to pay dividend, yet it
does not mean that preference capital is cost free. The cost of preference share capital is a
function of dividend expected by its investors i.e., its stated dividend. In case of dividends
are not paid to preference shareholders, it will affect the fund raising capacity of the firm.
Hence, dividends are usually paid regularly on preference shares expect when there are no
profits to pay dividend.
Preference shares are better than equity shares because they carry fixed rate of dividend. If
it is non – cumulative, it is as good as equity shares, as there is no need to pay dividend
during the years of loss making. In case of cumulative preference shares, payment of
dividend can be postponed to profit making years. In this respect, it is better than
debentures and bonds. Debentures/ Bonds are better than preference shares by resulting in
lower tax liability dividend pain on preference shares it not allowed as business expense,
while calculating the tax liability.
Preference Shares may be redeemable or irredeemable. In India, irredeemable preference
shares are not allowed. Hence, it can only mean the preference shares the redemption date
of which is not announced at the time of issue of shares. They are compulsorily repayable
within a maximum period of 20 years.
A. Computation of Cost of Irredeemable Preference Shares
B. Computation of Cost of Redeemable Preference Shares. (Not for exam)

A. COMPUTATION OF COST OF IRREDEEMABLE PREFERENCE SHARES:

Preference shares represent a special type of ownership interest in the firm. They
are entitled to a fixed dividend, but subject to availability of profits for
distribution. The preference shares must be paid their fixed dividends before any
distribution of dividends to the equity shareholders. Their dividends are not
allowed as an expense for the purpose of taxation. In fact, the preference dividend
is a distribution of profit of the business.

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When the preference shares do not have any specific date of redemption, we call them
irredeemable preference shares. The cost is calculated by the formula used for
calculating cost of equity shares under dividend yield method. However, preference
shares are not traded on the stock exchange usually. Therefore, we do not have a
market price. “P” represents net proceeds from the issue as in the case of cost of equity
of companies making a new issue of shares.
DPS
K p= X 100
NP

Where K p = Cost of Preference shares

D = Dividend Per share
NP = Net Proceeds

Further, if preference shares are issued at premium or discount or when cost of floatation are
incurred to issue preference shares, the nominal or par value of preference share capital has to be
adjusted to find out the net proceeds from the issue of preference shares.

It may be noted that as dividends are not allowed to be deducted in computation of tax, not
adjustment is required for taxes.

PROBLEMS:

1. Zen Motors Limited issued 12% irredeemable preference shares of Rs 100 each on 15 th June,
2004. Calculate the cost of preference shares if it is (a) at par (b) at a discount of 10% and
(C) if it is at a premium of 20%.Ans:- 12%, 13.33%, 10%
2. On 1st July, 2005, financial Maverick Limited issued 10,000 preference shares of Rs 10 each
at a discount of 20%. The dividend was payable @14%. The share issue expenses
amounted to 15% of face value of the share. Calculate the cost of preference shares. (ANs:-
18.67%)
3. Zoom Tak Limited issued convertible preference shares of Rs 100 each at a premium of Rs
400 per share. Dividend was payable at 15%. The floating expenses of the shares amounted
to 10% of the issue price. Calculate the cost of preference shares. (Ans:- 3.33%)

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4. Normal Operations Limited issued 1 lakh preference shares for a net amount of Rs 45 lakh.
Dividend payable on these shares amounted to Rs 8,00,000 per annum. The total share issue
expenses amounted to Rs 3,00,000. Calculate the cost of preference shares. (Ans:- 19.05%)

WEIGHTED AVERAGE COST OF CAPITAL

Weighted Average Cost of Capital represents the overall cost of capital of the firm. It
represents the average cost at which the company was able to raise long term funds. Naturally, it
represents both owned funds and borrowed funds.
Weighted Average Cost of Capital (WACC) is also known as the “Composite Cost of Capital”,
“Overall Cost of Capital”, or “Average Cost of Capital”. It is the minimum rate of interest
generated from a project to meet the expectations of the investors. It is defined as the total of
weighted average cost of individual sources of financing. Calculations of WACC involves
following steps;
Step 1: Specific Cost of each source of finance is calculated individually
Step 2: weight is assigned to each Specific cost in the ratio of their share in the total cost
Step 3: then the weighted average cost of individual sources is arrived at
Step 4; the total of weighted average cost of all the sources is WACC
The concept of WACC gains importance since its constituents have various sources of funds, but
once they become part of the overall cost of capital, a single homogenous pool is created, which
is used for financing specific projects. While evaluating such specific projects, there is not
consideration as to which individual source of capital is funding the specific project
The ideal capital structure depicts the minimum WACC
Systems of Weighting
The assignment of weights to various sources of funds may be carried out in the following two
manners;
A. Historical or Existing Weights, or
B. Marginal Weights
Historical or Existing Weights:
In an existing capital structure of a company weights are assigned to individual sources of funds
in the ratio of their share in the total capital. When additional funds are raised by the company, it

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is presumed under this method that the ratio of individual components of overall capital funds
would continue to remain same. In other words, the additional funds would be raised in the same
ratio as the existing capital structure is optimum.
However, the above presumption may not be true in actual practice as the companies face certain
practical difficulties in ensuring that the additional capital is raised in the same ratio, in view of
the following;
A. The existing capital structure may not be optimal and it may not be desirable to maintain
status quo in respect of various individual components of the overall capital.
B. The company may not be in a position to raise additional capital in the same ratio due to
various conditions beyond the control of the company, e.g., demand supply conditions,
political uncertainty, etc.,

Under the historical weight method, there are two ways of assigning weights;
1. Book Value Weights:
Book value weights are assigned on the basis of the book value of a specific source of
funds as shown in the balance sheet of the company. Book value of that specific source
of funds is dividend by the book value of the total long term capital.
2. Market Value Weights:
Market value weights are assigned on the basis of the market value of a specific source of
funds, which is divided by the market value of the total sources of long term capital.

Disadvantages of Weighted Average Cost of Capital:

There are certain difficulties and limitations of WACC as may be explained from the following;
1. Determination of the Weights: The fundamental problem faced in the determination of the
average cost relates to assignment of weights to various individual constituents of total
capital, which is a difficult task.
2. Choice of Capital Structure: The option to decide the type of capital structure for the
determination of the average cost is a challenging and difficult task. Various kinds of
capital structure are “Current Capital Structure”, “Marginal Capital Structure”,

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“Optimum Capital Structure”, etc., normally, (but not always) “Current Capital
Structure” is considered as the optimum capital structure.
Other Limitations:
1. Average cost of capital has certain limitations and therefore is not applicable under the
following situations;
A. When the debt policy of a company is under consideration for the fundamental
changes.
B. When the dividend policy of a company is under consideration for the fundamental
changes.
C. When a company is considering change in its “Growth Objective”
D. When the “Capital Structure” of a company is under change with regard to its debt
equity proportion.
2. The assumption that the cost incurred in raising the funds is independent to the value funds
raised, may not be practically possible
3. The specific cost relates to the existing capital structure and undergoes changes when
additional funds are raised. Measurement of the cost of additional funds is rather
difficult, it can only be estimated. Change in additional financing capital structure would
result in the change of effective rate of capital.

( Equity Capital X K e ) + ( Pre ShareCapital X K p ) +( Debt X K d )

KO= X 100
Total Capital

Problem

The sources of capital structure are enumerated below;

Equity share capital Rs8,00,000

`14% Preference Share Capital Rs5,00,000

10% Term Loan Rs10,00,000

The expected dividend on equity capital is 10%. The company tax rate is 50%. You are required
to calculate the weighted average cost of capital, before and after tax.
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Computation of Weighted Average Cost of Capital (Before Tax)

Source Book Values Weights Before Tax Cost Weighted Cost (Weight
(Rs) X Before Tax Cost)
Equity Share 8,00,000 0.35 0.10 0.035
Capital
Preference Share 5,00,000 0.22 0.14 0.0308
Capital
Term Loan 10,00,000 0.43 0.10 0.043
23,00,000 1.00 0.1088

Weighted Average Cost of Capital (before tax) is 0.1088 (10.88%)

Computation of Weighted Average Cost of Capital (after Tax)

Source Book Values Weights after Tax Cost Weighted Cost (Weight
(Rs) X after Tax Cost)
Equity Share 8,00,000 0.35 0.10 0.035
Capital
Preference Share 5,00,000 0.22 0.14 0.0308
Capital
Term Loan 10,00,000 0.43 0.10 (1-0.50) 00215
=0.05
23,00,000 1.00 0.0873

Weighted Average Cost of Capital (After tax) is 0.0873 (8.73%)

Problem No:

Data below show the various source of finance used in the capital structure of a company.

Source of Finance Book Values (Rs) Market Values (Rs)

Equity Capital (10% Expected 40,000 70,000
Dividend)
Retained Earnings 10,000 Nil
10% Preference Share Capital 20,000 15,000
Debentures 30,000 35,000
Total 1,00,000 1,20,000

The after cost of retained earnings 10% and debentures is 8%

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You are asked to

1. Calculate the weighted average cost of capital using book values weights
2. Calculate the weighted average cost of capital using market values weights

Solution:

Computation of Weighted Average Cost of Capital Using Book Value Weights

Source of Amount (Rs) Weights After tax cost Weighted Cost

Finance (Weight * After
tax cost)
Equity Share 40,000 0.4 0.1 0.04
Capital
Retained 10,000 0.1 0.1 0.01
Earnings
Preference Share 20,000 0.2 0.1 0.02
Capital
Debentures 30,000 0.3 0.08 0.024
1,00,000 1.00 0.094

Weighted Average Cost of Capital as per the book values is 0.094 (9.4%)

Computation of Weighted Average Cost of Capital Using Market Value Weights

Source of Amount (Rs) Weights After tax cost Weighted Cost

Finance (Weight * After
tax cost)
Equity Share 70,000 0.58 0.1 0.058
Capital
Retained
Earnings
Preference Share 15,000 0.13 0.1 0.03
Capital
Debentures 35,000 0.29 0.08 0.0232
1,20,000 1.00 0.0942

Weighted Average Cost of Capital as per the market values is 0.0942 (9.42%)

Calculation of Cost of Debt:

Problem No1
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A 5 – year Rs 100 debenture of a firm can be sold for a net price of Rs 96.50. The
coupon rate of interest is 14% per annum and the debenture will be redeemed at 5% premium on
maturity. The firm’s tax rate is 40%. Compute the after tax cost of debentures? (Ans:- 15.58%)

Problem No 2

Assuming that a firm pays tax at 50% rate, compute the after tax cost of debt capital in the
following cases;

A. A perpetual bond sold at par, coupon rate of interest being 7%.

B. A 10 year, 8%, Rs 1,000 per bond sold at Rs 950 less 4% underwriting commission

(Ans:- (A) 3.5% (B) 5.10%)

Problem No3

X Limited issues 50,000, 8% Debentures of Rs 1,000 each at a premium of 10%. The

costs of floatation are 2%. The rate of tax applicable to the company is 60%. Compute the cost
of debt capital? (Ans:- 2.96%)

Calculation of Cost of Preference Share Capital:

Problem No 5

A company issues 1,000, 10% preference shares of Rs 100 each at a discount of 5%. Cost of
rising capital is Rs 2,000. Compute the cost of preference share capital? (Ans:- 10.75%)

Problem No 6

Calculation of Cost of Equity Share Capital:

Problem No 7

A company’s share is quoted in the market at Rs 20 currently. The company pays a dividend of
Rs 1 per share and the investor’s market expects a growth rate of 5% per year;

A. Compute the company’s equity cost of capital?

B. If the anticipated growth rate is 6%p.a., calculate the indicated market price per share.
C. If the company’s cost of capital is 8% and the anticipated growth rate is 5%p.a., calculate
the indicated market price if the dividend of Rs 1 per share is to be maintained?
(Ans:- (A) 10% (B) Rs25 (C) Rs 33.33

Problem No 8

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Mr. X is a shareholder in ABC Company Limited. Although earnings for the BC Limited have
varied considerably, Mr. X has determined that the long run average dividends for the firm have
been Rs 2 per share. He expects a similar pattern to prevail in the future. Given the volatility of
the ABC’s dividends, Mr. X has decided that a minimum rate of 20% should be earned on his
share. What price would Mr. X be willing to pay for the ABC’s share? (Ans:- Rs 10 per share)

Leverages:
Types: Operating, financial leverage, combined
Format:
Sales --------
Less: VC -----------
________________
Contribution -----------
Less: fixed Operating Ex -------------
_________________
PBI T ----------------
Less Int -------------------
___________________
PBT ----------------
Less: Tax ----------------
___________________
PAT -----------------
Less: Preference Dd -----------------
___________________
Earnings to Eq.SH --------------
____________________
 The use of the fixed-charges sources of funds, such as debt and preference capital along
with the owners’ equity in the capital structure, is described as financial leverage or
gearing or trading on equity.

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 The financial leverage employed by a company is intended to earn more return on the
fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the
return on the owners’ equity. The rate of return on the owners’ equity is levered above or
below the rate of return on total assets.
 % change ∈PBT ∆ PBT / PBT PBIT
DFL= = =
% change inPBIT ∆ PBIT / PBIT PBT

Measures of Financial Leverage

 Debt ratio
 Debt–equity ratio
 Interest coverage
EPS, ROE and ROI are the important figures for analysing the impact of financial leverage

Problem: Finex Ltd, has currently a PBIT of Rs 50000. Its fixed interest Expenses are
Rs.30,000:
and its tax rate is 50%. It has 10,000 shares outstanding. . Compute Financial leverage
in the following cases:
i) PBIT Rs. 50,000 : ii) PBIT Rs.60,000

Solution: Total value of shares: 100008*10=100000

Case A Case B
PBIT/PBIT 50000 60000
Less: Fixed cost/Interest 30000 30000
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expenses
PBT 20000 30000
Less: 50% Tax 10000 15000
PAT 10000 15000
EPS 1 1.5

EPS= PAT/ No.of shares = 10000/10000 = 1 per share : 15000/10000 = 1.5 per share
Degree of financial Leverage:
PBIT= 50000 = 50000/(50000-30000) = 2.5 times
PBIT = 60000 = 60000/ (60000-30000) =2 times

Operating leverage affects a firm’s operating profit (PBIT).

 The degree of operating leverage (DOL) is defined as the percentage change in the
earnings before interest and taxes relative to a given percentage change in sales.
% change∈PBIT ∆ PBIT / PBIT Contribution
DOL= = =
% change∈Q ∆ Q/Q PBIT

 Operating leverage affects a firm’s operating profit (PBIT), while financial leverage
affects profit after tax or the earnings per share.
Problem: A firm is currently selling a product at Rs 1000 per Unit, its Variable costs are
Rs.500 per unit, and its Fixed operating costs are Rs.200000. Compute Operating
leverage in each of the following cases:
i) sales of 500 Units
ii) sales of 600 Units

500 Units 600 units

Revenue 500 *1000 500000 600*1000 600000
V.C 500*500 250000 600*500 300000
Contribution 250000 300000
Less: Fixed 200000 200000

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operating
cost
PBIT 50000 100000

Operating Leverage: Contribution/EBIT = 250000/50000 : 300000/100000

= 5times : 3 times
 The degrees of operating and financial leverages is combined to see the effect of total
leverage on EPS associated with a given change in sales.
 The degree of combined leverage (DCL) is given by the following equation:
another way of expressing the degree of combined leverage is as follows:
Combined Leverage = Operating Leverage *Financial Leverage

% change ∈PBT ∆ PBT / PBT Contribution

DCL= = =
% change ∈Q ∆ Q/ Q PBT

Case A Case B
Sales 600 units 500 units
Revenue 500000 600000
Variable Operating Costs 250000 300000
Fixed Operating Costs 200000 200000
PBIT/PBIT 50000 100000
Less: Fixed cost/Interest 30000 30000
expenses
PBT 20000 70000
Less: 50% Tax 10000 35000
PAT 10000 35000
EPS 1 3.5
DTL 4.29 12.5
Case Study: 516 Pg no

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The ZBB Ltd.needs Rs 500,000 for construction of a new plant. The following three
financial plans are feasible:

(i) The company may issue 50,000 equity shares at Rs 10 per share.
(ii) The company may issue 25,000 equity shares at Rs 10 per share and 2,500
debentures of Rs 100 denomination bearing an 8% rate of interest.
(iii) The company may issue 25,000 equity shares at Rs 10 per share and 2,500
preference shares of Rs 100 denomination bearing an 8% rate of interest.

If the company’s earnings before interest and taxes are Rs 10,000, Rs 20,000, Rs
40,000, Rs 60,000 and Rs 1,00,000, what are the earnings per share under each of
the three financial plans? Which alternative would you recommend and why?
Assume corporate tax rate to be 50%.
CAPITAL STRUCTURE AND FIRM VALUE

Capital structure theories: The term capital structure is used to represent the
proportionate relationship between debt and equity. The various means of financing
represent the financial structure of an enterprise. The left-hand side of the balance sheet
(liabilities plus equity) represents the financial structure of a company. Traditionally,
short-term borrowings are excluded from the list of methods of financing the firm’s
capital expenditure.

 Traditional approach and Net income (NI) approach.

 Net operating income (NOI) approach.
 MM hypothesis with and without corporate tax.
 Miller’s hypothesis with corporate and personal taxes.
 Trade-off theory
Net income (NI) approach : According to NI approach both the cost of debt and the cost
of equity are independent of the capital structure; they remain constant regardless of how
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much debt the firm uses. As a result, the overall cost of capital declines and the firm value
increases with debt.
 This approach has no basis in reality; the optimum capital structure would be 100 per
cent debt financing under NI approach.

Traditional approach :The traditional approach argues that moderate degree of debt
can lower the firm’s overall cost of capital and thereby, increase the firm value. The
initial increase in the cost of equity is more than offset by the lower cost of debt. But as
debt increases, shareholders perceive higher risk and the cost of equity rises until a point
is reached at which the advantage of lower cost of debt is more than offset by more
expensive equity.

Net operating income (NOI) approach :According to NOI approach the value of the
firm and the weighted average cost of capital are independent of the firm’s capital
structure. In the absence of taxes, an individual holding all the debt and equity securities
will receive the same cash flows regardless of the capital structure and therefore, value of
the company is the same.

MM hypothesis without corporate tax - MM’s Proposition I

Assumptions:
 Perfect Capital market
 Rational investors and Managers
 Homogenous Expectations
 Equivalent Risk Classes
 Absence of taxes
 MM’s Proposition I states that the firm’s value is independent of its capital structure.
With personal leverage, shareholders can receive exactly the same return, with the same

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risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-
priced firm and buy shares of the under-priced firm until the two values equate. This is
called arbitrage.
MM’s Proposition II :The cost of equity for a levered firm equals the constant overall cost
of capital plus a risk premium that equals the spread between the overall cost of capital and
the cost of debt multiplied by the firm’s debt-equity ratio. For financial leverage to be
irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt
employed. This implies that the cost of equity must rise as financial risk increases.

 MM hypothesis with and without corporate tax.

Under current laws in most countries, debt has an important advantage over equity: interest
payments on debt are tax deductible, whereas dividend payments and retained earnings are not.
Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal
to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity
rate and the second at the cost of debt shows that the value of the levered firm is equal to the
value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the
shield is fully usable).
It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be
able to use the tax shield. Also, it ignores bankruptcy and agency costs.
Miller’s hypothesis with corporate and personal taxes.
 To establish an optimum capital structure both corporate and personal taxes paid
on operating income should be minimised. The personal tax rate is difficult to determine because
of the differing tax status of investors, and that capital gains are only taxed when shares are sold.
 Merton miller proposed that the original MM proposition I holds in a world with
both corporate and personal taxes because he assumes the personal tax rate on equity income is
zero. Companies will issue debt up to a point at which the tax bracket of the marginal bondholder
just equals the corporate tax rate. At this point, there will be no net tax advantage to companies
from issuing additional debt.

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It is now widely accepted that the effect of personal taxes is to lower the estimate of the interest
tax shield
Trade off Theory: The optimal debt-equity ration of a firm depends on the trade off between
the tax advantage of debt on the one hand and the financial distress and agency costs on the other
hand.
Financial distress arises when a firm is not able to meet its obligations to debt-holders.
For a given level of debt, financial distress occurs because of the business (operating) risk . with
higher business risk, the probability of financial distress becomes greater.
 VL =Vu+ tc D
Value of the Levered firm = Value of the Unlevered firm + tax advantage of debt
Agency Costs: Agency relationship between shareholders and creditors of firms that have
substantial sums of debt.
Pecking Order of Financing : Retained EARNINGS, Debt finance and external equity
Signalling Theory : . Meyers proposed this asymmetric information theory to explain the
Pecking order of financing.
Practical Considerations in Determining Capital Structure
o Control
o Widely-held Companies
o Closely-held Companies
o Flexibility
o Loan Covenants (condition on loan)
o Early Repayability
o Reserve Capacity
o Marketability
o Market Conditions
o Flotation Costs
o Capacity of Raising Funds
o Agency Costs

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