COST OF CAPITAL

Introduction:
It has been discussed earlier that for evaluating capital investment proposals according to the
sophisticated techniques like Net Present Value and Internal Rate of Return, the criterion used to
accept or reject a proposal is the cost of capital. The cost of capital plays a significant role in
capital budgeting decisions. In the present lesson the concept of cost of capital and the methods
for its computation are explained.

Cost of capital-Key Concepts:

The term cost of capital refers to the minimum rate of return a firm must earn on its investments.
This is in consonance with the firm’s overall object of wealth maximization. Cost of capital is a
complex, controversial but significant concept in financial management.

The following definitions give clarity management.

Hamption J. : The cost of capital may be defined as “the rate of return the firm requires from
investment in order to increase the value of the firm in the market place”.
James C. Van Horne : The cost of capital is “a cut-off rate for the allocation of capital to
investments of projects. It is the rate of return on a project that will leave unchanged the market
price of the stock”.
Soloman Ezra : “Cost of Capital is the minimum required rate of earinings or the cut-off rate of
capital expenditure”.

It is clear from the above difinitions that the cast of capital is that minimum rate of return which
a firm is expected to earn on its investments so that the market value of its share is maintained.
can also conclude from the above definitions that there are three basic aspects of the concept of
cost of capital :

i) Not a cost as such: In fact the cost of capital is not a cost as such, it is the rate of return that a
firm requires to earn from its projects.
ii) It is the minimum rate of return: A firm’s cost of capital is that minimum rate of return which
will at least maintain the market value of the share.

iii) It comprises three components :

K=ro+b+f
Where, k=cost of capital;
ro = return at zero risk level:
b = premium for business risk, which refers to the variability in operating profit (EBIT) due to
change in sales.
f = premium for financial risk which is related to the pattern of capital structure.

Importance of Cost of Capital:

The cost of capital is very important in financial management and plays a crucial role in the
following areas :
i) Capital budgeting decisions : The cost of capital is used for discounting cash flows under Net
Present Value method for investment proposals. So, it is very useful in capital budgeting
decisions.
ii) Capital structure decisions : An optimal capital structure is that structure at which the value of
the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing
optimal capital structure.
iii) Evaluation of financial performance : Cost of capital is used to evaluate the financial
performance of top management. The actual profitabily is compared to the expected and actual
cost of capital of funds and if profit is greater than the cost of capital the performance nay be said
to be satisfactory.
iv) Other financial decisions : Cost of capital is also useful in making such other financial
decisions as dividend policy, capitalization of profits, making the rights issue, etc.
Classification of Cost of Capital :
Cost of capital can be classified as follows :
i) Historical Cost and Future Cost : Historical costs are book costs relating to the past, while
future costs are estimated costs act as guide for estimation of future costs.
ii) Specific Costs and Composite Costs : Specific cost is the cost of a specific source of capital,
while composite cost is combined cost of various sources of capital. Composite cost, also known
as the weighted average cost of capital, should be considered in capital and capital budgeting
decisions.
iii) Explicit and Implicit Cost : Explicit cost of any source of finance is the discount rate which
equates the present value of cash inflows with the present value of cash outflows. It is the
internal rate of return and is calculated with the following formula;

Io = Net cash inflow received at zero of time

C = Cash outflows in the period concerned
K = Explicit cost of capital
N = Duration of time period

Implicit cost also known as the opportunity cost is the opportunity foregone in order to take up a
particular project. For example, the implicit cost of retained earings is the rate of return available
to shareholders by investing the funds elsewhere.

iv) Average Cost and Marginal Cost : An average cost is the combined cost or weighted average
cost of various sources of capital. Marginal cost refers to the average cost of capital of new or
additional funds required by a firm. It is the marginal cost which should be taken into
consideration in investment decisions.
Determination of Cost of Capital:
As stated already, cost of capital plays a very important role in making decisions relating to
financial management. It involves the following problems.
Problems in Determination of Cost of Capital:
i) Conceptual controversy regarding the relationship between cost of capital and capital structure
is a big problem.
ii) Controversy regarding the relevance or otherwise of historic costs or future costs in decision
making process.
iii) Computation of cost of equity capital depends upon the excepted rate of return by its
investors. But the quantification of expectations of equity shareholders is a very difficult task.
iv) Retained earnings has the opportunity cost of dividends forgone by the shareholders. Since
different shareholders may have different opportunities for reinvesting dividends, it is very
difficult to compute cost of retained earnings.
v) Whether to use book value or market value weights in determining weighted average cost of
capital poses another problem.
Computation of Cost of Capital:
Computation of cost capital of a firm involves the following steps :
i) Computation of cost of specific sources of a capital, viz., debt, preference capital, equity and
retained earnings, and
ii) Computation of weighted average cost of capital.

Cost of Debt (kd)

Debt may be perpetual or redeemable debt. Moreover, it may be issued at par,at premium or
discount. The computation of cost of debt in each is explained below.

Perpetual / irredeemable debt :

Kd = Cost of debt before tax =I/Po

Kd = Cost of debt; I= interest; Po = net proceeds
kd(after-tax) = I/P(1-t)
Where t = tax rate

Example
Note:

Net Proceeds means: Total Amount Received- Cost for receiving such amount
Total Amount Received= 200000+ (200000*10%)(Premium)=200000+20000=220000
Total Cost for receiving such amount = 220000*2/100(2% floatation charges)=4400
Therefore, Net proceeds= 220000-4400= 215600.
Example
A company issued Rs. 1,00,000, 10% redeemble debentures at a discount of 5%. The cost of
floatation amount to Rs. 3,000. The debentures are redeemable after 5 years. Compute before
– tax and after – tax cost of debt. The tax rate is 50%.
Cost of Preference Capital (kP)
In case of preference share dividend are payable at a fixed rate. However, the dividends are not
allowed to be deducted for computation of tax. So no adjustment for tax is required. Just like
debentures, preference share may be perpetual or redeemable. Further, they may be issued at par,
premium or discount.

Perpetual Preference Capital

i) If issued at par ; Kp = D/P
Kp = Cost of preference capital
D = Annual preference dividend
P = Proceeds at par value
ii) If issued at premium or discount
Kp = D/NP Where NP = net proceeds.
Example :
A company issued 10,000, 10% preference share of Rs. 10 each, Cost of issue is Rs. 2 per share.
Calculate cost of capital if these shares are issued (a) at par, (b) at 10% premium, and (c) at
5% discount.
Example :
A company issues 1,00,000, 10% preference share of Rs. 10 each. Calculate the cost of
preference capital if it is redeemable after 10 years and issued.

Cost of Equity capital

Cost of Equity is the expected rate of return by the equity shareholders. Some argue that, as
there is no legal compulsion for payment, equity capital does not involve any cost. But it is
not correct. Equity shareholders normally expect some dividend from the company while
making investment in shares. Thus, the rate of return expected by them becomes the cost of
equity. Conceptually, cost of equity share capital may be defined as the minimum rate of
return that a firm must earn on the equity part of total investment in a project in order to
leave unchanged the market price of such shares. For the determination of cost of equity
capital it may be divided into two categories:
i) External equity or new issue of equity shares.
ii) Retained earnings.
The cost of external equity can be computed as per the following approaches :

Dividend Yield / Dividend Price Approach : According to this approach, the cost of equity
will be that rate of expected dividends which will maintain the present market price of equity
shares. It is calculated with the following formula :

This approach rightly recognizes the importance of dividends. However, it ignores the
importance of retained earnings on the market price of equity shares. This method is suitable
only when the company has stable earnings and stable dividend policy over a period of
time.

Example :
A company issues, 10,000 equity shares of Rs. 100 each at a premium of 10%. The company
has been paying 20% dividend to equity shareholders for the past five years and expected to
maintain the same in the future also. Compute cost of equity capital. Will it make any
difference if the market price of equity share is Rs. 150 ?
Dividend yield plus Growth in dividend methods

According to this method, the cost of equity is determined on the basis of the expected dividend
rate plus the rate of growth in dividend. This method is used when dividends are expected
to grow at a constant rate.

Cost of equity is calculated as :

Ke = D1 /NP +g (for new equity issue)
Where,
D1 = expected dividend per share at the end of the year. [D1 = Do(1+g)]
NP = net proceeds per share
g = growth in dividend for existing share is calculated as:
D1 / MP + g
Where,
MP = market price per share.

Example :
ABC Ltd plans to issue 1,00,000 new equity share of Rs. 10 each at par. The floatation costs
are expected to be 5% of the share price. The company pays a dividend of Rs. 1 per share and
the growth rate in dividend is expected to be 5%. Compute the cost of new equity share.
If the current market price is Rs. 15, compute the cost of existing equity share.
Solution :
Cost of new equity shares = (Ke) = D/NP +g
Ke = 1 / (10-0.5) + 0.05 = 1 / 9.5 + 0.05
= 0.01053 + 0.05
= 0.1553 or 15.53%
Cost of existing equity share: ke = D / MP + g
Ke = 1/ Rs. 15 + 0.05 = 0.0667 or 11.67%

Earnings Yield Method - According to this approach, the cost of equity is the discount rate
that capitalizes a stream of future earnings to evaluate the shareholdings. It is computed by
taking earnings per share (EPS) into consideration. It is calculated as :
i) Ke = Earnings per share / Net proceeds = EPS / NP [For new share]
ii) Ke = EPS / MP [ For existing equity]

Example
XYZ Ltd is planning for an expenditure of Rs. 120 lakhs for its expansion programme. Number
of existing equity shares are 20 lakhs and the market value of equity shares is Rs. 60. It has net
earnings of Rs. 180 lakhs.
Compute the cost of existing equity share and the cost of new equity capital assuming that
new share will be issued at a price of Rs. 52 per share and the costs of new issue will be Rs. 2
per share.
Cost of Retained Earnings (Kr)
Retained earnings refer to undistributed profits of a firm. Out of the total earnings, firms
generally distribute only part of them in the form of dividends and the rest will be retained
within the firms. Since no dividend is required to paid on retained earnings, it is stated that
‘retained earnings carry no cost’. But this approach is not appropriate. Retained earnings has
the opportunity cost of dividends in alternative investment, which becomes cost of retained
earnings. Hence, shareholders expect a return on retained earnings at least equity.
Kr = Ke = D/NP+g
However, while calculating cost of retained earnings, two adjustments should be made :
a) Income-tax adjustment as the shareholders are to pay some income tax out of dividends,
and b) adjustment for brokerage cost as the shareholders should incur some brokerage cost
while invest dividend income. Therefore, after these adjustments, cost of retained earnings
is calculated as :
Kr = Ke (1-t)(1-b)

Where, Kr = cost of retained earnings

Ke = Cost of equity
t = rate of tax
b = cost of purchasing new securities or brokerage cost.

Example
A firm ‘s cost of equity (Ke) is 18%, the average income tax rate of shareholders is 30% and
brokerage cost of 2% is excepted to be incurred while investing their dividends in alternative
securities. Compute the cost of retained earnings.
Solution : Cost of retained earnings = (Kr) = Ke (1-t)(1-b)=18(1-.30)(1-.02)
=18x.7x.98=12.35%