ADVANCED FINANCIAL MANAGEMENT

Module No. 1: Cost of Capital and Capital Structure Theories

Cost of Capital: Meaning and Definition – Significance of Cost of Capital – Types of
Capital – Computation of Cost of Capital – Specific Cost – Cost of Debt – Cost of
Preference Share Capital – Cost of Equity Share Capital – Weighted Average Cost of Capital
– Problems.
Theories of capital structures: The Net Income Approach, The Net Operating Income
Approach, Traditional Approach and MM Hypothesis – Problems.

------------------------------------------------------------------------------------------------------------

Cost of Capital
MEANING OF COST OF CAPITAL

Cost of Capital is the minimum rate of return expected by investors who contribute capital
for a business enterprise. In other words, cost of capital is the rate of return required to
persuade the investors to make an investment.

For investors, cost of capital represent the degree of perceived risk, it is the opportunity cost
of making specific investment. It is a decisive factor in financial decision making. Investors
will use the cost of capital to compare different investments with equal risk factors.

According to John J. Hampton, cost of capital is "the rate of return the firm required
from investment in order to increase the value of the firm in the market place".

According to Solomon Ezra, cost of capital is "the minimum required rate of earnings
or the cut-off rate of capital expenditure".

According to James C. Van Horne, cost of capital is "a cut-off rate for the allocation of
capital to investment projects. It is the rate of return on a project that will leave
unchanged the market price of the stock".

IMPORTANCE OF COST OF CAPITAL IN FINANCIAL DECISIONS:

The concept of cost of capital plays a significant role in decision making process of Financial
Management. The financial leverage, capital structure, dividend policy, working capital
management, financial performance appraisal of management etc. are largely influenced by
cost of capital. Cost of capital is the significant part of financial management. The
importance of cost of capital in financial decisions can be understood from the following:
MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,
MMK & SDM College, Mysuru. Page 1
 ADVANCED FINANCIAL MANAGEMENT

1. Maximizing the value of the firm: The objective of a financial decision is to maximize
the value of a firm. A firm can maximize its value by minimising the average cost of capital.
The average cost of capital can be minimized by judicious blend of debt and equity in firm's
capital structure. Thus cost of capital plays an important role in maximizing the value of the
firm.

2. Capital budgeting decisions: Capital budgeting decision mainly depends on the cost of
capital of each source. Cost of capital is used as a discounting rate to evaluate different kinds
of projects under the discounted cash flow techniques, such as - Net present value, Internal
Rate of Return, profitability Index, Accounting Rate of Return etc.

3. Designing capital structure: Cost of capital plays an important role while designing the
capital structure of a company. Capital structure is the mix or the proportion of different
types of long term securities. A company applies only a few source of capital which
promises to keep the cost of capital minimum or ensures good rate of return on investments.

4. Evaluating financial performance: The concept of cost of capital can be used to evaluate
the financial performance of the top management. This can be done by comparing the actual
profitability of the investment project with the overall cost of capital.

5. Management of working capital: Cost of capital plays an important role in management

of working capital. In management of working capital, cost of capital may be used to
calculate the cost of carrying investment in receivables and to evaluate alternative policies
regarding receivables.

6. Dividend decisions: Cost of capital contributes significantly while taking dividend

decisions. The dividend policy of a firm should be formulated according to the nature of the
firm (that means, whether it is growth firm, normal firm or declining firm). The nature of the
firm is determined by comparing the IRR and the cost of capital, which indicate the growth
firm, normal firm and decline firm, respectively.

TYPES OF COST OF CAPITAL

The cost of capital is determined for different sources of capital. Capital budgeting decisions
depend upon the careful analysis of cost of capital of different sources of finance. It includes
the following.

1. Cost of debt capital

2. cost of preferential capital
3. cost of equity share capital
4. cost of retained earnings

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 2
 ADVANCED FINANCIAL MANAGEMENT

1. COST OF DEBT CAPITAL (KD):

Cost of debt capital is the rate of return expected by the lenders of debt capital. The
debt capital is raised from different sources, they include issue of debentures and
bonds or public deposits. debt capital is one of the sources of outsiders fund.
The interest on debt is at tax deductible expense, therefore the cost of debt is
calculated as an after tax.
Debentures or issued either at par or at discount or at premium. For calculating cost of
capital, Debentures are classified into two types they are
A. Irredeemable debentures.
B. Redeemable debentures.
A. Calculation of Irredeemable debentures Formula for calculating Irredeemable
debentures or perpetual debt is:

Problem - 1
ABC Company Ltd issues irredeemable debentures of 1000 each with 10% coupon rate of
interest to raise 5,00,000. The debentures are issued at par and the company is in 25% tax
bracket.
Problem - 2
XYZ company limited issues 8% irredeemable debentures of 1000 each for 10,00,000. The
company’s tax rate is 30%. Calculate cost of debt - a) Before-tax, and b) After-tax, if
debentures are issued at a) par b) 10% premium and c) 10% Discount.
Problem - 3
ABC company limited issued 4,00,000, 7% debentures at a premium of 10%. The flotation
cost is 10,000. The tax rate applicable is 30%. Compute the cost of debt capital.

Flotation cost is the total cost incurred by a company in offering its securities to the
public. They arise from expenses such as - underwriting fees, legal fees,
registration fees etc.

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 3
 ADVANCED FINANCIAL MANAGEMENT

NET PROCEEDS

Issued at Par: Net Proceeds = Issue Price – Flotation Cost

Issued at Premium: Net Proceeds = Issue Price – Flotation Cost + Premium

Issued at Discount: Net Proceeds = Issue Price – Flotation Cost - Discount

B. Calculation of Cost of Redeemable debentures: The debentures which are repayable

after a certain period are called redeemable debentures. The formula used to calculate
the cost of redeemable debentures or debt is as follows.

Problem - 4
ABC company issues 8% debentures of ₹ 5,00,000 at 10% discount. They are redeemable at
the end of 20 years. The effective tax rate is 25%. Calculate the cost of debt.

Problem - 5
A limited company issued 9% debentures of ₹ 4,00,000 at 10% premium. They are
redeemable at the end of 15 years. The tax rate is 30%. Calculate the effective cost of debt
before tax and after - tax.

Problem - 6
A limited company issues 10 year, 8% redeemable debentures of the face value of 1000
each. It incurs 4% issue expenses. The company is in 30% tax bracket. Calculate the cost of
debt assuming that the debentures are redeemable at (a) par b) 10% discount, and c) 10%
premium.

Problem - 7
MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,
MMK & SDM College, Mysuru. Page 4
 ADVANCED FINANCIAL MANAGEMENT

A 5 year, 100 debenture of a firm can be sold for netprice of 97.75. The coupon rate of
interest is 15% per year and bond will be redeemed @ 5% premium on maturity. Compute
the cost of debt.

Problem – 8
15 years, 14% debentures of ₹1000 face value, redeemable at 5% premium , 3% flotation
cost. The tax rate is 35%. Calculate the cost of debt.

Problem – 9
A firm issues debentures of ₹ 1,00,000 and realizes 98,000 after allowing 2% commission to
brokers. The debentures carry interest @ 10%. The debentures are due for maturity at the end
of 10th year. Calculate effective cost of debt before and after tax, assuming corporate tax rate
of 30%.

2. COST OF PREFERENCE SHARE CAPITAL

Dividends payable to preference shareholders is known as cost of preference capital. The

dividend payable on preference shares is fixed well in advance of their issue.

The Method of computing cost of preference share capital

A. Cost of Irredeemable or perpetual preference share capital

B. Cost of Redeemable preference share capital.

A. Cost of Irredeemable or perpetual preference share capital

Formula:

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 5
 ADVANCED FINANCIAL MANAGEMENT

Problem – 1
ABC limited company issues 9% preference share capital without a maturity period (i.e.
irredeemable or perpetuity). The face value of the share is₹1000. Calculate the cost of
preference shares, when they are issued at a) 10% premium and b) 20% discount.

Problem – 2
A limited company issues 12% preference share capital for 10,00,000 divided into shares of
1000 having no maturity period (irredeemable debentures). You are required to calculate the
cost of preference share capital, when they are issued at par, at 20% discount and at 20%
premium.

Problem – 3
Calculate the cost of 8% preference shares of 1000 each, sales price 1000 per share, flotation
cost 12% of sales price

Problem – 4
A company issues 1000, 10% preference shares of 500 each at a discount of 20%. Cost of
raising capital is 10,000. Compute cost of preference capital.

B. Cost of Redeemable Preference Share:

Redeemable preference shares are like redeemable debentures or debt. Therefore, calculation
is similar to debentures. That means, calculation of cost of redeemable preference shares is
similar to calculation of redeemable debentures.

Formula:

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 6
 ADVANCED FINANCIAL MANAGEMENT

Problem – 5
A limited company issues 1000 face value preference shares carrying 12% dividend which
are repayable at par after 15 years. The company realised 950 per share. Calculate the cost of
preference share capital.

Problem – 6
ABC limited issues 1000 preference shares of 100 each with a dividend of 10% redeemable
at 20% premium after 10 years. Calculate the cost of preference share capital.

Problem – 7
ABC limited issues 15% preference shares of ₹ 1000 each for 2,00,000. Preference shares
are repayable at 20% premium after 10 years. The cost of issue amounted to ₹10 per share.
Calculate cost of preference shars.

Problem – 8
From the following particulars, calculate the cost of preference share capital.
a. Face value ₹ 100 each, 12% preference shares
b. Sold at par and redeemable at 10% premium
c. Issued for 7 years period
d. Flotation cost 5%
e. Corporate tax @25%

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 7
 ADVANCED FINANCIAL MANAGEMENT

3. COST OF EQUITY SHARE CAPITAL

James C. Van Horne defines cost of equity as "the minimum rate of return that the
company must earn on the equity financed portion of an investment project in order to
leave unchanged the market price of the existing stock". Thus, the cost of equity share
capital represents the minimum rate of return expected by equity shareholders on their
investments in a company.

Methods of Computation of Cost of Equity:

1. Dividend Yield or Dividend Capitalization Method
2. Growth in Dividend
3. Earning Price Model

1. Dividend yield or Dividend capitalization Method:

According to this method, the cost of equity capital is the expected dividend, which
will maintain the present market value of equity shares.

Problem 1
A company issues 2000 equity shares of Rs.100 each. Cost of issue 2 per share. Expected
dividend @ 12% per share. Compute cost of equity.

2. When there is growth in dividend

According to this method, the investor receives the dividend as well as the rate of growth
in dividend. The growth rate in dividend is assumed to be equal to the growth rate in
earnings per share.

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 8
 ADVANCED FINANCIAL MANAGEMENT

Problem 2
A limited company issues equity shares of Rs 100 each at a premium of 10%. The
company incurs 5% of the issue price towards expenses. The expected dividend per share
is Rs.15. The expected growth in dividend is 20%.
Compute cost of equity share capital.

Problem 3
A limited liability company has been distributing 25% of its earnings as dividends every
year. The average annual profits of the company for the past 3 years was Rs. 4,00,000 and
the number of equity shares outstanding are 20,000. The company's earnings recorded an
annual growth rate of 20%. The market price of shares Rs. 100 each.
You are required to calculate cost of equity.

Problem 4
The current market price of a company's share is Rs.100, but it is issued at 10% less and
the flotation cost of equity is 2 per share. The expected dividend per share is Rs. 20. The
shareholders expected that dividends will grow at a constant rate of 12% P.A. Find out
equity shareholders required rate of return.

3. Earnings price Model

Under this method, market price of the shares is decided by the earning per share (EPS).
Therefore, it takes into consideration dividends and retained earnings to calculate cost of
equity.

Problem 5
Calculate cost of equity share capital from the following:
a. Market price of an equity is Rs. 105.
b. Flotation cost of an equity is Rs.5 per share
c. Current earnings available to equity shareholders is Rs. 2,00,000.
d. No. of shares with the company 10,000

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 9
 ADVANCED FINANCIAL MANAGEMENT

Problem 6
ABC Limited’s present earnings are Rs. 5,00,000. The outstanding shares of the company
is 50,000. The market price per share is Rs. 500. The flotation cost is Rs.150 per share.
Now the company is able to sell its shares at Rs. 550 per share. Compute cost of equity.

4. Cost of Retained Earnings

Retained earnings are the undistributed profits of the company, which belongs to equity
shareholders. Companies use these accumulated profits for their expansion programmes.
The company need not pay any dividend on retained earnings. However, retained
earnings will also have the cost, known as 'opportunity cost'. The opportunity cost of
retained earnings is the rate of return the shareholder foregoes by not investing his
dividend income elsewhere. Thus cost of retained earnings is the rate of return on
dividend foregone by existing equity shareholders on their investment. In this respect, the
cost of retaining is equal to the cost of equity share capital.
If the company pays dividends on retained earnings, it is required to make the following
adjustments:
a. It should deduct the amount of income-tax from the gross dividend.
b. It should deduct the flotation cost.

Problem 1
From the following compute cost of retained earnings:
a. Shareholders' required rate of return or cost of equity is 25%
b. Income-tax applicable to shareholders 30%
C. Cost of brokerage & other expenses 5% of dividend income.

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 10
 ADVANCED FINANCIAL MANAGEMENT

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The weighted average of various sources of capital is known as 'weighted average cost
of capital'. According to experts, weighted average cost is "an average of the costs of
specific source of capital employed in a business, properly weighted by the proportion
they hold in the capital structure of the firm. The weighted average cost of capital is also
called composite or combined cost of capital. Because, WACC includes the cost of
capital belonging to various sources of finance.

Approaches to assign weights:

The following two approaches are used to assign weights to specific sources of fund:
a. Book value approach, and
b. Market value approach

a. Book Value approach

According to this approach, weights are assigned on the basis of value proportions found
on the balance sheet of the company. The proportion is obtained by dividing the book
value of a source of fund by the book value of total long term finance.

b. Market value approach :

According to this approach, weights are assigned on the basis of market value of each
source of funds. The proportion is obtained by diving the market value of each source by
the market value of total, long term finance.

Problem 1
ABC limited has the following capital structure:
Equity share capital (40,000 shares) ₹ 80,00,000
10% Preference share capital ₹ 20,00,000
14% Debentures ₹ 60,00,000
The company's share sells for ₹ 20. It is expected that the company will pay next year a
dividend of ₹ 6 per share which will grow at 4% for ever. Assume tax rate is 30%.
a. Compute the weighted average cost of capital based on the existing capital
structure.
b. Compute the new weighted average cost of capital if the company raises an
additional ₹ 40,00,000 debt by issuing 15% debentures. This would increase the
expected dividend to ₹ 7 per share and leave growth rate unchanged, but the price
of share will fall to ₹ 18 per share.

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 11
 ADVANCED FINANCIAL MANAGEMENT

Problem 2
Below given is the balance sheet of a limited company. You are required to calculate the
weighted average cost of capital

Additional information:
a. 10 years, 8% debentures of ₹100 each issued at par, 2% flotation cost,
debentures are redeemable at 10% premium
b. 12% preference shares of ₹100 each issued at par, 4% flotation cost.
c. The selling price of equity shares is ₹ 105, flotation cost ₹ 3.
d. The company is expected to pay a dividend of ₹ 10 per share. The company is
in 30% tax bracket. Dividends are expected to grow at 12% P.A.
e. Shareholders are expected to pay 20% income tax on dividends.

MAHADEVASWAMY. S. M.Com, UGC-NET, KSET, (Ph.D.) Assistant Professor, Department of Commerce,

MMK & SDM College, Mysuru. Page 12