UNIT II -- Expansion Decision

INVESTMENT DECISIONS -- Diversification Decision

• Capital Budgeting: Principles and techniques • On the Basics of Decision Situation
- Nature of capital budgeting- Identifying -- Independent investments
relevant cash flows - Evaluation Techniques: -- Contingent investments (dependent)
Payback, Accounting rate of return, Net -- Mutually Exclusive Investments
Present Value, Internal Rate of Return, PROCESS OF CAPITAL BUDGETING
Profitability Index - Comparison of DCF • Idea Generation
techniques – Project selection under capital • Screening Proposals
rationing- Inflation and capital budgeting - • Project Evaluation
Concept and measurement of cost of capital - • Establishing Priorities
Specific cost and overall cost of capital. • Selection
• Financing
Capital Budgeting • Execution
• Capital Budgeting refers to planning the • Review
deployment of available capital for the Factors Influencing Capital Expenditure Decisions
purpose of maximizing long-term profitability • Availability of Funds
of the firm • Urgency
• Capital Budget may be defined as the firm’s • Legal Compulsion
investment decision to invests its current • Degree of Uncertainty of Risk
funds most efficiently in the long term assets • Intangible Factors
in anticipation of an expected flow of benefits • Obsolescence
over a series of years • Research and Development Projects
• Capital Budgeting is the process of making • Competitors’ activities
investment decision regarding capital IDENTIFYING RELEVANT CASHFLOW
expenditure. • One of the most important task for evaluating
• According to Milton H. Spencer the project is estimating cashflows for each
• “Capital Budgeting involves the project
planning of expenditures for assets, • Inaccurate and Unreliable data can corrupt
the returns from which will be the entire capital budgeting process
realized in future time periods.” • Firms use qualitative and quantitative
• It benefits are expected to extend beyond one methods to estimate their cashflows
year Elements of Cashflow
• Example: • Initial Investment : Cost of new asset +
-- The Purchase of Fixed Assets capitalized expenses + net working capital –
-- Replacement of Fixed Assets already in use. net proceeds from sale of old investment
-- Expansion, Acquisition and Modernization • Operating Cash Inflows
NATURE AND IMPORTANCE OF CAPITAL BUDGETING • Terminal Cash Inflows
• Heavy Investment Time Horizon for Cashflow Analysis
• Permanent Commitment of Funds • Physical life of the plant
• Long Term Effect on Profitability • Technological Life of the Plant
• Irreversible in Nature • Product Market Life of the Plant
• Difficult to make Investment Decisions • Investment Planning Horizon of the Firm
Obstacles for Capital Budgeting Guidelines for Estimating Project Cashflows
• Measurement Problem • Identify Incremental Cashflows
• Uncertainty • Focus on After-Tax Flows
Types of Capital Expenditure Decisions • Postpone Considering Financial Costs
• On the Basis of Firm’s existence • Other Consideration:
-- Replacement and Modernization Decision -- Net Operating Working Capital
 -- Sunk Costs appropriate discount rate is the project’s
-- Opportunity Costs opportunity cost of capital.
-- Allocated Overhead • Present value of cash flows should be
COST OF CAPITAL calculated using the opportunity cost of
• The cost of capital is the minimum rate of capital as the discount rate.
return expected by investors • The project should be accepted if NPV is
• The capital of a firm may consist of debt, positive (i.e., NPV > 0).
preference share, retained earnings and • Net present value should be found out by
equity capital subtracting present value of cash outflows
• The cost of capital is the weighted average from present value of cash inflows.
cost of these sources Calculating Net Present Value
• It is also called as hurdle rate, cut-off rate or • Assume that Project X costs Rs 2,500 now and
target rate is expected to generate year-end cash inflows
• Cost of capital is a company's calculation of of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in
the minimum return that would be necessary years 1 through 5. The opportunity cost of the
in order to justify undertaking a capital capital may be assumed to be 10 per cent.
budgeting project, such as building a new
 Rs 900 Rs 800 Rs 700 Rs 600 Rs 500 
factory.The term cost of capital is used by NPV    2
 3
 4
 5
 Rs 2,500
analysts and investors, but it is always an  (1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10) 
evaluation of whether a projected decision
NPV  [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10 ) + Rs 700(PVF3, 0.10 )
can be justified by its cost. Investors may also
use the term to refer to an evaluation of an + Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10 )]  Rs 2,500
investment's potential return in relation to its NPV  [Rs 900  0.909 + Rs 800  0.826 + Rs 700  0.751 + Rs 600  0.683
cost and its risks.
Evaluation Criteria + Rs 500  0.620]  Rs 2,500
• 1. Discounted Cash Flow (DCF) Criteria NPV  Rs 2,725  Rs 2,500 = + Rs 225
• Net Present Value (NPV) Acceptance Rule
• Internal Rate of Return (IRR) • Accept the project when NPV is positive
• Profitability Index (PI) NPV > 0
• 2. Non-discounted Cash Flow Criteria • Reject the project when NPV is negative
• Payback Period (PB) NPV < 0
• Discounted Payback Period (DPB) • May accept the project when NPV is zero
• Accounting Rate of Return (ARR) NPV = 0
NPV • The NPV method can be used to select
• The net present value (NPV) method is the between mutually exclusive projects; the one
classic economic method of evaluating the with the higher NPV should be selected.
investment proposals. Net present value method
• It is a DCF technique that explicitly recognizes
the time value of money.
• It correctly postulates that cash flows arising
at different time periods differ in value and
are comparable only when their equivalents—
present values—are found out.
Net Present Value Method
• Cash flows of the investment project should
be forecasted based on realistic assumptions.
• Appropriate discount rate should be identified
to discount the forecasted cash flows. The
• Net Present Value = Present Value -
Investment
 • Net Present Value of Machine A: $1,04,616 -
$80,000 = $24,616
• Net Present Value of Machine B: $1,03,784 -
80,000 = $23,784
• According to the net present value (NPV)
method, Machine A
Solution Depreciation has been calculated under
From the following information, calculate the net straight line method. The cost of
present value of the two project and suggest which of capital may be taken at 10%. P.a. is given below.
the two projects should be accepted a discount rate of
the two.

Evaluation of the NPV Method

• NPV is most acceptable investment rule for
the following reasons:
• Time value
• Measure of true profitability
• All Cash flows considered
• Limitations:
• Difficult to understand
• Discount rate difficult to determine
• May not provide Good Results
Profitability Index
• The profitability index (PI), alternatively
referred to as value investment ratio (VIR) or
profit investment ratio (PIR), describes an
index that represents the relationship
If the cash inflows are not given in that cases the between the costs and benefits of a proposed
calculation of cash inflows are Net profit after project.
tax+Depreciation. In this type of situation first find out
• The profitability index is calculated as the
the Net profit after depreciation and deducting the tax
and then add the deprecation. It gives the cash inflow. ratio between the present value of future
expected cash flows and the initial amount
From the following information you can learn after tex invested in the project.
and depreciation concept. • A higher PI means that a project will be
considered more attractive.
 C1 C2 C3 Cn
C0     
• Profitability index is the ratio of the present (1  r ) (1  r ) 2 (1  r )3 (1  r ) n
n
value of cash inflows, at the required rate of CalculationC of
IRR C t

(1  r )
0 t
t 1
return, to the initial cash outflow of the • Uneven Cash n
C
Flows: Calculating IRR by Trial
investment. 
and Error (1 
t 1 r )
t
C  0t 0

• The initial cash outlay of a project is Rs • The approach is to select any discount
100,000 and it can generate cash inflow of Rs rate to compute the present value of
40,000, Rs 30,000, Rs 50,000 and Rs 20,000 cash inflows. If the calculated present
in year 1 through 4. Assume a 10 per cent rate value of the expected cash inflow is
of discount. The PV of cash inflows at 10 per lower than the present value of cash
cent discount rate is: outflows, a lower rate should be tried.
On the other hand, a higher value
should be tried if the present value of
inflows is higher than the present
value of outflows. This process will be
repeated unless the net present value
Acceptance Rule becomes zero.
• The following are the PI acceptance rules: • Level Cash Flows
• Accept the project when PI is greater • Let us assume that an investment
than one. PI > 1 would cost Rs 20,000 and provide
• Reject the project when PI is less than annual cash inflow of Rs 5,430 for 6
one. PI < 1 years.
• May accept the project when PI is • The IRR of the investment can be
equal to one. PI = 1 found out as follows:
• The project with positive NPV will have PI
greater than one. PI less than means that the
project’s NPV is negative.
Evaluation of PI Method
• Time value of money. Acceptance Rule
• It is consistent with the shareholder value • Accept the project when r > k.
maximisation principle. A project with PI • Reject the project when r < k.
greater than one will have positive NPV and if • May accept the project when r = k.
accepted, it will increase shareholders’ • In case of independent projects, IRR and NPV
wealth. rules will give the same results if the firm has
• In the PI method, since the present value of no shortage of funds.
cash inflows is divided by the initial cash
outflow, it is a relative measure of a project’s
profitability.
• Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the
discount rate.
• DRAWBACK: In practice, estimation of cash
flows and discount rate pose problems.
Internal Rate of Return Method
• The internal rate of return (IRR) is the rate
that equates the investment outlay with the
present value of cash inflow received after
one period. This also implies that the rate of
return is the discount rate which makes NPV =
0.
The factor thus calculated will be located in table II A project costs Rs. 16,000 and is expected to generate
below. This would give the estimated rate of return to cash inflows of Rs. 4,000 each 5
be applied discounting the cash for the internal rate of years. Calculate the Interest Rate of Return.
returns. In this of project A the rate comes to 10%
while in case of project B it comes to15%.

The present value at 10% comes to Rs. 22,544. The

initial investment is Rs. 22,000.
Interest rate of return may be taken approximately at
10%.
In the case more exactness is required another trial
which is slightly higher than 10%(since at this rate the
present value is more than initial investment) may be
taken.
Taking a rate of 12% the following results would
emerge.

Excess Present Value Index

Excess present value is calculated on basis of net
present value. It gives the results in percentage.

The initial of an equipment is Rs. 10,000. Cash inflow

for 5 years are estimated to be Rs. 3,500 per year. The
management is desired minimum rate of excess present
value index.

Evaluation of IRR Method

• IRR method has following merits:
• Time value
• Profitability measure – Indicates
profitability of proposal
• Easy to understand
Thus, internal rate of return in project ‘A’ is higher as
compared to project ‘B’. Therefore project ‘A’ is • IRR method may suffer from:
preferable. • Multiple rates
• Tedious Calculation
• Reinvestment of cash flows
Payback by adding up the cash inflows until the total is
• Payback is the number of years required to equal to the initial cash outlay.
recover the original cash outlay invested in a • Suppose that a project requires a cash outlay
project. of Rs 20,000, and generates cash inflows of
• If the project generates constant annual cash Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000
inflows, the payback period can be computed during the next 4 years. What is the project’s
by dividing cash outlay by the annual cash payback?
inflow. That is: 3 years + 12 × (1,000/3,000) months
• Assume that a project requires an outlay of Rs 3 years + 4 months
50,000 and yields annual cash inflow of Rs • Acceptance Rule
12,500 for 7 years. The payback period for the • The project would be accepted if its
project is: payback period is less than the
maximum or standard payback period
set by management.
• As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest
Project cost is Rs. 30,000 and the cash inflows are Rs. ranking to the project with highest
10,000, the life of the project is 5 years. Calculate the payback period.
pay-back period.

The annual cash inflow is calculated by considering • A project cost 1,00,000 and yields an annual
the amount of net income on the amount of cash inflow of 20,000 for 8 years, calculate
depreciation project (Asset) before taxation but after pay back period
taxation. The income precision earned is expressed as
• Pay back period = Original cost of the project
a percentage of initial investment, is called unadjusted
rate of return. The above problem will be calculated as (cash outlay)/Annual net cash inflow (net
below: earnings)=1,00,000/20,000= 5 Years
Unadjusted rate of return = Annual Return/Investment
× 100
• Initial Investment = 10,000 in a project
= Rs. 10,000 / Rs. 30,000 × 100
= 33.33%
• Expected future cash inflows 2000, 4000,
A project costs Rs. 20,00,000 and yields annually a
profit of Rs. 3,00,000 after depreciation @ 12½% but 3000, 2000
before tax at 50%. Calculate the pay-back period. • Calculation of Pay Back period.
• Year Cash Inflows ( ) Cumulative
Cash I nflows ( )
• 1 2000 2000
• 2 4000 6000
• 3 3000 9000
• 4 2000 11000
• The initial investment is recov ered between
the 3rd and the 4th year.
• Pay back period =Y+ B/C = 3+
1000/2000 years = 3+ 1/2
years= 3year 6months

Certain projects require an initial cash outflow of Rs.

25,000. The cash inflows for 6 years are Rs. 5,000, Rs.
8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.

Payback
• Unequal cash flows In case of unequal cash
inflows, the payback period can be found out
The above calculation shows that in 3 years Rs. 23,000
has been recovered Rs. 2,000, is balance out of cash Accounting Rate of Return Method
outflow. In the 4th year the cash inflow is Rs. 12,000. • The accounting rate of return is the ratio of
It means the pay-back period is three to four years, the average after-tax profit divided by the
calculated as follows average investment. The average investment
Pay-back period = 3 years+2000/12000×12 months would be equal to half of the original
= 3 years 2 months.
investment if it were depreciated constantly.
Evaluation of Payback
• A variation of the ARR method is to divide
• Certain virtues: average earnings after taxes by the original
• Simplicity cost of the project instead of the average cost.
• Cost effective • Acceptance Rule
• Short-term effects • This method will accept all those
• Risk shield projects whose ARR is higher than the
• Liquidity minimum rate established by the
• Serious limitations: management and reject those
• Cash flows after payback projects which have ARR less than the
• Cash flows ignored minimum rate.
• Rigid • This method would rank a project as
• Ignores time value money number one if it has highest ARR and
Discounted Payback Period lowest rank would be assigned to the
• The discounted payback period is the number project with lowest ARR.
of periods taken in recovering the investment
outlay on the present value basis.
• The discounted payback period still fails to
consider the cash flows occurring after the Evaluation of ARR Method
payback period. • The ARR method may claim some merits
• A company is considering whether to • Simplicity
purchase a new machine. Machines A and B • Accounting data – Consider total
are available for $80,000 each. Earnings after
earnings
taxation are as follows:
• • It adds weightage to the profit
• Year Machine A Machine B • Rate of return can be readily
• 1 24,000 8,000 calculated
• 2 32,000 24,000 • Serious shortcoming
• 3 40,000 32,000 • Cash flows ignored
• 4 24,000 48,000
• Time value ignored
• 5 16,000 32,000
• Required: Evaluate the two alternatives using • Two methods – different results
the following: (a) payback method b) net ARR Problems
present value method. You should use a
discount rate of 10%.

• a) Payback method
• 24,000 of 40,000 = 2 years and 7.2 months
• Payback period:
• Machine A: (24,000 + 32,000 + 1 3/5 of
40,000) = 2 3/5 years.
• Machine B: (8,000 + 24,000 + 32,000 + 1/3 of
48,000) = 3 1/3 years.
• According to the payback method, Machine A
is preferred.
 • =53107/100000*100 = 53%
A company has two alternative proposals. The details
are as follows:

Compute the profitability of the proposals under the

• ARR= AVG. ANNUAL PROFIT/ ORIGINAL return on investment method.
INVESTMENT *100
• A=1500/20000 *100=7.5%
• B=2000/30000 * 100= 6.67%
• ARR= AVG ANNUAL PROFIT/ AVG
INVESTMENT *100
• A=1500/10000 *100= 15%
• B= 2000/15000* 100 =13.35 %

The Ramakrishna Ltd., in considering the purchase of

a new investment. Two alternative investments are
available (X and Y) each costing Rs. 150000. Cash
inflows are expected to be as follows:

The company has a target return on capital of 10%.

Risk premium rate are 2% and 8% respectively for
investment X and Y. Which investment should be
preferred?
The profitability of the two investments can be
compared on the basis of net present
values cash inflows adjusted for risk premium rates as
follows:
• Avg Annual Profit= Total Profit/ No/ of Years
• = 265536/5= 53107
• ARR= Avg Annual Profit / Original Investment
*100
• = 53107/200000*100= 27 %
• ARR= Avg Annual profit/ Avg. Investment * Investment X
100
Net present value = 133415 – 150000
= – Rs. 16585
Investment Y
Net present value = 156485 – 150000
= Rs. 6485
As even at a higher discount rate investment Y gives a
higher net present value, investment Y should be
preferred.

Certainly equivalent method

It is also another simplest method for calculating risk
in capital budgeting info reduceds expected cash
inflows by certain amounts it can be employed by
Probability technique
multiplying the expected cash inflows by certainly Probability technique refers to the each event of future
equivalent co-efficient in order the uncertain cash happenings are assigned with relative frequency
inflow to certain cash inflows. probability. Probability means the likelihood of future
event. The cash inflows of the future years further
discounted with the probability.
The higher present value may be accepted.

Two mutually exclusive investment proposals are

Risk-free cutoff rate is 10%. Suggest which of the two being considered. The following
projects. Should be preferred. information in available.

Sensitivity technique
When cash inflows are sensitive under different
circumstances more than one forecast of the future
cash inflows may be made. These inflows may be
regarded on ‘Optimistic’, ‘most likely’ and
‘pessimistic’. Further cash inflows may be
discounted to find out the net present values under
these three different situations.
If the net present values under the three situations
differ widely it implies that there is a great risk in the
project and the investor’s is decision to accept or reject
a project will depend upon his risk bearing activities. COST OF CAPITAL
• The cost of capital is the minimum rate of
Mr. Selva is considering two mutually exclusive return expected by investors
project ‘X’ and ‘Y’. You are required to advise him • The capital of a firm may consist of debt,
about the acceptability of the projects from the preference share, retained earnings and
following information. equity capital
• The cost of capital is the weighted average
cost of these sources
• It is also called as hurdle rate, cut-off rate or
target rate
THREE VIEW POINTS – COST OF CAPITAL • Assigning weights to specific costs
• From investor’s point of view: the • Multiplying the cost by assigned weights
measurement of sacrifice made by him in • Divide the total weighted cost by the total
capital formation assigned weights
• Firms point: It is the minimum required rate COMPUTATION OF COST OF CAPITAL
of return needed to earn • Computation of the cost of specific sources
• Capital Expenditure Point such as debentures, preference capital and
FEATURES OF COST OF CAPITAL equity capital
• Rate of Return • Computation of the weighted average cost of
• It is calculated based on the actual cost of capital or the overall cost of capital
different components of capital 1. COST OF DEBENTURES
• Consideration of Risk Premium (k = Rf+ Rp ) COST OF IRREDEEMABLE DEBT
• Cost of Capital is used as discount rate of Irredeemable debt is that debt which is not
return required to be repaid during the lifetime of
Classification of Cost the company. Such debt carries a coupon rate
• Historical Cost and Future Cost of interest. This coupon rate of interest
-- Historical Cost is the cost incurred in the represents the before tax cost of debt.
past -- Issued at Par
-- Future Cost is the cost estimate for the future -- Issued at Premium
• Specific Cost and Composite Cost -- Issued at Discount
-- Specific Cost is Cost of individual source of capital
-- Composite Cost or Overall Cost is the combined Debt Issued at Par
cost of different sources of capital
• Average and Marginal Cost
-- Average Cost is the weighted average of cost of
different sources
-- Marginal Cost is the average cost of new and
additional funds
• Explicit Cost and Implicit Cost
-- Explicit Cost is rate at which cash inflows is Debt Issued at Premium or Discount
equal to cash outflows (IRR)
-- Implicit Cost is the rate of return that will be
foregone if the particular project were accepted
Importance of Cost of Capital
• Designing Optimum Capital Structure
• Capital Budgeting Decision
• Optimum Resource Mobilization – funds from
different sources to minimise the cost of
capital
(a) A Ltd. issues Rs. 10,00,000, 8% debentures at par.
• Evaluating Financial Performance
The tax rate applicable to the company is 50%.
Compute the cost of debt capital.
FACTORS AFFECTNG COST OF CAPITAL (b) B Ltd. issues Rs. 1,00,000, 8% debentures at a
• General Economic Conditions (inflation and premium of 10%. The tax rate applicable to the
demand & Supply) company is 60%. Compute the cost of debt capital.
• Market Conditions (readily marketable) (c) A Ltd. issues Rs. 1,00,000, 8% debentures at a
• Firm’s Operating and Financing Decisions discount of 5%. The tax rate is 60%, compute the cost
(financial and business risk) of debt capital.
• Amount of Financing (rupee amount need for (d) B Ltd. issues Rs. 10,00,000, 9% debentures at a
investments) premium of 10%. The costs of floatation are 2%. The
COMPUTATION OF SPECIFIC COST OF CAPITAL tax rate applicable is 50%. Compute the cost of debt-
• The company may resort to different financial capital.
sources In all cases, we have computed the after-tax cost of
• The components of specific cost of capital is debt as the firm saves on account of tax by using debt
the investors required rate of return as a source of finance.
COMPUTATION OF OVERALL COST OF CAPITAL
• Determination of type of funds to be raised
• Computation of costs for each type of funds
 -- Realised Yield Method
-- CAPM
DIVIDEND YIELD METHOD
• According to this method, the cost of
capital is the discount rate that equates
the present value of expected future
dividends per share with the net proceeds
or market price of the share
• Ke = Dividend / NP (or) Dividend / MP
• This method gives importance of
dividends
• Ignores retained earnings and growth in
dividends
• It is suitable only when the company has
stable earnings and stable dividend policy

Cost of Perpetual Debt and Redeemable Debt

• A company issues 10,000 equity shares of Rs.
100 each at a premium of 10%. The company
has been paying 25% 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 Rs. 175?

A company issues Rs. 20,00,000, 10% redeemable

debentures at a discount of 5%. The costs of floatation
amount to Rs. 50,000. The debentures are redeemable
after 8 years. Calculate before tax and after tax. Cost of
debt assuring a tax rate of 55%.

Dividend and Growth Method

• The cost of capital is determined based on the
dividend yield and growth rate in dividends
• Ke = ( D1 / NP ) + G or ( D1 / MP ) + G
• It recognises dividends as well as growth in
dividends
• But it assumes that dividend grow at a
constant rate. In reality is not true.
COST OF EQUITY CAPITAL
• The cost of equity capital is the
minimum rate of return that must be
earned to maintain the market price of
the share unchanged
• Methods:
-- Dividend Price Method
-- Dividend and Growth Method
-- Earnings Price Method
 • (a) A company plans to issue 10000 new
shares of Rs. 100 each at a par. The floatation
costs are expected to be 4% of the share
price. The company pays a dividend of Rs. 12
per share initially and growth in dividends is
expected to be 5%.Compute the cost of new
issue of equity shares.
• (b) If the current market price of an equity
share is Rs. 120. Calculate the cost of existing
equity share capital

Realised Yield Method

• Under this method, the cost of equity capital
is computed on the basis of return actually
realised by the shareholders
• The current market price of the shares of A • The return consists of dividend and capital
Ltd. is Rs. 95. The floatation costs are Rs. 5 per gains
share amounts to Rs. 4.50 and is expected to • The cost of capital is the rate at which the
grow at a rate of 7%. You are required to present value of inflows ( dividend + sale
calculate the cost of equity share capital. price) is equal to the present value of
outflows (cost of shares)
• The rate is found by trial and error method
MARGINAL COST OF CAPITAL
• Additional funds are to be raised from
different sources to finance these new
projects
• Marginal cost of capital is the weighted
average cost of new, additional or
Earnings Price Method (E/P Method) incremental capital raised by the company
• Earnings price method is also called earnings CAPITAL ASSET PRICING MODEL
model • The capital asset pricing model considers the
• It considers earnings as more appropriate risk element in determining the cost of
than dividends in computing the cost of equity capital.
• It is rate at which the present value of • The cost of equity capital is the return
expected future EPS is equal to the market required by investors
price per share • It has two elements: The Risk-free return (Rf)
• Ke = EPS/NP or EPS/MP and The premium for risk (Pr)
• Earnings model is suitable when: • Ke=Rf + B (Rm-Rf)
-- Earnings is expected to remain constant WACC
-- Pay out is 100% • WACC is very important in financial decision
-- The firm does not employ any debt making
A firm is considering an expenditure of Rs. 75 lakhs for • WACC is the weighted average of the costs of
expanding its operations. different source of finance
The relevant information is as follows : • It is also known as composite cost of capital or
Number of existing equity shares =10 lakhs overall cost of capital
Market value of existing share =Rs.100 • WACC is calculated on Book value weights or
Net earnings =Rs.100 lakhs Market value weights
Compute the cost of existing equity share capital and STEPS FOR CALCULATING WACC
of new equity capital assuming that new shares will be • After Tax cost (X) of each source of finance is
issued at a price of Rs. 92 per share and the costs of ascertained
new issue will be Rs. 2 per share. • The proportion of each source in total capital
(W) is determined
 • The cost of each source (x) is multiplied with
the appropriate weights (w) i.e.. (X) x (W) A company has on its books the following amounts
• The total of the weighted costs of each source and specific costs of each type of capital.
is the weighted average cost of capital (WACC
= € XW)

• Determine the weighted average cost of

capital using:
• (a) Book value weights, and
• (b) Market value weights.
• How are they different? Can you think of a
situation where the weighted average cost of
capital would be the same using either of the
weights?

A company’s after tax specific cost of capital are as follows:

Cost of debt 10%
Cost of Preference Shares 12%
Cost of Equity Shares 15%
The following is the capital structure:
Source Amount
Debt 3,00,000
Preference Share Capital 2,00,000
Equity Share Capital 5,00,000

10,00,000
Sources of Book Value Proportion or Cost (%) Weighted
Funds (1) Rs. (2) Weight (3) (4) Cost (5)
=(3x4)
Debt 3,00,000 .3 10 3.0
Preference 2,00,000 .2 12 2.4
Share Capital
Equity 5,00,000 .5 15 7.5
Share Capital
Total 10,00,000 1.00 12.9

A firm has the following capital structure and after-tax

costs for the different sources of funds used :

COST OF PREFERENCE SHARE CAPITAL

• Cost of Irredeemable Preference Share
Capital
• You are required to compute the weighted • Kp = Dividend/Net Proceeds
average cost of capital. -- Preference Shares issued at Par
Sources of Funds Amount % Proportion After Tax Cost% Weighted cost= (3)*(4) -- Preference Shares issued at Premium
Debt 12000 0.2 4 0.8 -- Preference Shares issued at Discount
PS 15000 0.25 8 2 a) When issued at Par: Net Proceeds = Face
ES 18000 0.3 12 3.6 Value – Issue expenses
RE 15000 0.25 11 2.75 b) When issued at Premium: Net Proceeds =
TOTAL 60000 1 Kw= 9.15 Face Value – Issue expenses + Premium
 c) When issued at Discount: Net Proceeds = Face ABC Ltd. issues 20,000, 8% preference shares of Rs.
Value – Issue expenses - Discount 100 each at a premium of 5% redeemable after 8
• Cost of Redeemable Preference Share Capital years at par. The cost of issue is Rs. 2 per share.
• RPS = Annual Cost / Average Value of RPS Calculate the cost of preference share capital.
• Annual Cost = Annual Dividend + Issue
Expenses + Discount on Issue – Premium on
Issue + Premium on redemption
• Average Value of RPS: (NP+RV)/2
a) When issued at Par: Net Proceeds = Face
Value – Issue expenses
b) When issued at Premium: Net Proceeds =
Face Value – Issue expenses + Premium
c) When issued at Discount: Net Proceeds = Face COST OF RETAINED EARNINGS
Value – Issue expenses - Discount • All Profits earned by the company are not
Cost of redeemable preference share capital distributed as dividends to the shareholders
• Generally, companies retain a portion of the
earnings for use in business. This is called
retained earnings
Cost of irredeemable preference share capital • Cost of Retained Earnings = Cost of Equity
Capital – Tax on Cost of Equity – Brokerage
• Alternatively, Kr = Ke (1-t) (1-b)
• Where,
• Kr=Cost of retained earnings
• Ke=Cost of equity
• Kp = Cost of preference share
• t=Tax rate
• Dp= Fixed preference share
• b=Brokerage cost
• P = Par value of debt
• Np = Net proceeds of the preference share
• n = Number of maturity period.
XYZ Ltd. issues 20,000, 8% preference shares of Rs.
A firm’s Ke (return available to shareholders) is 10%,
100 each. Cost of issue is Rs. 2 per share. Calculate
the average tax rate of shareholders is 30% and it is
cost of preference share capital if these shares are
expected that 2% is brokerage cost that shareholders
issued (a) at par, (b) at a premium of 10% and (c) of a
will have to pay while investing their dividends in
debentures of 6%.
alternative securities. What is the cost of retained
earnings?

• Kr = 10% (1–0.3) (1–0.02)

• = 10%×0.7×0.98
• = 6.86%
A firm’s Ke (return available to shareholders) is 10%,
the average tax rate of shareholders is 50% and it is
ABC Ltd. issues 20,000, 8% preference shares of Rs. expected that 2% is brokerage cost that shareholders
100 each. Redeemable after 8 years at a premium of will have to pay while investing their dividends in
10%. The cost of issue is Rs. 2 per share. Calculate the alternative securities. What is the cost of retained
cost of preference share capital earnings?

• Kr = 10% (1–0.5) (1–0.02)

• = 10%×0.5×0.98
• = 4.9%