INSTITUTE OF ACCOUNTANCY ARUSHA (IAA)

FACULTY OF ACCOUNTANCY AND FINANCE

CORPORATE FINANCE (AFU 07412 & BBU 07421)
BA II, BFB II AND BB-Appr II. - 2023/2024

COST OF CAPITAL

Meaning of Cost of Capital

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its
market value and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity, debt and
retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares
will fall and it will result in the reduction of overall wealth of the shareholders.

IMPORTANCE OF COST OF CAPITAL

Computation of cost of capital is a very important part of the financial management to decide the
capital structure of the business concern.

Importance to Capital Budgeting Decision

Capital budget decision largely depends on the cost of capital of each source. According to net
present value method, present value of cash inflow must be more than the present value of cash
outflow. Hence, cost of capital is used to capital budgeting decision.

Importance to Structure Decision

Capital structure is the mix or proportion of the different kinds of long-term securities.
A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital
helps to take decision regarding structure.

Importance to Evolution of Financial Performance

Cost of capital is one of the important determine which affects the capital budgeting, capital
structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.

Importance to Other Financial Decisions

Apart from the above points, cost of capital is also used in some other areas such as, market
value of share, earning capacity of securities etc. hence, it plays a major part in the financial
management.

COMPUTATION OF COST OF CAPITAL

Computation of cost of capital consists of two important parts:

1. Measurement of specific costs
2. Measurement of overall cost of capital

1
Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:

• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings

Cost of Equity

Cost of equity capital is the rate at which investors discount the expected dividends of the firm to
determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return 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”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.

Dividend Price Approach

The cost of equity capital will be that rate of expected dividend which will maintain the present
market price of equity shares.
Dividend price approach can be measured with the help of the following formula:

Ke = D/Np

Whereby;
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share

Exercise 1

A company issues 10,000 equity shares of shs. 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 shs. 175?

Dividend Price Plus Growth Approach

The cost of equity is calculated on the basis of the expected dividend rate per share plus growth
in dividend. It can be measured with the help of the following formula:

Ke = (D/Np) +g

2
Whereby;
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend and
Np = Net proceeds of an equity share

Exercise 2

(a) A company plans to issue 10000 new shares of Shs. 100 each at a par. The dividend of Shs.
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 Shs. 120. Calculate the cost of existing equity
share capital

Exercise 3

The current market price of the shares of A Ltd. is Shs. 95. The floatation costs are Shs. 5 per
share amounts to Shs. 4.50 and is expected to grow at a rate of 7%. You are required to calculate
the cost of equity share capital.

Earning Price Approach

Cost of equity determines the market price of the shares. It is based on the future earnings
prospects of the equity. The formula for calculating the cost of equity according to this approach
is as follows.

Ke = E/Np

Whereby;

Ke = Cost of equity capital

E = Earnings per share
Np = Net proceeds of an equity share

Exercise 4

A firm is considering an expenditure of Shs. 75,000,000 for expanding its operations.

The relevant information is as follows:
Number of existing equity shares = Shs.10,000,000
Market value of existing share = Shs.100
Net earnings = Shs.100,000,000

Compute the cost of existing equity share capital and of new equity capital assuming that new
shares will be issued at a price of Shs. 92 per share and the costs of new issue will be Shs. 2 per
share.

3
Cost of Debt

Cost of debt is the after-tax cost of long-term funds through borrowing. Debt may be issued at
par, at premium or at discount and also it may be perpetual or redeemable.

Debt Issued at Par

Debt issued at par means; debt is issued at the face value of the debt. It may be calculated with
the help of the following formula.

Kd = (1 – t) R

Whereby;

Kd = Cost of debt capital

t = Tax rate
R = Debenture interest rate

Debt Issued at Premium or Discount

If the debt is issued at premium or discount, the cost of debt is calculated with the help of the
following formula.
Kd = I x (1 – t)
Np

Whereby;
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate

Exercise 5

(a) A Ltd. issues Shs. 1,000,000, 8% debentures at par. The tax rate applicable to the company is
50%. Compute the cost of debt capital.

(b) B Ltd. issues Shs. 100,000, 8% debentures at a premium of 10%. The tax rate applicable to
the company is 60%. Compute the cost of debt capital.

(c) A Ltd. issues Shs. 100,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute
the cost of debt capital.

(d) B Ltd. issues Shs. 1,000,000, 9% debentures at a premium of 10%. The costs of floatation are
2%. The tax rate applicable is 50%. Compute the cost of debt-capital.
In all 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.

4
Cost of Perpetual Debt and Redeemable Debt

It is the rate of return which the lenders expect. The debt carries a certain rate of interest.

Kdb = I+ 1/n(P- Np )
(P+ Np)/ 2

Whereby;

I = Annual interest payable

P = Par value of debt
Np = Net proceeds of the debenture
n = Number of years to maturity
Kdb = Cost of debt before tax.

Cost of debt after tax can be calculated with the help of the following formula:

Kda =Kdb × (1–t)

Whereby;
Kda = Cost of debt after tax
Kdb = Cost of debt before tax
t = Tax rate

Exercise 6

A company issues Shs. 2,000,000, 10% redeemable debentures at a discount of 5%. The costs of
floatation amount to Shs. 50,000. The debentures are redeemable after 8 years. Calculate before
tax and after tax. Cost of debt assuring a tax rate of 55%.

Cost of Preference Share Capital

Cost of preference share capital is the annual preference share dividend by the net proceeds from
the sale of preference share.
There are two types of preference shares irredeemable and redeemable. Cost of redeemable
preference share capital is calculated with the help of the following formula:

Kp= Dp
Np

Whereby;
Kp = Cost of preference share
Dp = Fixed preference dividend and Np = Net proceeds of an equity share

Kp = Dp+ 1/n(P- Np )
(P+ Np)/ 2

5
Whereby;

Kp = Cost of preference share

Dp= Fixed preference share dividends
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.

Exercise 7

XYZ Ltd. issues 20,000 8% preference shares of Shs. 100 each. Cost of issue is Shs. 2 per share.
Calculate cost of preference share capital if these shares are issued (a) at par, (b) at a premium of
10% and (c) of a discount of 6%.

Exercise 8

ABC Ltd. issues 20,000 8% preference shares of Shs. 100 each. Redeemable after 8 years at a
premium of 10%. The cost of issue is Shs. 2 per share. Calculate the cost of preference share
capital.

Exercise 9

ABC Ltd. issues 20,000 8% preference shares of Shs. 100 each at a premium of 5% redeemable
after 8 years at par. The cost of issue is Shs. 2 per share. Calculate the cost of preference share
capital.

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment proposal; it is different from
other sources like debt, equity and preference shares. Cost of retained earnings is the same as the
cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of
equity capital. Cost of retained earnings can be calculated with the help of the following formula:

Kr =Ke(1 – t) (1 – b)

Whereby;

Kr=Cost of retained earnings

Ke=Cost of equity
t=Tax rate
b=Brokerage cost

Exercise 10
A firm’s Ke (return available to shareholders) is 10%, the average tax rate of shareholders is 30%
and it is expected that 2% is brokerage cost that shareholder will have to pay while investing their
dividends in alternative securities. What is the cost of retained earnings?

6
Measurement of Overall Cost of Capital

It is also called as weighted average cost of capital and composite cost of capital. Weighted average
cost of capital is the expected average future cost of funds over the long run found by weighting
the cost of each specific type of capital by its proportion in the firm’s capital structure.
The computation of the overall cost of capital (Ko) involves the following steps.

(a) Assigning weights to specific costs.

(b) Multiplying the cost of each of the sources by the appropriate weights.

(c) Dividing the total weighted cost by the total weights.

The overall cost of capital can be calculated with the help of the following formula;

Ko= Kd Wd + Kp Wp + Ke We + Kr Wr

Whereby;
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings

Weighted average cost of capital is calculated in the following formula also:

Kw= ∑XW
∑W
Whereby;

Kw = Weighted average cost of capital

X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance

7
Exercise 11

A firm has the following capital structure and after-tax costs for the different sources of funds
used:
Source of Funds Amount Proportion After-tax cost
Shs. % %
Debt 12,000 20 4
Preference Shares 15,000 25 8
Equity Shares 18,000 30 12
Retained Earnings 15,000 25 11
Total 60,000 100

You are required to compute the weighted average cost of capital

Exercise 12

A company has on its books the following amounts and specific costs of each type of capital.

Type of Capital Book Value Market Value Specific Costs (%)

Shs. Shs.
Debt 400,000 380,000 5
Preference 100,000 110,000 8
Equity 600000 900,000 15
Retained Earnings 200,000 300,000 3
Total 1,300,000 1,690,000

Determine the weighted average cost of capital using:

(a) Book value weights, and

(b) Market value weights.

(c) 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?