Cost of Capital

Required rate of return

Cost of capital- Concept
 In capital decision making, the cost of capital is the
discount rate or the minimum required rate of return.
 The cost of capital is the minimum required rate of
return , a project must earn in order to cover the cost of
funds raised .
 The minimum rate expected by the investors depends on
the risk perception of the investors as well as on the risk
return characteristics of the firm .
 Thus, the minimum rate of return that a firm must earn in
order to satisfy the expectations of its investor is called the
cost of capital of the firm .
Factors affecting the cost of capital
Risk free interest rate
It is the interest rate on the risk free and default free
securities.
Business risk
It is related to the promise of payment of interest/
dividend to the investor. i.e. If a firm takes a project
riskier than the risk profile of the firm, then the investor
would ask for a higher rate of return. This premium
added for the business risk compensation is known as
business risk premium .
Factors affecting the cost of capital
Financial risk
 The composition of the capital structure can affect the return
available to the investors.
 It is defined as the likelihood that the firm would not be able
to meet its fixed financial charges
 Higher the component of fixed cost securities in the overall
capital structure, greater would be the financial risk.
Other considerations such as marketability –Higher the
liquidity available with an investment ,lower would be the
premium demanded by investor .
Liquidity means easy sale ability, low transaction cost , wider mkt
acceptance etc.
Risk and return relationship
The risk and return relationship is based on the
argument that investor must be compensated for
undertaking the additional risk.
Higher the risk , higher is the required rate of return .
Therefore, generally, govt securities and bonds have
the lowest return offered to the investor.
Equity shares are considered to be most risky
investment , thus, the rate of return expected is also
highest.
Cost of Capital- Explicit and implicit
The explicit cost of capital of a particular source may
be defined in terms of the interest or dividend that the
firm has to pay to the suppliers of the funds .
Implicit cost is the return forgone by retaining the
profits. Thus, only retained earnings have the implicit
cost of capital.
Generally, in capital budgeting decisions, we are only
concerned about the explicit costs .
Sources of capital - Costs
Long term
debt and
loans

Preference
share capital
Long term
Retained
earnings

Sources of
capital Equity share
capital

Bank credit ,
Short term trade credit
etc

Thus, the cost of capital is calculated as the combined

cost of long term sources of funds .
 BOND CHARACTERISTICS
• A BOND IS AN IOU (informal document acknowledging debt). IT
IS DESCRIBED IN TERMS OF:
• PAR VALUE
• COUPON RATE
• MATURITY DATE

• GOVERNMENT BONDS ALSO CALLED GOVERNMENT

SECURITIES (G-SECS) OR GILT-EDGED SECURITIES.
THESE ARE GENERALLY MEDIUM TO LONG-TERM
BONDS ISSUED BY RBI ON BEHALF OF THE
GOVERNMENT OF INDIA AND STATE GOVERNMENTS.
• CORPORATE BONDS OR CORPORATE DEBENTURES ARE
DEBT INSTRUMENTS ISSUED BY COMPANIES.
Cost of bonds and debentures
Definitions
 Bonds
 Debentures
 Cost of debt – It is return expected by the potential
investors of debt securities of the firm .
There are three components of the cash flows of debt:
 Net proceeds from the issue
 Periodic payments of interest
 Maturity payment
Debentures
DEBENTURES is a type of debt instrument that is not
secured by physical assets or collateral . Debentures have a
more specific purpose than bonds. Both can be used to raise
capital, but debentures are typically issued to raise
comparatively short-term capital for upcoming expenses or
to pay for expansions.

In some markets (India, for instance) the two terms are

interchangeable, but in the United States they refer to two
separate kinds of debt-based securities. 
BONDS
Contract requires the borrower to pay interest
income to the lender
Issued by the govt and the corporate
Rate of interest is known as the coupon rate
At the end of the maturity period , the value is
repaid .
Par value indicates the face value
Coupon rate is applied on the par/Face value
Cost of bonds and debentures
Cost of perpetual debt
Cost of perpetual debt before tax = ki= I/B0
Cost of perpetual debt after tax = kd= ki (1-t)
Note : for loss making or no tax paying firm , this tax
adjustment is not required
Cost of Redeemable debt
Kd= I(1-t)+(RV-B0)/N
(RV+B0)/2
Where, RV = Redemption value, T= tax rate , N= Life of
debenture, B0= Net proceeds
Preference share capital
Difference btw Equity shares and preference shares
1) Pref. shares are entitled to dividend at the fixed
rate in priority over the equity shares .
2)In case of liquidation, the preference
shareholders will get the capital repayment in
priority over the distribution among the equity
shareholders .
3)However, pref dividend is payable as an
appropriation and is not legally binding on the
company
Cost of preference share capital
I) Cost of irredeemable Pref. shares
Kp= PD/P0
Pd =Annual pref dividend
P0= Net proceeds on issue of pref. shares i.e. FV-Floatation
cost
II)Cost of redeemable pref shares (Approximation )
Kp=PD+(Pn-P0)/N (Pn+P0)/2
Equity share capital
Equity share capital is the owner’s fund
Holders are the residual owners of the firm and
provide long term funds .
They are the last claimant on the profits of the
company
There is no commitment as to pay the dividend and
BOD decide to pay or not and how much ?
The shareholders expect return in the form of increase
in the economic value of share
Is Equity capital cost free ?
NO
 Equity capital involves an opportunity cost
 Equity shareholders supply funds to the firm to earn
dividends and capital gains
 The market value of shares is determined by the
DD and SS conditions of the share in the capital
markets
 Thus, shareholders’ required rate of return , which
equates the PV of expected dividends with the
market value of the share , is the cost of equity
Is Equity capital cost free ?
The rate of discount at which the expected dividends
are discounted to determine their PV is known as the
cost of equity share capital.
The market price of a share is equal to the present
value of all expected future dividends on the share plus
the sale proceeds realized when the share is sold.
Cost of equity share capital- Dividend
Discount Model
Zero growth dividend
Formula
D
P0 =
Ke
Assumptions – Constant / Normal growth
model
The present dividend is positive
The dividends grow at a constant rate
The growth rate rate is less than Ke
The growth rate =
 Return on equity (RoE) X Retention ratio (b)
The payout ratio = 1-b
Formula
CONSTANT GROWTH MODEL
D1
P0 =
Ke- g
Super Normal growth
 Dividend is assumed to grow at different rates for
different years
 Illus 9.5
Cost of Equity – Earnings –Price Ratio
 According to this approach, the cost of equity is equal
to :
E1 / P0  
where E1 = expected earnings per share for the next year
P0 = current market price per share
 
E1 may be estimated as : (Current earnings per share) x
(1+ growth rate of earnings per share).

This approach provides an accurate measure of the rate

of return required by equity investors in the following two
cases :
Cost of Equity – Earnings –Price Ratio
When the earnings per share are expected to
remain constant and the dividend payout ratio is
100 per cent.
When retained earnings are expected to earn a
rate of return equal to the rate of return required
by equity investors.
The first case is rarely encountered in real life and
the second case is also somewhat unrealistic.
Hence, the earnings-price ratio should not be
used indiscriminately as the measure of the cost
of equity capital.
Points to remember
Ke= Cost of equity
Po= Current market price of the share
D0/ D1 = Dividend declared /Dividend expected
G= Growth rate of dividends
Dividend declared is % of the FV of the equity share
In zero growth model, since no growth D=D1= D2 …n
so on
Focus on the words such as “Dividend declared=D0 ,
Expected to pay dividend =D1
Cost of retained earnings
The cost of retained earnings as the opportunity cost
of the foregone dividends .
Therefore, Cost of retained earnings , Kr= Ke
Cost of external equity
When a firm raises funds to finance a new project
through fresh issue of equity capital , what return
must be earned on these funds
Practically, the net proceeds to the firm are reduced as
the firm is required to bear additional expenses of
floatation…such as underwriting, brokerage , issue
expenses etc
Therefore , cost of capital for fresh equity
Kn = (D1/NP)+g
Where , Np is the net proceeds , g is the growth rate , D1 is……..?
Difference Btw external(New issue) and
internal equity (retained earnings)
Cost of external equity is greater than the cost of
internal equity
Because 1)The selling price is
less than the market price 2)Additional costs
incurred such as floatation cost, issuance cost etc ,
thereby, reducing the net proceeds
Cost of Equity (CAPM model)
Ke=Rf+ ß(Rm-Rf)
Where,
Rf= Risk free return
beta= Syatematic Risk
Rm = Market Return
Flotation Costs
Flotation or issue costs consist of items like
underwriting costs, brokerage expenses, fees
of merchant bankers, under pricing cost, and so on.
One approach to deal with floatation costs is to adjust the
WACC to reflect the floatation costs:
WACC
Revised WACC =
1 – Floatation costs

A better approach is to leave the WACC unchanged but to

consider floatation costs as part of the project cost as the
floatation costs are incurred at the time the investment project is
financed . These costs can be added to the project’s initial cost.
WACC
WACC= (D/D+E)*kd +(E/D+E)*Ke
Weights are assigned to each source of fund and the
average cost of capital is calculated .
Basis for weight assignment
 Book value
 Market Value

Eg: A firm has raised 60% and 40% of its total funds by equity
and 12% debentures resp. The required rate of return for
equity is 16% . Calculate WACC, assuming the tax rate is 30%.