Cost of Capital, cost of preference shares, cost of equity, cost of debentures, WACC

1. Cost Of Capital
• “ The rate of the return that the firm must earn on investment
so that the market value of the company’s equity share does not
fall”
• The minimum rate of return that the firm earn on its investment
so that the market value of the equity does not fall
• Importance of the cost of capital
– Importance from the capital budgeting decisions
• The NPV is calculated using the cost of capital as the discount factor
• The IRR calculated is compared with the IRR while selected and rejecting the
project

2. Cost of capital
Cost of Debt
Irredeemable Redeemable
Cost of Equity
Normal Equity
Retained
earnings
Cost of
Preference
Share
Redeemable Irredeemable

3. Cost Of Debt
• Cost of Debt
– Irredeemable
• AT Par
• AT Discount/Premium
– Redeemable
• AT Par
• AT Discount/Premium

4. Cost Of Debt
• Cost of Irredeemable Debt( issued at par)
kd= (1-T) X I
k = cost of capital ( to be calculated)
T= tax rate
I= annual interest rate to be paid to the creditor ( in
percentage)
– Example: A company has issued debentured worth Rs
1,00,00 of par value of Rs 1000.The coupon rate is 9%.What
is the cost of debt. Tax rate is 50%
– There is no mention of the maturity date
– Thus this is the case of irredeemable debt
– kd= (1-T)I
– Kd = 0.5X9% = 4.5%

5. Cost Of Debt
• Cost of Irredeemable Debt( issued at Premium or Discount)
kd= (1-T) X I
Net Proceeds
k = cost of capital ( to be calculated)
T= tax rate
I= annual interest rate to be paid to the creditor( in Rs)
Net Proceeds = Total amount raised by the company by issuing
the debentures ( in Rs)
– Incase of par --- It is equal to the par value
– In case of discount --- it is less than par value
– In case of premium--- it is more than the par value

6. Cost Of Debt
• Cost of Irredeemable Debt(Par/Discount/Premium)
• Example : A company issues the debentures worth Rs 1,00,000
at coupon rate 10%.The company is in the tax bracket of
55%.Calculate the cost of debt if the debentures are issued
1. At PAR
2. At a discount of 10%
3. At a premium of 10%
kd (1-T) X I
Net Proceeds
– I = Rs 10,000
– T= .55
– In case of Par Net proceeds = Rs1,00,000 Kd = 4.5%
– In case of Discount Net Proceeds = Rs 90,000
• Kd = 5%
– In case of Premium Net Proceeds = Rs1,10,000
• Kd= 4.09%
=

7. Cost Of Debt
• Cost of Redeemable Debt
– In the previous case we have assumed that the bonds are not
maturing and thus are continuously going on
– In case the bond matures after the certain period of time
then it is called redeemable debt
– The formula to be used is
kd (before tax) = I + (P-Net Proceeds)/n
(P + Net Proceeds)/2
– I = annual interest payment ( in RS)
– Net Proceeds = Total amount raised by the company by issuing the
debentures ( in Rs)
– P = Par value of debenture (the value that the creditor gets at maturity)
(in Rs)
– n = Maturity period of the bond

8. Cost Of Debt
• Example
• A firm issues debenture of Rs 1,00,000 but is able to realize only
98,000 due to 2% commission to the broker. The debentures
carry an interest rate of 10%The debentures are due for
maturity after 10 years. Calculate the cost of capital
kd (before tax) = I + (P-Net Proceeds)/n
(P + Net Proceeds)/2
– I = 10,000, P= 1,00,000, NP =98000, n= 10
Kd ( before Tax) = 10.30%
kd (after tax) =( 1-T) X kd (before tax)
Calculate after tax cost of capital if the firm is in the tax bracket of 55%

9. Cost of Preference Capital
• Cost of Preference Capital
– Cost of Irredeemable Preference Capital
Kp = Dp
Np
Dp= Total Preference dividend to be given
Np = Net proceeds generated by the firm
Example: A company raises the capital of Rs 1,00,000 by issuing 10000
preference share of Rs 10 each. The dividend rate on the preference
share is 10%. Calculate the cost of preference share when
1. Preference share are issued at par
2. Preference shares are issued at 10% premium
3. Preference share are issued at 10% discount

10. Cost of Preference Capital
• Cost of Preference Capital ( Irredeemable)
– Kp = Dp
Np
1. Preference shares are issued at 10% premium
1. Dp = Rs 10,000
2. Np = 1,10,000
3. Kp = 9.09%
2. Preference share are issued at 10% discount
1. Dp = Rs 10,000
2. Np = 90,000
3. Kp = 11.11%

11. Cost of Preference Capital
• Cost of Preference Capital ( redeemable)
Kp = D + (P-Net Proceeds)/n
(P + Net Proceeds)/2
– D = Dividend on preference shares
– P = Principal to be paid to the creditors
– Net Proceed= Amount actually received by the firm
– n = Maturity period

12. Cost of Preference Capital
Example: A firm has issued preference share of Rs 100 each
generating a proceed of Rs 1,00,000.The dividend rate is
14%.The Preference shares will be redeemed after 10 years.
Floatation cost is about 5%.Determine the cost of preference
share.
Kp = D + (P-Net Proceeds)/n
(P + Net Proceeds)/2
• D ( Dividend to be paid ) = 14% of 1,00,000 = RS 14,000
– P = Principal to be paid to the creditors = 1,00,000
– Net Proceed= 95,000
– n = 10
•

13. Cost of Preference Capital
Kp = D + (P-Net Proceeds)/n
(P + Net Proceeds)/2
= 14,000+( 1,00,000-95000)/10 = 14500/97500 = 14.87%
(1,00,000+95000)/2

14. Cost of Preference Capital
Example 2: A firm 10 % redeemable shares of Rs 1,00,000,
redeemable at the end of 10 years. The underwriting cost is
about 2 %.Calculate the preference share cost
Kp = D + (P-Net Proceeds)/n
(P + Net Proceeds)/2
• D ( Dividend to be paid ) = 10% of 1,00,000 = RS 10,000
– P = Principal to be paid to the creditors = 1,00,000
– Net Proceed= 98,000
– n = 10
Kp = 10,200/99000 X 100 =10.30 %

15. Cost Of Capital
• Cost of Equity Capital
• Very difficult to calculate as there is no apparent cost involved
as compared to the cost of debt
• Some people argue that equity capital does not have any cost ,
since it is not legally binding on them to pay dividends, but this
argument is wrong
• People invest in the equity with an expectation of
– Getting the dividends
– Increase in the price of the share
• If a firm is not able to meet the expectation of share holders the
price falls
• Thus cost of equity is defined as the “ rate of return” that the
share holders expect to earn on their investment

16. Cost of Equity
Dividend Price
Approach
Without Growth in
Dividends
New Issue of
Equity
Already existing
equity
With Growth in
Dividends
New Issue of
Equity
Already Existing
Equity

17. Cost Of Capital
• Approaches to finding the Cost of Equity
• Dividend Price Approach
– Without growth in dividends
1. New issue of equity
2. Already existing Equity
– With growth in dividends
1. New issue of equity
2. Already existing Equity

18. Cost Of Capital
• Dividend Price Approach
– Without growth in dividends (New issue of equity)
Ke = D
Np
• Ke = Cost of Equity
• D= Dividend Given
• Np = Net proceeds
• Example : A company offers for public subscription the shares
of Rs 10 at a premium of 10%.The commission cost for the
company is 5%.The dividend rate is 20 % .Calculate the cost of
equity.

19. Cost Of Capital
• Dividend Price Approach
– Without growth in dividends (New issue of equity)
Ke = D X 100 %
Np
• Ke = To be calculated
• D= Rs 2
• Np = 11- (5% of 11) = Rs 10.45
• Ke = (2/10.45)X 100 = 19%

20. Cost Of Capital
• Existing Share ( No Dividend Growth)
• Example : A company s share of face value Rs 10,has a market
value of Rs 15.The expected dividend to be paid is 20% of the
face value. Calculate the cost of equity.
Ke = D X 100 %
Mp
D = Dividend given
Mp = Market Price of the share
• = Rs 2/15 = 0.133

21. Cost Of Capital
• Dividend Price Approach
– With growth in dividends (New issue of equity)
Ke = D + g
Np
• Ke = Cost of Equity
• D= Dividend
• Np = Net proceeds
• g = expected growth in dividends

22. Cost Of Capital
Example: A company issues new equity with each share at Rs
150. The underwriting cost is 2%. Following is the
dividend history of the company. The expected dividend
on the new share is Rs 14.10 .Find the cost of equity.
Calculate the cost of equity?
Year Dividend per share ( in Rs)
1994 10.50
1995 11
1996 12.50
1997 12.75
1998 13.40

23. Cost Of Capital
• Dividend Price Approach
– With growth in dividends (New issue of equity)
– So formula to be used is
Ke = D + g
Np
• Ke = Cost of Equity
• D= Rs 14 .10
• Np = 98% of Rs 150 = Rs 147
• g = expected growth in dividends??? Can be calculated from
the table

24. Cost Of Capital
• Rs 10.50 is invested for 4 years and becomes Rs 13.40.
• 10.50(1+g)4 = 13.40
(1+g)4 = 13.40/10.50
Calculate g
Easier way :>>>>
– Divide the latest dividend by the first dividend
– Look in the compound value table for 4 year row for the above
calculated factor to find g.
• From both ways g= 6%.
• Put in the formula to calculate Ke = 14.10/147 + .06 = 15.6%

25. Cost Of Capital
• Dividend Price Approach
– With growth in dividends (Existing equity)
– So formula to be used is
Ke = D + g
Mp
• Ke = Cost of Equity
• D= Dividend given
• Mp = Market price of the share
• g = expected growth in dividends

26. Cost Of Capital
• Example: A company's share has a market price of Rs 20.The
company pays a dividend of Rs 1 per share. The shareholders
expect a growth rate of 5 % per year. Calculate the cost of
equity.
– So formula to be used is
Ke = D + g
Mp
• Ke = Cost of Equity
• D= Rs 1
• Mp = Market price of the share = Rs 20
• g = expected growth in dividends = 5%
Ke = 10%

27. Cost Of Retained Earnings
• Cost of Retained earnings
– The net Profit after tax that is not distributed by the company to the
share holders is called retained earnings.
– Such earnings are used by the companies for the future expansions
– Some people think that these earnings are free of cost and does not
cost anything to the company, WHICH IS ABSOLUTLEY WRONG!
– Because if theses earnings were given to the share holders then they
would have invested them somewhere and in turn have earned on that
investment.
– Thus the cost of the retained earnings is the “ Earnings Sacrificed “ or
the “Opportunity Lost” by the investors, if they were given the
earnings retained by the company.

28. Cost Of Retained Earnings
• Adjustment Required in Retained earnings
– The money retained by the company is not equal to that given to the
investors.
• Investors pay tax on the money given as dividends
• They also incur brokerage cost on making adjustment
– This means if the company has 50,000 Rs as retained earnings and it
decides to give it to the investors then the investors will have less than
50,000 to invest while the company will have Rs 50,000 to invest.

29. Cost Of Retained Earnings
• ABC limited is earning a net profit of Rs 50,000 per annum. The shareholders
require a rate of return of 10%.It is expected that the retained earning if
distributed among the shareholders can be invested in a security of similar
type carrying a rate of return of 10% per annum. It is further expected that
the shareholders will incur a brokerage cost of 2% on the dividend received
to make the new investment. The shareholders are in the tax bracket of
30%.Calculate the cost of retained earnings for the company.
Solution: In order to calculate the cost of retained earning we should first
calculate the net dividend available to the share holders net of tax and other
costs.

30. Cost Of Retained Earnings
Now the available money in the hands of the
investor is Rs 34,300.Expected earnings = 10%
of Rs 34,300 = Rs3430
Dividend
Given
50,000
Less Income
tax @ 30%
15,000
After tax
dividend
35,000
Brokerage
cost@2%
700
Net dividend
available for
investment
34,300

31. Cost Of Retained Earnings
Thus the expectation of the investors is to earn Rs 3430 from the retained
earnings. Which in other words mean if the money is not distributed to the
share holders the company need to earn Rs 3430 but on 50,000.
Therefore Kr = 3430/50,000 = 6.86%
In general Kr = Ke X (1-T)(1-B)

32. Weighted Average Cost of Capital
The capital of the company consists of various components. Thus the
company wants to calculate the total cost of the capital. This total overall or
the total cost of capital is calculated based on the “weights” of each
component on the total capital. Thus the total cost of capital is also called
the “weighted cost of capital “
Steps involved in calculating the weighted average cost of capital.
1. Calculate the cost of different capital components like cost of debt,
cost of preference shares, cost of equity, cost of retained earnings etc.
2. Assign weights to each components.
Ways to calculate the weights
1. Weights based on the book value of the capital ( Book value Weights)
2. Weights based on the basis of Market value of the capital ( Market Value weights)
Both of the above together is called the “HISTORICAL WEIGHT METHOD” of calculating the
weight

33. Weighted Average Cost of Capital
Example: From the following capital structure calculate the overall cost of
capital by
1. Book Value method
2. Market Value method
After tax cost of different components is as follows
cost of equity capital =14%, Cost of Debt = 5%, cost of Preference shares = 10%,
Cost of retained earnings = 13%.
Source Book Value Market Value
Equity Share Capital
( Rs 10 pr share)
Rs 45,000 90,000
Retained earnings 15,000
Preference Share 10,000 10,000
Debenture 30,000 30,000

34. Weighted Average Cost of Capital
Steps: ( Book Value Method)
1. Calculate the weights of different components
2. Multiply diff weights with after tax cost of capital.
3. Add all to get the weights average cost of capital
Source Weights After cost of
capital
Weights cost
Equity Share
Capital ( Rs 10 pr
share)
Rs
45,000/1,00,000
0.45
14% 6.30
Retained earnings 15,000/100,000 =
0.15
13% 1.95
Preference Share 10,000/1,00,000 =
0.10
10% 1
Debenture 30,000/1,00,000
=0.30
5% 1.5
TOTAL 10.75%

35. Weighted Average Cost of Capital
Example: Excel industries ltd has the assets of Rs 1,60,000 which have been
financed by Rs 52,000 of debt, Rs 90,000 of equity and a general reserves of
Rs 18,000.The forms Profit after tax for the firm has been Rs 13,500.It pays
8% interest on the borrowed funds .It has 900 equity shares of FV Rs 100
each, selling in the market at a price of Rs 120 per share. Calculate the
weighted average cost of capitalboth by market value method and book value
method. Tax Rate is 50%.
Steps( by Market Value Method)
1. Calculate the weights
1. Total capital =MV of Debt + MV of Equity
1. Rs 52,000+108,000 = 1,60,000
2. Wt of debt = 52,000/1,60,000 =0.325
3. Wt of Equity = 0.675
2. Calculate the cost of various components
1. Kd =4%
2. Ke= Not given so need to be calculated. EPS/MPPS = Ke
3. Calculate the total cost of capital = .325X4% +0.675X12.5% = 9.74%

36. Weighted Average Cost of Capital
Exercise : Calculate the Overall cost of capital from book value method
• Hint :
– In the absence of any specific cost of retained earning the cost equity calculated can be
used as the cost of retained earnings
– From Book Value perspective total equity base = Reserves + share capital at face
value ( = 18,000+90,000 = 1,08,000)
• ANS WACC ( Book Value Method) = 9.74%

37. Weighted Average Cost of Capital
Example: A limited company has the following capital Structure
1. Equity Share Capital = Rs 40,00,000 ( 2,00,000 shares)
2. 6% preference shares = Rs 10,00,000
3. 8% debentures = Rs 30,00,000
The MPPS = Rs 20. It is expected that the company will give a current
dividend of Rs 2 per share which will grow at a rate of 7% forever.
Tax rate is 50%. Find the weights average cost of capital based on
1. Existing capital Structure
1. 10.75%
2. The new weighted average cost of capital if the company raises an additional
debt of Rs 20,00,000 by issuing 10% debenture his would result in and increase
in the expected dividend to Rs 3 and will leave the growth rate unchanged, but
the price of the share will fall to Rs 15 per share
1. 13.60%
3. The total cost of capital in in (2) the growth rate increase to 10%
1. 14.80%