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Cost of Capital

Cost of debenture capital (Kd)


( R − P)
C (1 − T ) +
kd = n
( R + P)
2

Question
Given Face value (F) = Rs. 500
Issue price (f) = 4%
Tax (T) = 35%
Interest (I) = 15%
Time (n) = 10 years
P – Net amount realized
R = Maturity Value
F (big) = Face Value
f(small) = issue price
(here face value = redeemed price)

( R − P)
C (1 − T ) +
n
Kd = ( R + P)
2

C= 15% of 500 = Rs. 75


f = 4% of 500 = 20
P = F (big) – f (small) = 500 – 20 = 480


(500 − 480 )
75 (1 − .35 ) +
10
(500 + 480 )
2

Answer = 0.10357 x 100


 10.35%

Cost of preference share capital


Redeemable preference shares then
( R − P)
D+
kp = n
( R + P)
2

Irredeemable Preference shares then


D
kp =
P

Kp and D are post tax types

Illustration for Cost of Captial when Redeemable Preference


Shares are there:
D= Annual Dividend Payment
 12% of 100 = Rs. 12
P=F–f
 100 – 3% of 100
 100 -3
 97
n = 7 years

R= 100 + 5% of 100
 100 + 5
 Rs. 105

(105 − 97 )
12 +
kp = 7
(105 + 97 )
2

 0.13
 0.13 x 100
 13%

Illustration for cost of capital when Irredeemable Preference


Shares are there:
D
kp =
P

12
kp =
97

 0.123
 0.123 x 100
 12.3%

Cost of Loan
Kl = I (1-T)
No flotation cost
I = Interest
T = Tax rate
No illustration needed as it is simple

Cost of Equity capital


Two methods:
1) Dividend Growth Model
2) Capital Asset Pricing Model

Dividend Growth Model


Assumption : It is assumed that the dividend payment will
grow at constant rate
Let D0  Current DPS
Let g is the dividend growth rate
D1 = D0 (1 + g)  DPS at the end of 1st year
 D1 = D0 + D0 x g
 D0 (1 + g )

D2 = D1( 1 + g )
 D0 ( 1 + g ) 2

D3 = D2( 1 + g )
 D0 ( 1 + g ) 3

D1
ke = +g
P

P  Rs. 30
g = ? (have to compute)
D0 = 3
Time = 7 years
2 ------------------------------------- 3
7 years

 FV (2) = 3 [ FV means Future Value]

 2 x FVIF ( g% , 7 ) = 3

 FVIF ( g% , 7 ) = 3/2

 FVIF ( g% , 7 ) = 1.5

 g% = 6% ( approx. ) [refer to FV , PV table in any book]

D1
ke = +g
P

D 0(1 + g )
ke = +g
P

3(1 + 0.06 )
ke = + 0.06
30

 0.166

 0.166 x 100

 16.6%

CAPM ( Capital Asset Pricing Model)


 ke = rf + risk premium

Where rf = risk free return

Risk Premium is the additional return expected on account of


additional risk.

How to calculate risk premium

 β ( rm - rf )

Beta ( β ) measures the responsiveness of company’s return


with respect to market return
Co var iance ( XYZ , Nifty )
β = Variance ( Nifty )

Covariance (XYZ, Nifty)


= σ (XYZ) x σ (Nifty)

Note: XYZ means any company


In present situation or exam (according to course) Beta (β )
will be already given.
If β = 1.5

Market = 10↑ (Market growth)

XYZ = 10% x 1.5


 15%
Therefore if Market is 10%↓ (down) then
XYZ = 15% ↓
If β = 0 then company is unaffected

Therefore,

Ke = rf + β ( rm – rf )

Where Risk Premium = β ( rm – rf )


Illustration 1
Calculate the Cost of Capital using the following
information:
Sources of Finance Book Value (BV)
Equity Capital 10,00,000
(1,00,000 shares @
Rs. 10/share)
Reserve and 50,000
Surplus
Preference Capital 1,00,000
(1000 shares @
Rs. 100)
Debenture Capital 10,00,000
(1000 debentures
@ Rs. 100)
Loan 1,00,000

The current market price of equity shares is Rs. 35 per share.


Current market price of Preference shares is Rs. 90 per share.
Current market price of debentures is Rs. 110 per debenture

Calculate overall cost of capital for ABC limited in case


following additional information is given:

1) The dividend per share expected at the end of 1st year is


Rs. 6 per share. Dividend growth rate is 20%
2) Debentures are redeemable after 10 years at par
( assume 50% as tax rate)
3) Preference shares carry 12% fixed rate of dividend and
are perpetual in nature
4) Shareholders expect same return against retained
earnings
5) The rate of interest for debenture holders is 15% per
annum.
Calculate overall cost of capital as per book value and market
value.

Sources of Finance Book Value (BV) Market Value


(MV)
Equity Capital 10,00,000 35,00,000
(1,00,000 shares @
Rs. 10/share)
Reserve and 50,000 50,000
Surplus
Preference Capital 1,00,000 90,000
(1000 shares @
Rs. 100)
Debenture Capital 10,00,000 11,00,000
(10000 debentures
@ Rs. 100)
Loan 1,00,000 1,00,000
22,50,000 48,40,000

First calculate weight as per market value (can also do as per


book value)
How to calculate weight
35 ,00 ,000
We = 48 ,40 ,000  0.72 (weight of equity)
50 ,000
Wr = 48 ,40 ,000  0.010 (weight of retained earnings)

90 ,000
Wp = 48 ,40 ,000  0.018 (weight of preference capital)

11 ,00 ,000
Wd = 48 ,40 ,000  0.227 (weight of debenture capital)

1,00 ,000
Wl = 48 ,40 ,000  0.02 (weight of loan capital)

Similarly weights using book value can be calculated


10 ,00 ,000
We = 22 ,50 ,000  0.44
(Calculate for others, here I am not using book value)

Ko = kewe + kpwp + kdwd + kpwp + krwr + klwl

Ke ( cost of equity capital)

D1
ke = +g
P

D1 = 6 (given of 1st year so do not calculate)


g = 20%  0.02
p = 35 (given)

Therefore
6
ke = + 0.02
35
= 0.37
 0.37 x 100
 37%

Cost of preference capital


D
kp =
P
D = 12% of 100
 Rs. 12

P = Rs. 90

12
kp =
90

 0.13 or 13%

Cost of Debenture Capital


( R − P)
C (1 − T ) +
kd = n
( R + P)
2

C  15% of 100  Rs. 15


T = 50%  0.5 (given)
P = Rs. 110 (given)
R = Rs. 100 (given)
n = 10 years (given)
(100 −110 )
15(1 − 0.5) +
kd = 10
(100 +110 )
2

 0.06 or 6%

Cost of Loan Capital


Kl = I ( 1 – T )
I  15%  0.15
T  50%  0.5
Kl = 0.15 ( 1 – 0.5)

 0.15 x 0.5

 0.075 or 7.5%

Cost of Retained earnings = Cost of Equity Capital


Kr = ke

 0.37 or 37%

COST OF WEIGHT COST X


CAPITAL (W) WEIGHT
(K) (KW)
Equity 0.37 0.72 0.2664
Retained 0.37 0.010 0.0037
Earnings
(Reserve and
Surplus)
Preference 0.13 0.018
Capital 0.00234
Debenture 0.06 0.227
Capital 0.01362
Loan Capital 0.075 0.02 0.0015
Total Cost of Capital 0.28756

Answer = Cost of Capital = 28.756 %

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