Osama Ahmed Khan

Cost Of Capital: The cost of capital to a company is the minimum required rate of return that it must Earn on its investments in order to satisfy the various categories of investors, who have made investments in the form of shares, debentures & term loans.

SOURCE OF FINANCE: 1. Equity share capital; Preference share capital; Debt amount if it is new organization. 2. In case of existing organization in addition to above Reserve & Surplus also the one source.

DEBT

IRREDEMABLE DEBT

REEDEMABLE DEBT

1. Kd, before tax = I -----------NP/Mpo 2. Kd, after tax = I [ 1- T ] -----------NP

Where : Kd = Cost of debt, I = Interest Amount, T = Tax Rate, Rv = Redemption value, Np = Net Proceedings [ issue price-flotation cost ]

N = No of years, Mpo = Current Market Price.

Example: @ 50 Solution:

1. A 10% debentures, face value of Rs 100 each issued at [a] 100; [b] 90; [c] 110 compute cost of debt, before tax

With tax rate rate

Formula (1-T) Kd = I

With out tax

Kd = I

--------

-------NP

----

NP 1. Kd = 10/100 = 10% = 5% 2. Kd = 10/90 = 11.11% 5.5% 3. Kd = 10/110 = 9.09% = 4.54%

Kd = 10 (1-0.5)/100 Kd = 10 (1-0.5)/90 = Kd = 10 (1-0.5)/110

REEDEMABLE PREFERENCE SHARE Formula Solution:

Kd = I (1-T) + Rv-NP/n ----------------------------Rv + Np/2 =

Kd = 10 (1-40%) + (110-100)/5 ----------------------------------7.6% 110+100/2

If FV, IP, RV = 100 Then Kd = CR(1-T)

I = Interest amount = 10 T = Tax rate = 40% Rv = Redemption value = 110 Np = Net proceeds = 100 n = No of years = 5

Were:- FV = Face Value IP = Issue Price RV = Redemption Value CR = Coupon Rate Kd = Cost of Debt

YEAR

CASH FLOW (100) 10 110

DISFAC @ 8% 1 3.99 0.68 NPV

DIS CASH FLOW

9% 1 3.88 0.649

DIS CASH FLOW

12% 1 3.60 0.567

DIS CASH FLOW

0 1-5 5

(100) 39.9 74.8 14.7

(100) 38.8 71.39 10.19

(100) 36 62.37 (1.63)

Internal Rate of Return [ IRR ], Formula

IRR = Li + NPVLi --------------------------NPVLi - NPVHi

Di

8 + 14.7 -------------16.33
8 + 3.6 = 11.60

Formula :

Kp =

Pd ------------NP/MPo

Where: Kp = Cost of preference share Pd = Preference Dividend Mpo = Current market value Rv = Redemption value Np = Net proceedings [ issue price floatation cost ]n = No of years

Solution:

Kp = Pd/NP 1. Kp = 10/100 = 10% 2. Kp = 10/90 = 11.11% 3. Kp = 10/110 = 9.09%

2. 10% preference share of Rs 100 each issued at 100 but redeemable after 5 years @ 120 Rs ? Compute KP ? Solution: KP = Pd + [ Rv Np ] = 10 + [ 120-100 ] ---------------------------n 5 ------------------------------------------------------Rv + Np/2 120 + 100/2

= 10 + 4 ----------- = Kp = 12.72% ; This formula gives only approximate answer. 110

By Using IRR Method

YEAR CASH FLOW (100) 10 120 DIS FAC 13% 1 3.517 0.542 NPV DCF DIS FAC 14% 1 3.433 0.519 DCF

0 15 5

(100) 35.17 65.04 0.12

(100) 34.33 62.28 (3.39)

= 13 + 0.21 ---------------0.21 + 3.39

= 13 + 0.058 = 13.058%

COST OF EQUITY [ Ke ]
Formulas

1. Dividend Yield Model = Ke = D/MPo

2. Dividend Yield + Growth Model = Ke = d1 Where: ------- + g E = EARNINGS MPo = d0 ( 1+g ) -------------- + g MPo
D = DIVIDENDS CE = CAPITAL EMPLOYED

d1 = Dividend at the end of current year; MPo = Current Market Value; g = Growth Rate in Dividend; b = Retention Rate = E D/D r = Required Rate of Return = E/CE

3. Dividend Net Worth Model =

Ke = D ------------------------Average Net Worth

D = Dividend Per Share

Avg Net Worth = Opening + Closing Net Worth/2

4. Price Earning Approach [ PEA ], Ke = 1 1 ------------- = --------------PER MPS/EPS PER = Price Earning Ratio EPS = Earning Per Share PER = MPS/EPS MPS = Market Price Per Share 5 . Price Earning + Growth Model, Ke = EPS ---------- + g MPS g = Growth in Earning Per Share

EPS --------MPS

6 . CAPITAL ASSET PRICING MODEL [ CAPM ]

1. Ke = Rf + [ Rm Rf ]

2. Rp =

Rm - Rf
Risk free rate of return Return on market Portfolio Beta Factor Risk Premium

Were: Rf = Rm = = Rp =

Note: 1. If floatation cost was given in problem then reduce floatation cost from market price. { Mpo Floatation cost }
2. If issue price differs with market price use issue price rather than market price in the formula.

Note:- If there is involvement of floatation cost, cost of retained earnings are slighter cheaper than cost of equity.

A company cost of capital is nothing but the weighted arithmetic average of The cost of various sources of finances that have been used by it. WACC / Ko = [ Ko is also known as overall cost of capital ] Source of Cost of Weighted Average Fund Amount Weights Capital Cost of Capital -----------------------------------------------------------------------------------------------------------Equity Capital Preference Capital 50 25 0.50 0.25 15% 14% 7.5% 3.5%

Debt

25 ----------100 -----------

0.25 ----------1 ----------{ OR }

8%

2% ------------WACC 13 --------------

The End