Advanced Financial Management (Cost of Capital and Capital Structure)

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Department of Management, AIGS
1
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UNIT-2
COST OF CAPITAL
• Meaning of capital:-
Capital refers to cash or goods used to generate income either by
investing in a business or a different income property. It is the net
worth of a business; that is, the amount by which its assets exceed its
liabilities.
• Definition of Capital:-
According to Alfred Marshall, “Capital consists of all kinds of wealth,
other than free gifts of nature, which yield income”.
• Features of Capital:-
1. Productive factor.
2. Elastic supply.
3. Man-made factor.
4. Durable.
5. Easy mobility.
6. Derived demand.
7. Social cost.
8. Round about production.
• Meaning of cost of capital:-
Cost of Capital is the rate of return the firm expects to earn from its
investment in order to increase the value of the firm in the market
place. In other words, it is the rate of return that the suppliers of
capital require as compensation for their contribution of capital.
• Definition of Cost of Capital:-
According to John J Hampton, “Cost of capital is the rate of return the
firm required from investment in order to increase the value of the
firm in the market place”.
ADVANCED FINANCIAL MANAGEMENT

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• Significance/ Importance of cost of capital:-
1. Capital budgeting decisions.
2. Designing the corporate financial structure.
3. Deciding about the method of financing.
4. Performance of top management.
5. Dividend decisions.
6. Working capital policy.
• Factors affecting cost of capital:-
1. Tax rates.
2. Level of interest rates.
3. Amount of financing.
4. Operating and financial decisions made by management.
5. Marketability of company securities.
6. General economic conditions.
7. Source of finance.
8. Business Risk.
9. Financial Risk.
10. Dividend Policy.
• Classification of cost of capital:-
1. Historical cost. 7. Average cost.
2. Future Cost. 8. Marginal cost.
3. Specific cost.
4. Composite cost.
5. Explicit Cost.
6. Implicit cost.
• Computation of cost of capital:-
A)Computation of cost of specific sources of finance.
1. Cost of equity share capital.
2. Cost of Preference share capital.
3. Cost of Debt capital.
4. Cost of retained Earnings.
B)Computation of weighted average cost of capital.

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A). Computation of cost of specific sources of finance.
1. Cost of equity share capital.
a) Dividend yield method.
=
Where,
Ke= Cost of equity capital.
D= Expected Dividend rate per share.
MP= Net proceeds of an equity share.
Problem-01
ABC ltd. has disbursed dividend of Rs. 50 on each equity share of
Rs.10 the current market price of Equity shares is Rs.120. Calculate
the cost of equity as per dividend yield method.
Problem-02
A Company issues 20,000 equity shares of Rs.100 each at a premium
of 10%. The company has been paying 20% dividend to equity
shareholders for the past 5 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 Rs.180?

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b) Dividend yield plus growth in dividend method.
= +
Where,
G= Growth rate.
NP= Net proceeds per share.
Ke= Cost of equity.
D1= Expected dividend per share.
MP= Market price of equity per share.

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Problem-03
The market price of share is Rs.125 and company plans to pay a
dividend of Rs.5 per share. The growth in dividend expected at the
rate of 8%. Find out the cost of equity capital.
Problem-04
a) A Company plans to issue 2,000 shares of 100 each at par. The
flotation costs are expected to be 5% of the share price. A company
pays a dividend of 10 per share initially and the growth in dividends is
expected to be 5%. Compute the cost of new equity share.
b) If the current market price of an equity share is 160, calculate the
cost of existing equity share capital.

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Problem-05
The shares of Infosys co., are selling at Rs.30 per share.
Dividend paid is Rs.3 per share
Estimated growth is 6%
a) Calculate cost of equity capital (Ke).
b) Determine the estimated market price of the equity share, if growth
rate i) Raises to 9% and ii) Falls to 3%

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Problem-06
A firm current earning is Rs.40, 000 distributed among 4,000 shares.
The market price of each share is Rs.125. The growth rate of dividend
is 8%.

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2. Cost of Preference Share capital.
a) Cost of Irredeemable preference shares.
=
Where,
PD= Preference dividend.
NP= Net proceeds.
Kp= Cost of preference shares.
Problem-07
Archita and Company issues 40,000, 12% preference shares of Rs.100
each at Par. Calculate the cost of preference share capital.

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Problem-08
A Company issues 20,000, 10% preference share of Rs.100 each. The
cost of issues is Rs 2 per share. Calculate the cost of preference share
capital if these shares are issued (i) at par, (ii) at 10% premium (iii) at
Discount 5%.

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b) Cost of Redeemable Preference share capital.
=
+ / ( − )
( + )
Problem-09
A Company issues 20,000, 10% redeemable preference share of
Rs.100 each, redeemable after 10 years at a premium of 5%. The cost
of issue is Rs.2 per share. Calculate the cost of redeemable preference
share capital.

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3.Cost of Debt capital.
=
Where,
I= Interest.
P= Principal.
Problem-10
A Company issues Rs.5, 00,000, 8% debentures at par what is the cost
of debt?
a) Cost of Irredeemable Debt.
Before Tax cost of Debt.
=

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Problem-11
A Company issues Rs.1, 00,000, 10% debentures at par. Find out the
cost of debt?
Problem-12
A Company issues Rs.10, 00,000, 10% debentures at a discount of
5%. Find out the cost of debt?

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After Tax Cost of Debt.
= [ − ]
Problem-13
A Company issues Rs.50, 000, 8% debenture at par. The tax rate
applicable is 50%. Compute the cost of debt capital.
Problem-14
Ganga Pvt. Ltd issues 50,000, 8% debentures of Rs.100 each at a
premium of 10%. The tax rate applicable to the company is 50%.
Compute the after tax cost of debt.

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Problem-15
Macro Land Ltd. issues 20,000, 8% debentures of Rs.10 each at a
premium of 10%. The costs of flotation are 2%. The tax rate
applicable is 50%. Compute after tax cost of debt.
Problem-16
ABC Ltd. issues 12% debentures of Rs.6, 00,000. The tax rate
applicable is 50%. Compute cost of debt capital (i) at Par, (ii) at 10%
Premium and (iii) at 10% discount.

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b)Cost of Redeemable Debt.
=
[ − ] + / ( − )
( + )
Where,
P= Payable on Maturity.
NP= Net Proceeds.
N= No. of years to maturity.
T= Tax rate.
I= Interest.
Problem-17
A Company issues Rs.50,00,000, 10% debentures at a discount of 5%.
The costs of floatation amount to 1,50,000. The debentures are
redeemable after 5 years at par. The tax rate of 50%. Calculate cost of
debt capital.

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Problem-18
Company issues debentures of Rs.2,00,000 and realizes Rs.1,96,000
after allowing 2% commission to brokers. The debentures carry
interest rate 10% and the debentures are due for maturity at the end of
the 10th
year. Calculate the effective cost of debt capital after tax if the
rate is 55%.

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4.Cost of Retained Earnings.
Kr= Ke (1-T) (1-B)
Problem-19
A Company’s Ke is 20% the average cost tax rate of shareholders is
40% and it is expected that 2% is brokerage cost that shareholders
will have to pay while investing their dividends in alternatives
securities. What is the cost of retained earning?

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Problem-20
A company issues 1,000 equity of Rs.100 each at a premium of 5%.
Company is paying dividend 20% to equity share holder. Growth rate
is expected to be 5%. And tax rate applicable is 45%. It is expected
3% brokerage cost. Calculate cost of retained earnings.

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B)Computation of weighted average cost of capital.
Once, the specific cost of individual sources of finance is determined,
we can compute the weighted average cost of capital by putting
weights to the specific cost of capital in proportion of various sources
of funds to the total.
The weighted average cost of capital is the rate that a company is
expected to pay on average to all its security holders to finance its
assets. The WACC is commonly referred as the firm’s cost of capital.
Importantly, it is decided by external market and not by management.
It is the average cost of various sources of finance. It is also called as
Composite cost of capital, overall cost of capital, average cost of
capital.
Formula:-
=
∑
∑
Problem-21
The following information is available from the balance sheet of
Alexa Company:
Particulars Amount
Equity share capital 5,00,000
12%, Preference share 5,00,000
10%, Debenture 10,00,000
20,00,000
Company is paying Dividend of Rs.20 per share
Growth rate is 0%
Income Tax rate is 30%
Current price of Rs.100 per share is Rs.160
Calculate WACC?

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Problem-22
The following information is the capital structure and the firms
expected after tax component costs of various source of finance.
Sources of Finance Amount Expected After tax
costs (%)
Equity share capital 6,50,000 20
Retained Earnings 2,50,000 20
Preference share capital 1,50,000 15
Debt Capital 4,50,000 12
Calculate the Weighted average cost of capital.

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Problem-23
A] Calculate WACC of ABC co., ltd from the following information:
Sources of Finance Amount Cost
Equity share 15,00,000 20%
Preference share 6,00,000 15%
Retained Earnings 3,00,000 10%
Long term debt 6,00,000 10%
B] The current Market price of an Equity share is Rs.80. Current
dividend per share is Rs.5. Expected growth rate is 6%. Calculate Ke?

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Problem-24
The following information is furnished by Gamma limited:
Sources of Finance Amount
Equity share capital 65,00,000
12%, Preference share 12,00,000
15%, Redeemable Debentures 18,00,000
10%, Convertible Debentures 10,00,000
• The Ke of the company is 17.20%.
• Income Tax rate is 35%, Redeemable after 5 years.
Calculate WACC?

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Problem-25
A] Rao Corporation has a target capital structure of 60% equity and
40% debt.
If the Ke is 18% and its pre-tax cost of debt is 13%.
If the relevant tax rate is 35%. What is Rao WACC?
B] Calculate the Ke of a firm. Whose shares are quoted at Rs.120. The
dividends are expected to be Rs.9.72 per share and the growth rate is
8%.

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Problem-26
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 Cost
(%)
Debt 4,00,000 3,80,000 5
Preference 1,00,000 1,10,000 8
Equity 6,00,000 9,00,000 15
Retained Earnings 2,00,000 3,00,000 13
Calculate WACC?
A] Book Value Weights.
B] Market Value Weights.

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CAPITAL STRUCTURE
• Meaning:-
Capital structure of a company refers to arranging capital from
various sources, in order, to meet the need of long-term funds for the
business. It is the combination of equities, preference share capital,
long-term loans, debentures, retained earnings along with various
other long-term sources of funds.
We can say that capital structure refers to the proportion of each of
these sources of funds in the capital, which the company should raise
or arrange to carry its business effectively.
• Meaning of Capitalization:-
Capitalization means all the money received by that business in
exchange for long - term debt and equity
Capitalization is the total value of a company’s outstanding shares. It
is calculated by multiplying the number of shares by their current
price.
The market capitalization formula is:
MC = N x P
Where
MC stands for market capitalization
N stands for the number of outstanding shares
P is the closing price per share
Depending on their size, companies are generally classified as large-
cap (typically $10 billion+), mid-cap ($2 billion to $10 billion) or
small-cap (typically $300 million to $2 billion).

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Meaning of Financial structure:-
Financial structure refers to mix of equity and debt that
company uses to finance its assets and operations.
It includes short-term debt, long-term debt, and short-term
liabilities and owners equity.
• Forms/Patterns of capital structure:-
1.Equity share.
2.Equity and Preference share.
3.Equity shares and debentures.
4.Equity shares, preference shares, debentures.
• Principles of Capital structure decisions:-
1.Cost principle.
2.Risk principle.
3.Control principle.
4.Flexibility principle.
5.Timing principle.

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• Factors affecting the capital structure:-
1.Financial leverage or trading on equity.
2.Growth and stability of sales.
3.Cost of capital.
4.Risk.
5.Nature and size of a firm.
6.Control.
7.Flexibility.
8.Requirements of investors.
9.Capital market conditions.
10. Asset structure.
11. Purpose of financing.
12. Period of finance.
13. Costs of floatation,
14. Corporate tax rate.
15. Legal requirements.

• Types of Risk:-
• Causes of Risk:-
1. Wrong method of investment.
2. Wrong timing of investment.
3. Wrong quantity of investment.
4. Interest rate risk.
5. Nature of investment instruments.
6. Nature of industry in which the company is operating.
7. Creditworthiness of the issuer.
8. Maturity period or length of investment.
9. Terms of lending.
10. Natural calamities.
Systematic
Risk
1.Market Risk
2. Interest rate Risk
3. Purchasing power
risk
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Wrong method of investment.
Wrong timing of investment.
Wrong quantity of investment.
Nature of investment instruments.
Nature of industry in which the company is operating.
Creditworthiness of the issuer.
Maturity period or length of investment.
Natural calamities.
Risk
Systematic
1.Market Risk
2. Interest rate Risk
3. Purchasing power
Unsystematic
Risk
1. Business Risk
2. Financial Risk
3. Operational risk
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Nature of industry in which the company is operating.

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Problems on EPS (Earning Per Share)
Problem-27
ABC Company has currently having all Equity capital structure consisting of
15,000 of Rs.100 Each. The Management is planning to raise another
Rs.25, 00,000 to finance a major program of expansion and is considering 3
alternative methods of Financing:
i) To issue 25,000 equity shares of Rs.100 each.
ii) To issue 25,000, 8% debentures of Rs.100 each.
iii) To issue 25,000, 8% preference shares of Rs.100 each.
The company’s expected earnings before interest and taxes will be
Rs.8 lakhs. Assuming a corporate tax rate of 50%, determine the earnings per
share (EPS), in each alternative and comment which alternative is best and
why?
Solution:-

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Problem-28
A ltd company has equity share capital of Rs.5, 00,000 divided into shares of
Rs.100 Each. It wishes to raise further Rs.3, 00,000 for Expansion and
Modernization Plan.
Company plans following financial schemes:
i) All common stocks.
ii) Rs.1,00,000 in common stock and Rs.2,00,000 in debenture at 10% p.a.
iii) All debts at 10% p.a.
iv) Rs.1,00,000 in common stock out Rs.2,00,000 in preference capital with the
rate of dividend at 8%.
The company’s expected earnings before interest and tax (EBIT) are Rs.1,50,000.
The corporate rate of tax is 50%.
Determine the earning per share (EPS) in each plan and comment on the
implication of financial leverage.

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Solution:-

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• CAPITAL STRUCTURE THEORIES:-
1. Net Income (NI) Approach:
Net Income Approach was propounded by Durand.
The theory suggests increasing value of the firm by decreasing
the overall cost of capital which is measured in terms
of Weighted Average Cost of Capital. This can be done by
having a higher proportion of debt, which is a cheaper source of
finance compared to equity finance.
Weighted Average Cost of Capital (WACC) is the weighted
average costs of equity and debts where the weights are the
amount of capital raised from each source.
Assumptions:-
a. The cost of debt is less than the cost of equity.
b. There are no taxes.
c. The risk perception of investors is not changed by the use of
debt.

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Formulas:-
Market value of the firm = S + D
Where, S= Market value of equity shares,
=
!"#"$% ' #( )(* +, *-.#+/ %0 !*0,(1*!%
-.#+/ 2 3#+ (#% +#," ! +*
D= Market value of Debt.
Overall cost of capital:-
45 =
EBIT
V
x100
Particulars Amount
EBIT
Less:-Interest on Debentures
Earnings available to Equity
Shareholders
Market capitalization rate:-
Market value of equity= >>>>>
??
>>
(S)
Market value of Debentures (D)
Value of the firm (S+D)
xxxx
xxxx
xxxx
XXXXX
XXXXX
XXXXXXX

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Problems on Net Income Approach
Problem-29
X Ltd. is expecting an annual EBIT of Rs.1,00,000. The company has
Rs.4,00,000 in 10% debentures. The cost of equity capital or
capitalization rate is 12.5%. You are required to calculate the total
value of the firm according to the Net Income Approach.
Solution:-

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Problem-30
a) A Company expects a Net Income of Rs.80, 000. It has
Rs.2, 00,000, 8% debentures. The equity capitalization rate of the
company is 10%. Calculate the value of the firm and overall
capitalization rate according to the Net Income Approach (Ignoring
income-tax).
b) If the debenture debt is increased to Rs.3,00,000, what shall be the
value of the firm and the overall capitalization rate?
Solution:-

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2. Net Operating Income (NOI) Approach / Theory:
Net Operating Income Approach was advocated by David
Durand.
This theory is Opposite to Net Income Theory.
According to this theory, change in capital structure of a
company does not affect the market value of the firm and the
overall cost of capital remains constant irrespective of the
method of financing.
Use of Debt increases the financial risk of the equity
shareholders and hence the cost of equity increases.
As per NOI Approach, value of a firm is not dependent upon its
capital structure.
Assumptions:-
a. The Business Risk remains Constant at every level of debt and
equity mix.
b. There is no corporate taxes.
c. The cost of debt (Kd) is constant.
d. Increase in debt increases the expectations of the investor.
The NOI Approach can be illustrated with the help of the
following diagram:

Formulas:-
Value of the Firm:-
Where,
EBIT= Earnings before Interest and Tax
Ko=Overall cost of capital
Market Value of Equity:
S = V – D
Equity Capitalization Rate or Cost of Equity:
=
@ABCDB
EDF
x 100
Where,
EBIT= Earnings before interest and tax.
I= Interest on Debentures.
V= Value of the firm.
D= Value of debt capital.
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V=
@ABC
GH
EBIT= Earnings before Interest and Tax
Ko=Overall cost of capital.
Market Value of Equity:
Capitalization Rate or Cost of Equity:-
EBIT= Earnings before interest and tax.
I= Interest on Debentures.
D= Value of debt capital.
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Problem-31
a) A Company expects a net operating income of Rs.1,00,000. It has
Rs.5,00,000, 6% Debentures. The overall capitalization rate is 10%.
Calculate the value of the firm and the equity capitalization rate (Cost
of equity) according to the Net Operating Income Approach.
b) If the debenture debt is increased to Rs.7,50,000. What will be the
effect on the value of the firm and the equity capitalization rate?
Solution:-

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Problem-32
Agastya Ltd. expects annual net operating income of Rs.2,00,000. It
has Rs.5,00,000 outstanding debt, cost of debt is 10%. If the overall
capitalization rate is 12.5%. What would be the total value of the firm
and the equity capitalization rate according to the Net operating
Income Approach.
What will be the effect of the following on the total value of the firm
and equity capitalization rate if:
(i) The firm increases the amount of debt from Rs.5,00,000 to
Rs.7,50,000. What will be the effect on the value of the firm and Ke?
(ii) The firm redeems debt of Rs.2,50,000 by issuing fresh equity
shares of the same amount.
Solution:-

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3. Traditional Theory / Approach:
This theory was propounded by Ezta Solomon & Fred Weston.
The traditional approach, also known as “Intermediate approach”,
is a Comprises between the two extremes of Net Income approach
and Net operating income Approach.
According to this theory, the value of the firm can be increased
initially or the cost of capital can be decreased by using more debt as
the debt is a cheaper source of funds than equity. Thus optimal
capital structure can be reached by a proper debt-equity mix.
Beyond a particular point, the cost of equity increases because
increased debt increases the financial risk of the equity shareholders.
The advantage of cheaper debt at this point of capital structure is
offset by increased cost of equity. After this there comes a stage,
when the increased cost of equity cannot be offset by the advantage
of low-cost debt. Thus, overall cost of capital, according to this
theory decreases up to a certain point, remains more or less
unchanged for moderate increase in debt thereafter; and increase or
rise beyond a certain point. Even the cost of debt may increase at this
stage due to increased in financial risk.
In other words, after attaining the optimum level, any additional debt
taken will offset the use of cheaper debt capital since the average cost
of capital will increase along with a corresponding increase in the
average cost of debt capital.
Thus, the basic proposition of this approach is:
(a) The cost of debt capital, Kd, remains constant more or less up to a
certain level and thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or
rises gradually up to a certain level and thereafter increases rapidly.
(c) The average cost of capital, Kw, decreases up to a certain level
remains unchanged more or less and thereafter rises after attaining a
certain level.

The traditional approach
taking the data from the
Formulas:-
Average cost of Capital
Particulars
EBIT
Less:-Interest on Debentures
Earnings available
Market capitalization
Market value of equity
Market value of Debentures
Value of the firm (S+D)
Average cost of capital
=
IJKL
M
x 100
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approach can graphically be represented
the previous illustration:
Average cost of Capital=
@ABC
E
x 100
Debentures
available to Equity Shareholders
capitalization rate:-
equity= >>>>>
??
>>
(S)
Debentures (D)
(S+D)
capital
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represented under
Amount
xxxx
xxxx
xxxx
XXXXX
XXXXX
XXXXXXX
XX

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Problem-33
Compute the market value of the firm, value of shares and the average
cost of capital from the following information:
Net operating Income Rs.2,00,000
Total Investment Rs.10,00,000
Equity capitalization rate:
(a) If the firm uses no debt 10%
(b) If the firm uses Rs.4,00,00 debentures 11%
(c) If the firm uses Rs.6,00,000 debentures 13%
Assume that Rs.4,00,000 debentures can be raised at 5% rate of
interest whereas Rs.6,00,000 debentures can be raised at 6% rate of
interest.
Solution:-

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Problem-34
A Company current’s Net operating Income (EBIT) is Rs.8,00,000.
The company has Rs.20,00,000 of 10% debt outstanding. Its equity
capitalization rate is 15%. The company is considering to increase its
debt by raising additional Rs.10,00,000 and to utilize these funds to
retire the amount of equity. However, due to increased financial risk,
the cost of entire debt is likely to increase to 12% and the cost of
equity is 18%.
You are required to compute the market value of the company using
traditional model and also make recommendations regarding the
proposal.
Solution:-

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4. Modigliani-Miller (M-M) Approach:
This approach was devised by Modigliani and Miller during the
1950s.
The fundamentals of the Modigliani and Miller Approach
resemble that of the Net Operating Income Approach.
Modigliani and Miller advocate capital structure irrelevancy
theory, which suggests that the valuation of a firm is irrelevant
to the capital structure of a company. Whether a firm is highly
leveraged or has a lower debt component in the financing mix
has no bearing on the value of a firm.
Value of levered firm will be having high Firm value than
Unlevered Firm. But it will be balanced by Arbitrage Process.
ASSUMPTIONS:
• There are no corporate taxes.
• There is symmetry of information. This means that an investor will
have access to the same information that a corporation would and
investors will thus behave rationally.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission,
payment to merchant bankers, advertisement expenses, etc.
• All earnings are distributed to the shareholders.
Formulas:-
A] In the absence of taxes [Theory of
Irrelevance]:
Firms total market value =
NO P
QR
Firm’s market value of Equity S = V-D

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Firms leverage cost of equity:-
= cost of equity + (cost of equity - cost of debt)
B] When the corporate taxes are assumed to
exist [Theory of Relevance]:
Value of Unlevered Firm (Vu) =
IJKL
S
x (1-t)
Value of levered firms (Vl) =Vu + td
Problem-35
ABC Company currently has no debt, it is an all equity company;
The Expected EBIT is Rs.24,00,000;
There is no taxes, so T = 0 per cent;
ABC Company pay all its income as dividends;
The cost of Debt is 8% & Cost of Equity is 12%;
Using MM Approach without corporate taxes and assuming a debt of
Rs.1 Crore, you are required to:
a) Determine the firm’s total market value;
b) Determine the firm’s Value of Equity;
c) Determine the firm’s leverage cost of equity.

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Solution:-

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Problem-36
There are 2 firm’s X and Y which are identical except that X does not
use any debt in its financing, while Y has Rs.1,00,000, 5%
Debentures in its financing. Both the firms have earnings before
interest and tax of Rs.25,000 and the equity capitalization rate is 10%.
Assuming the corporate tax of 50%. Calculate the value of the firm
using MM Approach.
Solution:-

Advanced Financial Management (Cost of Capital and Capital Structure)

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Advanced Financial Management (Cost of Capital and Capital Structure)