cost of capital

1. Cost of Capital

2. • The project’s cost of capital is the minimum required rate of return
on funds committed to the project, which depends on the riskiness of
its cash flows.
• The firm’s cost of capital will be the overall, or average, required rate
of return on the aggregate of investment projects.

3. Significance of the Cost of Capital
• Evaluating investment decisions,
• Designing a firm’s debt policy, and
• Appraising the financial performance of top management.

4. The Concept of the Opportunity Cost of
Capital
• The opportunity cost is the rate of return foregone on the next best
alternative investment opportunity of comparable risk.
OCC
.Equity shares
Risk
.Preference shares
.Corporate bonds
.Government bonds
.Risk-free security

5. • The opportunity cost of capital is the expected rate of return forgone
by bypassing of other potential investment activities for a
given capital. It is a rate of return that investors could earn in financial
markets

6. • In bond investing, face value, or par value, is commonly referred to
the amount paid to a bondholder at the maturity date, given the
issuer doesn't default. However, bonds sold on the secondary market
fluctuate with interest rates. For example, if interest rates are higher
than the bond's coupon rate, then the bond is sold at a discount
(below par). Conversely, if interest rates are lower than the bond's
coupon rate, then the bond is sold at a premium (above par).

7. Weighted Average Cost of Capital Vs.
Specific Costs of Capital
• The cost of capital of each source of capital is known as component,
or specific, cost of capital.
• The overall cost is also called the weighted average cost of capital
(WACC).
• Relevant cost in the investment decisions is the future cost or the
marginal cost.
• Marginal cost is the new or the incremental cost that the firm incurs if
it were to raise capital now, or in the near future.
• The historical cost that was incurred in the past in raising capital is
not relevant in financial decision-making.

8. Cost of debt
• X Ltd Co. issues 50,000 Rs ,8% debentures at par. The tax rate
applicable to the company is 50%.Calculate cost of debt?

9. • Kda=I/NP(1-t)

10. • 4000/50000(1-0.5)=4%

11. • X Ltd Co. issues 50,000 Rs ,8% debentures at a premium of 10%. The
tax rate applicable to the company is 60%.Calculate cost of debt?

12. • Kda=4000/50000+5000(1-0.6)=2.91%

13. • X Ltd Co. issues 50,000 Rs ,8% debentures at a discount of 5%. The tax
rate applicable to the company is 50%.Calculate cost of debt?

14. • Kda=4000/47500(1-0.5)=4.21%

15. Cost of redeemable debt
• Debt is issued to be redeemed after a certain period during the life
time of a firm.such a debt issue is known as redeemable debt.
• Before tax=
• Kdb= INT+1/n(P-NP)
• ½(P+NP)
• P=PROCEEDS AT PAR

16. • A co. issues Rs 10,00,000 ,10% debentures at a discount of 5%.The
cost of floatation amount to Rs 30000.The debentures are
redeemable after 5 years.Cal before tax and after tax cost of debt
assuming tax 50%

17. • Kdb= INT+1/n(P-NP)
• ½(P+NP)

18. • INT=1,00,000 Rs
• N=5
• P=10,00,000 Rs
• NP=9,20,000 Rs
• NP=10,00,000-50,000-30,000
Kdb=12.09%
• Kda=12.09(1-0.5)=6.045%

19. Cost of redeemable debt at premium
• A 5 year Rs 100 debentures of a firm can be sold for a net price of Rs
96.50.The coupon rate of interest is 14% per annum,debenture will
be redeemed at 5% premium on maturity .Tax rate=40% compute
after tax cost of debenture

20. • Kdb= INT+1/n(RV-NP)
• ½(RV+NP)

21. • Int=14
• N=5
• RV=105
• NP=96.50
• Kda=15.58(1-0.4)=15.58%

22. Cost of equity
• Dividend yield method
• Ke=D/NP or D/MP
• A co issues 1000 equity shares of rs 100 each at a premium of 10%
.The co has been paying 20% dividend to equity shareholders for the
past 5 years and expects to maintain the same in future also.Calculate
Ke ?
Will it make any difference if the market price of the share is Rs 160

23. • D=20
• NP=110
• MP=160
• Ke=18.18%
• Ke=12.5%

24. Dividend yield +growth in dividend
method
• Ke= D 1 +G
• NP
• Ke= D 0(1+G) +G
• NP
A co plans to issue 1000 new shares of Rs 100 each at par .The
floatation costs are expected to be 5% of the share price. The co. pays
a dividend of Rs 10 per share initially and the growth in dividends is
expected to be 5% .compute the cost of new issues of equity shares.

25. • D=10
• G=5%
• NP=100-5=95
• 15.53%

26. • If market price of an equity share is Rs 150 Calculate the cost of
existing equity share capital.
• Ke=11.67%

27. • Raj plastic has been in operation for the last 15 years and its shares in
the stock market are currently trading at Rs 120.The most recent
dividend by the firm was Rs 10 per share. historically,the dividend of
raj plastic has been growing at 10% .what would be cost of equity.

28. • Ke= D 1 +G
• NP
Ke= D 0(1+G) +G
• NP
• 10*1.10 +0.10
• 120
• 19.17%

29. • Earning yield method=Ke=EPS/NP
• Ke=EPS/MP

30. COST OF PREFERENCE CAPITAL
• A co issues 10,000,10% preference shares of Rs 100 each .cost of
issue is Rs 2 per share,Cal kp if these shares are issued at
• (a)par
• (b) at premium of 10%
• (c)at discount of 5%

31. • D=1,00,000 Rs
• (a)D=1,00,000 Rs
• NP=10,00,000-20,000
• kp=10.2%
• (b)NP=10,00,000-1,00,000-20,000
• 9.26%
• © NP=10,00,000-50000-20000
• 10.75%

32. • A co issues 10,000,10% preference shares of Rs 100 each redeemable
after 10 years at a premium of 5% The cost of issues is Rs 2 per share

33. • D=1,00,000
• MV=10,50,000
• NP=9,80,000
• 10.54%

34. The Capital Asset Pricing Model (CAPM)
• As per the CAPM, the required rate of return on equity is given by the
following relationship:
• Equation requires the following three parameters to estimate a
firm’s cost of equity:
• The risk-free rate (Rf)
• The market risk premium (Rm – Rf)
• The beta of the firm’s share (β)
( )e f m f jk R R R β= + −

35. • The following steps are involved for calculating the firm’s WACC:
• Calculate the cost of specific sources of funds
• Multiply the cost of each source by its proportion in the capital structure.
• Add the weighted component costs to get the WACC.
(1 )
(1 )
o d d d e
o d e
k k T w k w
D E
k k T k
D E D E
= − +
= − +
+ +