Cost of

Capital

“The cost of raising funds that are needed to operate the firm is the cost of capital.”

Sources of CapitalEquity

Preference Shares

Debentures

Retained Earnings

Cost of Debt

Cost of Debt

“The firm has to pay as the contractual amount to the debenture holders.”

Formula

Cd =

Cd → Cost of Debti → interestNP → Net Proceed (Par Value)

Perpetual / Redeemable Debt

NP

ix 100 Cd =

(1 – t)

NP

i x x 100

(After Tax)

Redeemable Debt

Cd =MV-NP

n

MV+NP2

i +{ }Cd → Cost of Debti → interestNP → Net Proceed (Par Value)MV→ Maturity Value

(After Tax)

Cd =MV-NP

n

MV+NP2

i +(1-t)

x 100

Cost of Preference Share

“It is payable to preference shareholders in the form of dividend with fixed rate.”

Formula Irredeemable Preference Share

Cp =

Cp → Cost of Preference SharePD → Preference Share Per ShareNP → Net Proceed (Par Value)

NP

PDx100

(After Tax)

After Tax1-Tax

Rate

Cp =(Before Tax)

Cost of Shares

“It is that part of cost of capital which is payable to equity shareholder.”

Formula

Ce → Cost of Equity ShareCDPS → Cash Dividend per ShareMP → Market PriceEPS → Earning per Share

Dividend Yield method

Ce =CDPS

MPx 100

(After Tax)

Earning Yield method

Ce =EPSMP

x 100

After Tax1-Tax

Rate(Before Tax)

Ce =

Cost of Retained Earnings

“The residual of an firm's earnings over expenditures, including taxes and dividends, that are reinvested in its business. The cost of these funds is always lower than the cost of new equity capital, due to taxes and transactions costs.”

Ce =DPS ( 1 – Ti ) ( 1 – B )

MP ( 1 – Te )x 100

Formula

Cr → Cost of Retained EarningsDPS → Dividend per ShareTi → Marginal Tax Rate Applicable to Individual ShareholderB → Brokerage Cost MP → Present Market Price per ShareTc → Capital Gain Tax

Weighted Average Cost of Capital

“Weighted Average Cost of Capital is the composite or overall cost of capital from the different sources of financing.”

Book Value Weighted MethodSources Amount Specific Cost

Long Term Debt 1500000 4%

Preference Share 1000000 12%

Equity Share 2000000 15%

Retained Earnings 500000 15%

Total 5000000

Book Value of Weights Weighted Cost

Percentage Proportion (x) Specific Cost = Weighted cost

30% .3 1.2

20% .2 2.4

40% .4 6

10% .1 1.5

11.10%

Market Value WeightsSources Amount Specific Cost

Long Term Debt 1500000 4%

Preference Share 1000000 12%

Equity Share 2000000 15%

Retained Earnings 500000 15%

Total 5000000

Sources Market Value Market Value Weights

Specific Cost Weighted Cost

Percentage Proportion

Long Term Debt 1500000 21.45 .214 4% .856

Preference Share

1500000 21.4 .214 12% 2.568

Equity Share 3200000 45.7 .457 15% 6.855

Retained Earnings

800000 11.5 .115 15% 1.725

8000000 12.004% or12%

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