Cost of Capital

• 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.

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

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

• 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

• 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).

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.

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?

• Kda=I/NP(1-t)

• 4000/50000(1-0.5)=4%

• 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?

• Kda=4000/50000+5000(1-0.6)=2.91%

• 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?

• Kda=4000/47500(1-0.5)=4.21%

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

• 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%

• Kdb= INT+1/n(P-NP)• ½(P+NP)

• 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%

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

• Kdb= INT+1/n(RV-NP)• ½(RV+NP)

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

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

• D=20• NP=110• MP=160• Ke=18.18%

• Ke=12.5%

Dividend yield +growth in dividend method• Ke= D 1 +G• NP

• Ke= D 0(1+G) +G• NPA 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.

• D=10• G=5%• NP=100-5=95

• 15.53%

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

• 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.

• Ke= D 1 +G• NPKe= D 0(1+G) +G• NP• 10*1.10 +0.10• 120

• 19.17%

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

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%

• 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%

• 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

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

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 ()

( )e f m f jk R R R

• 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.

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o d d d e

o d e

k k T w k wD Ek k T k

D E D E