The chapter covers Meaning of cost of capital Importance of cost of capital Classification of cost Computation of Cost of capital Computation of specific cost Cost of Debt Cost of Preference share Cost of Equity share Overall cost of capital

Meaning of Cost of Capital The rate of which an organization must pay to the suppliers of capital for the use of their funds. In other words, COC means that rate which is paid for the use of capital. Each source of funds has different cost,such as cost of equity share capital, cost of preference share capital, cost of debt, cost of retained earning.

Meaning of Cost of Capital From the view point of investor:- COC is the reward for that sacrifice which he expect to receive in future in return for making investment by postponing current consumption

Importance of Cost of Capital As determination of the COC is very important in the area of financial management :- Capital Budgeting Capital Structure Decision Dividend Policy Decision Helpful in Evaluation of financial efficiency of Top mgt. Helpful in comparative Analysis of various sources of finance

Classification of Cost Specific or combined cost :- Cost refers to the individual component of capital viz. equity share, preference share,debentures, retained earning. Combined cost refers to the combined or weighted avg COC of the various individual components.It is also called the average /weighted cost of capital or overall cost of capital.

Classification of Cost Explicit and Implicit cost :- Explicit cost is the one which is attached with the source of capital explicitly or apparently while implicit cost is the hidden cost which is not incurred directly.

Example of explicit and Implicit cost Eg. In case of the debt capital, the interest which the company is required to pay on the same . However, if the company introduces more and more doses of debt capital in the overall capital structure, it makes the investment in the company a risky proposition. As such , the expectation of the investor in terms of return on their investment may increase and share price of the company may decease. These increased expectations of the investor or the decreased share price may be considered to be implicit cost of debt capital.

Classification of Cost Historical and Future Cost :- Historial cost means the cost that has been paid in the past for financing a specific project. Future cost is the estimated cost to be incurred to finance a project.Future cost is important for taking financial decision.

Computation of Cost of Capital It includes:- Computation of cost of specific source of finance. - Cost of Debt - Cost of Preference share capital - Cost of Equity share capital - Cost of Retained Earnings Computation of weighted average cost of capital

Cost of Debt Debt fund can be in the form of in the form of debentures of loans from financial institution. Debt can be of 2 types:- Irredeemable or perpetual Debt Redeemable Debt

Cost of Irredeemable Debt Calculation of Irredeemable Debt, before tax :- Kdb = I/ NP * 100 where Kdb = Cost of Debt before tax I = Annually Interest charge NP = Net Proceeds

Example of Cost of Debt, before tax:- X Ltd. issues Rs 15 lakh, 8% debentures (a) at par, (b) at a discount of 7 % and ( c) at a premium of 10% You are required to calculate the cost of Debt to the company.

Cost of Irredeemable debt, after tax Formula:- Kda = I / NP * 100(1- t) Example:- X Ltd has 8% perpetual debt of Rs 20 Lakh. The tax applicable to the company is 40%. Determine the cost of capital after tax assuming the debt is issued (a) at par, (b) at 10% discount,and © at 10% premium

Example of Cost of Irredeemable Debt X Ltd.issues 40,000, 8% debentures of Rs 100 each and incurred the following expenditure: Underwriting Commission 2% of issue price Brokerage 0.5% of issue price Printing and other expense Rs 20,000 Calculate cost of Debt assuming debt is issued At 10% premium At 10% discount Tax rate is 40%

Cost of Redeemable Debt Before tax :- Kdb = I +1/n( RV – NP ) *100 ½(RV+ NP) After tax :- Kdb = I +1/n( RV – NP ) *100 ( 1-t)

Example of Redeemable debt A company issues Rs 5,00,000 , 10% redeemable debentures redeemable after 5 years .The cost of Floatation amount to 4% of face value. Tax rate is 35% You are required to calculate before tax and after tax cost of debt if debentures are issued at par,at a discount of 10%, at a premium of 5%

Example A company issues 20,000, 7.5% debentures of Rs. 100 each at a discount of 2% t be redeemed after 10 years at a premium of 5% .The cost of floatation amount to Rs 50,000.. Calculate cost of debt assuming tax rate at 40%

Cost of Preference Share Capital 2 types of Preference share capital is there:- Irredeemable Preference share Redeemable Preference share Formula of computing cost (irredeemable) Kp = D / NP where:- Kp = cost of preference share D = Dividend NP = Net proceed

Redeemable Preference share Formula of computing:- Kpr = D+ (MV-NP / n) ½ ( MV + NP ) where:- Kpr= cost of redeemable preference Share D = Dividend MV = Market value n = no of years

Example of preference share A company issues 10,000, 10% preference share of Rs 100 each. Cost of issue is Rs 2 per share. Calculate cost of preference capital if these are issued at par, at a premium of 10 % , at a discount of 5%.

Example A company issues 10,000 , 10% 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 preference capital.

Cost of Equity share capital The cost is difficult to measure, as the rate of return fluctuates every year Its not legally binded to pay dividend to equity share holder. As the future earning and dividend are expected to grow overtime.

Cost of Equity The cost of equity can be computed with the following methods:- Dividend yield method Dividend yield method plus growth in dividend Earning yield method Earning yield method plus growth in earning Realized yield method CAPM Approach

Dividend Yield Method It is also known as Dividend/ Price method. This investor invests in the equity shares of a method is based on the assumption that when an company he expect to get a payment at least equal to the rate of return prevailing in the market. This method is suitable only when the company has stable earnings and stable dividend policy.

Cost of Equity Share Capital Formula of computing Cost of Equity:- (Dividend yield method) Ke = DPS/ MP * 100 where:- ke = cost of equity DPS= Dividend Per share MP = Market Price

Example of Equity Share Capital Equity capital of a company consists of 5,00,000 equity shares of Rs 10 each issued at a premium of Rs 2.5 per share.The average rate of dividend paid by the company has been Rs 3 per share .The market value of the share is Rs 25.Calculate the cost of equity capital.

Dividend yield plus growth in dividend method This method takes care of the future growth in the rate of dividend .hence, when dividend are expected to grow at constant rate,we compute cost by:- Ke = DPS/ MP *100+G Ex:- X Ltd pays a dividend of Rs 12 per share initially and the growth in dividend is expected to be 5 % . Compute the cost of equity share if the current market price of an equity share is Rs 150.

Earning Yield Method Formula:- Ke = EPS/ MP * 100 Example:- A company plans to incur an expenditure of Rs 80 lakhs for expanding its operations. The relevant operation is as follows:- No of existing share = 20 lakhs Net earning = Rs 160 lakhs Market value of existing share = 40 s Compute the cost of equity capital.

Earning yield plus growth in Earning Method Formula:- Ke= EPS/ MP *100 + G Ex:- The current market price of the equity share of a company is Rs 60 per share .The expected earning per share after one year is Rs 9 per share .Thereafter EPS is expected to grow constantly at 4% per annum .Find out the cost of equity capital.

Capital Assets Pricing Model or CAPM Approach Ke = Rf + b (Km – Rf) where:- Rf = risk free return b = beta coeff. Km= req return on market return Ex :- Calculate the cost of equity capital where the beta factor (Risk) is 1.5. Risk free rate of interest on Government Securities is 8% . Return on market portfolio is 12%