Chapter – 2 – Revision Notes

CHAPTER - 2 Cost of Capital

1. MEANING OF COST OF CAPITAL
 Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the debt-
holders) to the business as a compensation for their contribution to the total capital.
 When an entity (corporate or others) procured finances from either source as listed above, it has to pay
some additional amount of money besides the principal amount.
 The additional money paid to these financiers may be either one off payment or regular payment at
specified intervals.
 This additional money paid is said to be the cost of using the capital and it is called the cost of capital.
 Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc.
 It is used as a benchmark for:
 Framing debt policy of a firm.
 Taking Capital budgeting decisions.

2. COST OF LONG-TERM DEBT (Kd)

The calculation of cost of loan from a financial institution is similar to that of redeemable debentures.
2.1 FEATURES OF DEBENTURES OR BONDS:
Face Value:
 Debentures or bonds are denominated with some value, this denominated value is called face value of
the debenture.
 Interest is calculated on the face value of the debenture.
 E.g. if a company issue 9% non- convertible debentures of ` 100 each, this means the face value is ` 100
and the interest @ 9% will be calculated on this face value.
Interest (Coupon) Rate:
 Each debenture bears a fixed interest (coupon) rate (except Zero coupon bond and Deep discount
bond).
 Interest (coupon) rate is applied to face value of debenture to calculate interest, which is payable to the
holders of debentures periodically (annually, semi-annually, etc.).
Maturity period:
 Debentures or Bonds has a fixed maturity period for redemption. However, in case of irredeemable
debentures maturity period is not defined and it is taken as infinite.
Redemption Value:
 Redeemable debentures or bonds are redeemed on its specified maturity date.
 Redemption value may vary from the face value of the debenture.
Benefit of tax shield:
 The payment of interest to the debenture holders are allowed as expenses for the purpose of corporate
tax determination.
 Hence, interest paid to the debenture holders save the tax liability of the company.
 Saving in the tax liability is also known as tax shield.
2.2 COST OF IRREDEEMABLE DEBENTURES

The debentures which are not redeemed by the issuer of the debentures is known as irredeemable
debentures.
Cost of debentures not redeemable during the life time of the company is calculated as below:

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.1 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
I
Kd = (1-t)
NP
Where,
Kd = Cost of debt after tax
I = Annual interest payment
NP = Net proceeds of debentures or Current market price
t = Tax rate
● Net proceeds means issue price less issue expenses or floatation cost (defined below).
● If issue price is not given, then students can assume it to be equal to current market price.
● If issue expenses are not given, then simply assume it to be equal to zero.
Floatation Cost:
 The new issue of a security (debt or equity) involves some expenditure in the form of underwriting or
brokerage fees, legal and administrative charges, registration fees, printing expenses etc.
 The sum of all these costs is known as floatation cost.
 This expenditure is incurred to make the securities available to the investors.
 Floatation cost is adjusted to arrive at net proceeds for the calculation of cost of capital.

2.3 COST OF REDEEMABLE DEBENTURES (USING APPROXIMATION METHOD)

The cost of redeemable debentures will be calculated as below:

Where,
I = Interest payment
NP = Net proceeds or Current market price
RV = Redemption value of debentures
t = Tax rate applicable to the company
n = Remaining life of debentures
The above formula to calculate cost of debt is used where only interest on debt is tax deductible. Sometime,
debts are issued at discount and/ or redeemed at a premium. If discount on issue and/ or premium on
redemption are tax deductible, the following formula can be used to calculate the cost of debt:

In absence of any specific information, students may use any of the above formulae to calculate the Cost of
Debt (Kd) with logical assumption.
IMPORTANT POINTS:
● Above formulas give approximate value of cost of debt.
● In these formulas, higher the difference between RV and NP, lower the accuracy of answer.
● Therefore, one should not use these formulas if difference between RV and NP is very high.
● Also, these formulas are not suitable in case of gradual redemption of bonds.
2.3.1 COST OF DEBT USING PRESENT VALUE METHOD [YIELD TO MATURITY (YTM)
APPROACH]
 The cost of redeemable debt (Kd) is also calculated by discounting the relevant cash flows using
Internal rate of return (IRR).

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.2 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
 Here, YTM is the annual return of an investment from the current date till maturity date.
 So, YTM is the internal rate of return at which current price of a debt equals to the present value of all
cash-flows.
 The relevant cash flows are as follows:
Year Cash flows
0 Net proceeds in case of new issue/ Current market price in case of existing debt (NP or P0)
Interest net of tax [I(1 -t)]
1 to n
Redemption value (RV)
Steps to calculate relevant cash flows:
Step-1 : Identify the cash flows.
Step-2 : Calculate NPVs of cash flows as identified above using two discount rates (guessing).
Step-3 : Calculate IRR.
EXAMPLE - 1:
A company issued 10,000, 10% debentures of ` 100 each on 1.4.2013 to be matured on 1.4.2018. The company
wants to know the current cost of its existing debt if the market price of the debentures is ` 80, assuming 35%
tax rate.
Step-1: Identification of relevant cash flows
Year Cash flows
0 Current market price (P0) = ` 80
1 to 5 5 Interest net of tax [I(1 -t)] = 10% of ` 100 (1-0.35) = ` 6.5
Redemption value (RV) = Face value i.e. ` 100
Step- 2: Calculation of NPVs at two discount rates
Cash flows Discount factor PresentValue Discount factor Present Value
Year
(`) @ 10% (L) (`) @ 15% (H) (`)
0 80 1.000 (80.00) 1.000 (80.00)
1 to 5 6.5 3.791 24.64 3.352 21.79
5 100 0.621 62.10 0.497 49.70
NPV + 6.74 -8.51
Step- 3: Calculation of IRR

Important Points:
 YTM or present value method is a superior method of determining cost of debt of company to
approximation method and it is also preferred in the field of finance.
 We may keep in mind that in the above formula, higher the difference between H and L, lower the
accuracy of answer.
2.3.2 AMORTISATION OF BOND

A bond may be amortised every year i.e., principal is repaid every year rather than at maturity. In such a
situation, the principal will go down with annual payments and interest will be computed on the outstanding
amount. The cash flows of the bonds will be uneven.
The formula for determining the value of a bond or debenture that is amortised every year is as follows:

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.3 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
PROBLEM : 1
RBML is proposing to sell a 5-year bond of ` 5,000 at 8 per cent rate of interest per annum. The bond
amount will be amortised equally over its life. CALCULATE the bond`s present value for an investor if he
expects a minimum rate of return of 6 per cent?
SOLUTION : 1
The amount of interest will go on declining as the outstanding amount of bond will be reducing due to
amortisation. The amount of interest for five years will be:
First year : ` 5,000 x 0.08 = ` 400;
Second year : (` 5,000 - ` 1,000) x 0.08 = ` 320;
Third year : (` 4,000 - ` 1,000) x 0.08 = ` 240;
Fourth year : (` 3,000 - ` 1,000) x 0.08 = ` 160; and
Fifth year : (`2,000 - ` 1,000) x 0.08 = ` 80
The outstanding amount of bond will be zero at the end of fifth year.
Since RBML will have to return ` 1,000 every year, the outflows every year will consist of interest payment
and repayment of principal as follows:
First year : ` 1,000 + ` 400 = ` 1,400;
Second year : ` 1,000 + ` 320 = ` 1,320;
Third year : ` 1,000 + ` 240 = ` 1,240;
Fourth year : ` 1,000 + `160 = ` 1,160; and
Fifth year : ` 1,000 + ` 80 = ` 1,080
The above cash flows of all five years will be discounted with the cost of capital. Here, cost of capital will be
the minimum expected rate of return i.e. 6%.
Value of the bond is calculated as follows:

*****
2.3.3 COST OF CONVERTIBLE DEBENTURES

 The holders of the convertible debentures has the option to either get the debentures redeemed into the
cash or get specified numbers of company`s shares in lieu of cash.
 The calculation of cost of convertible debentures are very much similar to that of redeemable debentures.
 While determining the redemption value of the debentures, it is assumed that all the debenture holders
will choose the option which has the higher value and accordingly, it will be considered to calculate the
cost of debentures.
EXAMPLE - 2 :
A company issued 10,000, 15% Convertible debentures of ` 100 each with a maturity period of 5 years. At
maturity, the debenture holders will have an option to convert the debentures into equity shares of the
company in the ratio of 1:10 (10 shares for each debenture). The current market price of the equity shares
is ` 12 each and historically the growth rate of the shares is 5% per annum. Compute the cost of
debentures assuming 35% tax rate.
Determination of Redemption value:
Higher of
The cash value of debentures = ` 100
Value of equity shares = 10 shares x ` 12 (1+0.05)5

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.4 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
= 10 shares x 15.312 = `153.12
`153.12 will be taken as redemption value as it is higher than the cash option and is more attractive to the
investors.
Calculation of Cost of Convertible debenture (using approximation method):

Alternatively:
Calculation of Cost of Convertible debenture (using present value method):
Discount factor Present Value Discount factor Present Value
Year Cash flows (`)
@ 15% (L) (`) @ 20% (H) (`)
0 100 1.000 (100.00) 1.000 (100.00)
1 to 5 9.75 3.352 32.68 2.991 29.16
5 153.12 0.497 76.10 0.402 61.55
NPV + 8.78 -9.29

2.4 COST OF PREFERENCE SHARE CAPITAL (Kp)

 The preference shareholders are paid dividend at a specified rate on face value of preference shares.
 Payment of dividend to the preference shareholders are not mandatory but are given priority over the
equity shareholder.
 The payment of dividend to the preference shareholders are not charged as expenses but treated as an
appropriation of after-tax profit.
 Hence, dividend paid to preference shareholders does not reduce the tax liability of the company.
 Like the debentures, Preference share capital can also be categorised as redeemable and irredeemable.

2.4.1 COST OF IRREDEEMABLE PREFERENCE SHARES

 The cost of irredeemable preference shares is similar to the calculation of perpetuity.
 The cost of irredeemable preference share is calculated by dividing the preference dividend with the
current market price or net proceeds from the issue.
 The cost of irredeemable preference share is as below:

Where,
PD = Annual preference dividend
P0 = Net proceeds from issue of preference shares
Net proceeds means issue price less issue expenses or floatation cost. If issue price is not given, then students
can assume it to be equal to current market price. If issue expenses are not given, then simply assume it to be
equal to zero.

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.5 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

2.4.2 COST OF REDEEMABLE PREFERENCE SHARES

 Preference shares issued by a company which are redeemed on its maturity is called as redeemable
preference shares.
 Cost of redeemable preference share is similar to the cost of redeemable debentures with the exception
that the dividends paid to the preference shareholders are not tax deductible.
 Cost of preference capital is calculated as follows:

Where,
PD = Annual preference dividend
RV = Redemption value of preference shares
NP = Net proceeds from issue of preference shares
n = Remaining life of preference shares
● Net proceeds mean issue price less issue expenses or floatation cost.
● If issue price is not given, then students can assume it to be equal to current market price.
● If issue expenses are not given, then simply assume it to be equal to zero.
● The cost of redeemable preference shares can also be calculated as the discount rate that equates the
net proceeds of the sale of preference shares with the present value of the future dividends and
principal payments.
2.5 COST OF EQUITY SHARE CAPITAL (Ke)
 Cost of equity is expectation of equity shareholders.
 In case of debentures and preference shares, amount of interest or dividend is fixed but in case of
equity shares it is uncertain.
 Therefore, there is not a single method to calculate cost of equity but different methods which depends
on various factors like:
1) If dividend is expected to be constant, then dividend price approach should be used.
2) If earning per share is expected to be constant, then earning price approach should be used.
3) If dividend and earning are expected to grow at a constant rate, then growth approach (Gordon`s
model) should be used.
4) If it is difficult to forecast future, then realised yield approach should be used, which looks into
past.
5)All the above methods calculate the cost of equity as a balancing figure. When the cost of equity or
expectation of investors is dependent on risk i.e., Higher the risk, higher the expectations and vice
versa, then Capital asset pricing model (CAPM) should be used, which is based on risk.
Different methods employed to compute the cost of equity share capital are:

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.6 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

2.5.1 DIVIDEND PRICE APPROACH

 This is also known as Dividend Valuation Model.
 This model makes an assumption that the dividend per share is expected to remain constant forever.
 Here, cost of equity capital is computed by dividing the expected dividend by market price per share as
follows:

Where,
Ke = Cost of equity
D = Expected dividend (also written as D1)
P0 = Market price of equity (ex- dividend)
2.5.2 EARNINGS PRICE APPROACH
 The advocates of this approach co-relate the earnings of the company with the market price of its share.
 Accordingly, the cost of equity share capital would be based upon the expected rate of earnings of a
company.
 The argument is that each investor expects a certain amount of earnings, whether distributed or not
from the company in whose shares he invests.
 Thus, if an investor expects that the company in which he is going to subscribe for shares should have
at least a 20% rate of earning, the cost of equity share capital can be construed on this basis.
 Suppose the company is expected to earn 30% the investor will be prepared to pay `150 ( 30x 100) for
each share of ` 100.
Earnings Price Approach:

Where,
E = Current earnings per share
P = Market price per share
This approach assumes that the earnings per share will remain constant forever.
The Earning Price Approach is similar to the dividend price approach; only it seeks to nullify the effect of
changes in the dividend policy.
2.5.3 GROWTH APPROACH OR GORDON`S MODEL
 As per this approach, the rate of dividend growth remains constant.
 Where, earnings, dividends and equity share price all grow at the same rate, the cost of equity capital
may be computed as follows:

Where,
D1 = [D0 (1 + g)] i.e. next expected dividend
P0 = Current Market price per share
g = Constant Growth Rate of Dividend
In case of newly issued equity shares where floatation cost is incurred, the cost of equity share with an
estimation of constant dividend growth is calculated as below:

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.7 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

Where,
F = Flotation cost per share
Dividend Discount Model with variable growth rate is explained in chapter 9 - Dividend Decisions.
PROBLEM : 2
A company has paid dividend of ` 1 per share (of face value of ` 10 each) last year and it is expected to
grow @ 10% every year. CALCULATE the cost of equity if the market price of share is `55.
SOLUTION : 2

*****
Estimation of Growth Rate
The calculation of ‘g’ (the growth rate) is an important factor in calculating cost of equity share capital.
Generally, two methods are used to determine the growth rate, as discussed below:
(i) Average Method

Where,
D0 = Current dividend,
Dn = Dividend in n years ago
Growth rate can also be found as follows:
Step-I : Divide Do by Dn, find out the result, then refer the FVIF table.
Step-II : Find out the result found at Step-I in corresponding year’s row.
Step-III : See the interest rate for the corresponding column. This is the growth rate.
EXAMPLE – 3 :
The current dividend (Do) is ` 16.10 and the dividend 5 year ago was ` 10. The growth rate in the
dividend can found out as follows:
Step-I : Divide D0 by Dn i.e. ` 16.10 -f ` 10 = 1.61
Step-II : Find out the result found at Step-I i.e. 1.61 in corresponding year’s row i.e. 5th year.
Step-III : See the interest rate for the corresponding column which is 10%. Therefore, growth rate (g) is
10%.
(ii) Gordon’s Growth Model
 Unlike the Average method, Gordon’s growth model attempts to derive a future growth rate.
 As per this model, increase in the level of investment will give rise to an increase in future
dividends.
 This model takes Earnings retention rate (b) and rate of return on investments (r) into account to
estimate the future growth rate.
It can be calculated as below:
Growth (g) = b x r
Where,
b = earnings retention rate*

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.8 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
r = rate of return on fund invested
*Proportion of earnings available to equity shareholders which is not distributed as dividend.
2.5.4 REALIZED YIELD APPROACH
 According to this approach, the average rate of return realized in the past few years is historically
regarded as ‘expected return’ in the future.
 It computes cost of equity based on the past records of dividends actually realised by the equity
shareholders.
DRAWBACK OF THIS METHOD - it has unrealistic assumptions like
 risks faced by the company remain same;
 the shareholders continue to expect the same rate of return; and
 the reinvestment opportunity cost (rate) of the shareholders is same as the realised yield.
If the earnings do not remain stable, this method is not practical.
PROBLEM : 3
Mr. Mehra had purchased a share of Alpha Limited for ` 1,000. He received dividend for a period of five
years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for ` 1,128.
You are required to COMPUTE the cost of equity as per realised yield approach.
SOLUTION : 3
As per the realised yield approach, cost of equity is equal to the realised rate of return.
This realised rate of return is the discount rate which equates the present value of the dividends received in
the past five years plus the present value of sale price of ` 1,128 to the purchase price of ` 1,000.
The discount rate which equalises these two is 12 percent approximately.
Let us look at the table given for a better understanding:
Year Dividend (`) Sale Proceeds (`) Discount Factor @ 12% Present Value (`)
1 100 - 0.893 89.3
2 100 - 0.797 79.7
3 100 - 0.712 71.2
4 100 - 0.636 63.6
5 100 - 0.567 56.7
6 Beginning 1,128 0.567 639.576
1,000.076
We find that the purchase price of Alpha Limited’s share was ` 1,000 and the present value of the past five
years of dividends plus the present value of the sale price at the discount rate of 12 per cent is ` 1,000.076.
Therefore, the realised rate of return may be taken as 12 percent. This 12 percent is the cost of equity.
*****
PROBLEM : 4
CALCULATE the cost of equity from the following data using realized yield approach:
Year 1 2 3 4 5
Dividend per share (`) 1.00 1.00 1.20 1.25 1.15
Price per share (at the beginning) (`) 9.00 9.75 11.50 11.00 10.60
SOLUTION : 4
In this question, we will first calculate the yield for last 4 years and then will calculate it `s geometric mean.
Yield for last 4 years:

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.9 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

Geometric mean:
Ke = [(1+Y1)x(1+Y2)x (1+Yn)]1/n-1
Ke = [1.1944x1.2821x1.0609x1.0772]1/4-1 = 0.15 = 15%
*****
2.5.5 CAPITAL ASSET PRICING MODEL (CAPM) APPROACH
CAPM model describes the risk-return trade-off for securities. It describes the linear relationship between risk
and return of securities.
The risk to which a security is exposed, can be classified into two groups:
(i) Unsystematic Risk:
 This is also called company specific risk as the risk is related with the company`s performance.
 This type of risk can be reduced or eliminated by diversification of the securities portfolio.
 This is also known as diversifiable risk.
(ii) Systematic Risk:
 It is the macro-economic or market specific risk under which a company operates.
 This type of risk cannot be eliminated by the diversification.
 It is non-diversifiable.
 The examples are inflation, Government policy, interest rate etc.
As diversifiable risk can be eliminated by an investor through diversification, the non-diversifiable risk is the
risk which cannot be eliminated; therefore, a business should be concerned as per CAPM method, solely with
non-diversifiable risk.
The non-diversifiable risks are assessed in terms of beta coefficient (b or P) through fitting regression
equation between return of a security and the return on a market portfolio.

COST OF EQUITY UNDER CAPM

Thus, the cost of equity capital can be calculated under this approach as:

Where,
Ke = Cost of equity capital

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.10 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
Rf = Risk free rate of return
B = Beta coefficient
Rm = Rate of return on market portfolio
(Rm - Rf) = Market risk premium

RISK RETURN RELATIONSHIP OF VARIOUS SECURITIES

Therefore, Required rate of return = Risk free rate + Risk premium
 The idea behind CAPM is that the investors need to be compensated in two ways –
(i) Time value of money and
(ii) Risk.
 The time value of money is represented by the risk-free rate in the formula and compensates the
investors for placing money in any investment over a period of time.
 The other half of the formula represents risk and calculates the amount of compensation the investor
needs for taking on additional risk.
 This is calculated by taking a risk measure (beta) which compares the returns of the asset to the market
over a period of time and compares it with the market premium.
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus
risk premium.
If this expected return does not meet or beat the required return, then the investment should not be
undertaken.
BENEFITS OF THIS APPROACH - CAPM is useful in calculating cost of equity, even when the firm is
suffering losses.
SHORTCOMINGS of this approach:
a) Estimation of beta with historical data is unrealistic; and
b) Market imperfections may lead investors to unsystematic risk.
3. COST OF RETAINED EARNINGS (Kr)
 Retained earnings also involves cost.
 It is the opportunity cost of dividends foregone by shareholders.
 If the cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have
obtained by investing in financial assets.
 The given below figure depicts how a company can either keep or reinvest cash or return it to the
shareholders as dividends. (Arrows represent possible cash flows or transfers.)

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.11 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

COST OF RETAINED EARNINGS

 The cost of retained earnings is often used interchangeably with the cost of equity, as cost of retained
earnings is nothing but the expected return of the shareholders from the investment in shares of the
company.
 However, normally cost of equity remains higher than the cost of retained earnings, due to issue of
shares at a price lower than current market price and floatation cost.
Formulas used for calculation of cost of retained earnings are same as formulas used for calculation of cost
equity:

For the calculation of Ke : P = net proceeds realized = issue price less floatation cost.
But for calculation of Kr : P = current market price.
However, sometimes issue price may also be used.
The concept of Floatation cost is not used for the calculation of cost of retained earnings.
PROBLEM : 5
Face value of equity shares of a company is ` 10, while current market price is ` 200 per share. Company is
going to start a new project, and is planning to finance it partially by new issue and partially by retained
earnings. You are required to CALCULATE cost of equity shares as well as cost of retained earnings if
issue price will be ` 190 per share and floatation cost will be ` 5 per share. Dividend at the end of first year
is expected to be ` 10 and growth rate will be 5%.
SOLUTION : 5

If personal income tax is also considered then a shortcut formula may be as follows:
Kr = Ke (1-tp) (1-f)
Here tp is rate of personal income tax on dividend and "f" is rate of flotation cost.
Here, personal income tax means income tax payable on dividend income by equity shareholders.
*****
EXAMPLE – 4 :
Cost of equity of a company is 20%. Rate of floatation cost is 5%. Rate of personal income tax is 30%.
Calculate cost of retained earnings.

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.12 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

SOLUTION :
Kr = Ke (1-tp)(1-f) = 20% x (1-0.30) x (1-0.05) = 13.3%
PROBLEM : 6
ABC Company provides the following details:
D0 = `4.19 P0 = `50 g = 5%
CALCULATE the cost of retained earnings.
SOLUTION : 6

*****
PROBLEM : 7
ABC Company provides the following details:
Rf = 7% B = 1.20 Rm - Rf = 6%
CALCULATE the cost of retained earnings based on CAPM method.
SOLUTION : 7
Kr = Rf + B (Rm - Rf)
= 7% + 1.20 (6%) = 7% + 7.20
Kr = 14.2%
*****
3.1 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

 To balance financial risk, control over the company and cost of capital, a company usually does not
procure entire fund from a single source, rather it makes a mix of various sources of finance. Hence,
cost of total capital will be equal to weighted average of cost of individual sources of finance.
 WACC is also known as the overall cost of capital which includes the cost of different sources of capital
as explained above. WACC of a company depends on the capital structure of a company. It weighs the
cost of capital of a particular source of capital with its proportion to the total capital. Thus, weighted
average cost of capital is the weighted average after-tax costs of the individual components of firm`s
capital structure. That is, the after-tax cost of each debt and equity is calculated separately and added
together to a single overall cost of capital
THE STEPS TO CALCULATE WACC IS AS FOLLOWS:
Step 1 : Calculate the total capital from all the sources of capital.
(Long-term debt capital + Pref. Share Capital + Equity Share Capital + Retained Earnings)
Step 2 : Calculate the proportion (or %) of each source of capital to the total capital.

Step 3 : Multiply the proportion as calculated in Step 2 above with the respective cost of capital.
(Ke x Proportion (%) of equity share capital (for example) calculated in Step 2 above)
Step 4: Aggregate the cost of capital as calculated in Step 3 above. This is the WACC.
(Ke + Kd + Kp + Ks as calculated in Step 3 above)
3.1.1 CHOICE OF WEIGHTS
There is a choice weights between the book value (BV) and market value (MV).

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.13 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
Book Value (BV) :
 Book value weights is operationally easy and convenient.
 While using BV, reserves such as share premium and retained profits are included in the BV of equity,
in addition to the nominal value of share capital.
 Here, the value of equity will generally not reflect historic asset values, as well as the future prospects
of an organisation.
Market Value (MV) :
 Market value weight is more correct and represent a firm’s capital structure.
 It is preferable to use MV weights for the equity.
 While using MV, reserves such as share premium and retained profits are ignored as they are in effect
incorporated into the value of equity.
 It represents existing conditions and also take into consideration the impacts of changing market
conditions and the current prices of various security.
 Similarly, in case of debt, MV is better to be used rather than the BV of the debt, though the difference
may not be very significant.
 There is no separate market value for retained earnings.
 Market value of equity shares represents both paid up equity capital and retained earnings.
 But cost of equity is not same as cost of retained earnings.
 Hence to give market value weights, market value of equity shares should be apportioned in the ratio
of book value of paid up equity capital and book value of retained earnings.
PROBLEM : 8
CALCULATE the WACC using the following data by using:
a) Book value weights
b) Market value weights
The capital structure of the company is as under:
(`)
Debentures (`100 per debenture) 5,00,000
Preference shares (`100 per share) 5,00,000
Equity shares (`10 per share) 10,00,000
20,00,000
The market prices of these securities are:
Debentures ` ` 105 per debenture
Preference shares ` ` 110 per preference share
Equity shares ` 24 per equity share
Additional information:
1) ` 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10-year maturity.
2) ` 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10-year maturity.
3) Equity shares has ` 4 floatation cost and market price of ` 24 per share.
The next year expected dividend is ` 1 with annual growth of 5%. The firm has practice of paying all earnings
in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.
(Nov. 2020 – RTP + Similar Question in March 2021 – MTP – 10 Marks)
SOLUTION : 8
i) Cost of Equity (Ke)

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.14 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
ii) Cost of Debt (Kd)
Current market price (P0) - floatation cost = I(1-t) x PVAF(r,10) + RVxPVIF (r,10)
` 105 - 4% of `105 = ` 10(1-0.3) x PVAF (r, 10) + ` 100xPVIF (r, 10)
Calculation of NPV at discount rate of 5% and 7%
Cash flows Discount factor Present Value Discount factor Present Value
Year
(`) @ 5% (`) @ 7% (`)
0 100.8 1.000 (100.8) 1.000 (100.8)
1 to 10 7 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV + 14.65 -0.83
Calculation of IRR

iii) Cost of Preference shares (Kp)

Current market price (P0) - floatation cost = PD x PVAF (r,10) + RV x PVIF (r,10)
` 110 - 2% of ` 110 = `` 5 x PVAF (r,10) + `100 x PVIF (r, 10)
Calculation of NPV at discount rate of 3% and 5%
Cash flows Discount factor Present Value Discount factor Present Value
Year
(`) @ 3% (`) @ 5% (`)
0 107.8 1.000 (107.8) 1.000 (107.8)
1 to 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV + 9.25 -7.79
Calculation of IRR

Cost of Preference Shares (Kp) = 4.08%

(a) Calculation of WACC using book value weights
Book Value Weights After tax cost of capital WACC (Ko)
Source of capital
(`) (a) (b) (c) = (a)x(b)
10% Debentures 5,00,000 0.25 0.0689 0.01723
5% Preference shares 5,00,000 0.25 0.0408 0.0102
Equity shares 10,00,000 0.50 0.10 0.05000
20,00,000 1.00 0.07743
WACC (Ko) = 0.07743 or 7.74%
b) Calculation of WACC using market value weights
Market After tax cost WACC
Weights
Source of capital Value of capital (Ko)
(`) (a) (b) (c) = (a)x(b)
10% Debentures (` 105x 5,000) 5,25,000 0.151 0.0689 0.0104
5% Preference shares (` 110x 5,000) 5,50,000 0.158 0.0408 0.0064
Equity shares (` 24x 1,00,000) 24,00,000 0.691 0.10 0.0691
34,75,000 1.000 0.0859
WACC (Ko) = 0.0859 or 8.59%
*****

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.15 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

3.2 MARGINAL COST OF CAPITAL

 The marginal cost of capital may be defined as the cost of raising an additional rupee of capital.
 Marginal cost is referred to as the cost incurred in raising new funds.
 Marginal cost of capital is derived, when the average cost of capital is calculated using the marginal
weights.
 The marginal weights represent the proportion of funds the firm intends to employ.
 Thus, the problem of choosing between the book value weights and the market value weights does not
arise in the case of marginal cost of capital computation.
 To calculate the marginal cost of capital, the intended financing proportion should be applied as
weights to marginal component costs.
 When a firm raises funds in proportional manner and the component’s cost remains unchanged,
there will be no difference between average cost of capital (of the total funds) and the marginal cost of
capital.
 The component costs may remain constant upto certain level of funds raised and then start increasing
with amount of funds raised.
For example, the cost of debt may remain 7% (after tax) till ` 10 lakhs of debt is raised, between `10 lakhs and
` 15 lakhs, the cost may be 8% and so on.
Similarly, if the firm has to use the external equity when the retained profits are not sufficient, the cost of
equity will be higher because of the floatation costs. When the components cost start rising, the average cost
of capital will rise and the marginal cost of capital will however, rise at a faster rate.
PROBLEM : 9
Masco Limited wishes to raise additional finance of ` 10 lakhs for meeting its investment plans. It has `
2,10,000 in the form of retained earnings available for investment purposes. Further details are as
following:

(1) Debt / Equity mix 3:7

(2) Cost of debt:
Upto ` 1,80,000 10% (before tax)
Beyond ` 1,80,000 16% (before tax)
(3) Earnings per share `4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate of dividend 10%
(6) Current market price per share ` 44
(7) Tax rate 50%
You are required to:
a) DETERMINE the pattern for raising the additional finance.
b) DETERMINE the post-tax average cost of additional debt.
c) DETERMINE the cost of retained earnings and cost of equity.
d) COMPUTE the overall weighted average after tax cost of additional finance.
SOLUTION : 9
(a) Pattern for raising the additional finance:
Equity 70% of ` 10,00,000 = ` 7,00,000
Debt 30% of ` 10,00,000 = ` 3,00,000
The capital structure after raising additional finance:
(`)
Shareholders’ funds

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.16 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

Equity Capital (` 7,00,000 - ` 2,10,000) 4,90,000

Retained earnings 2,10,000
Debt (Interest at 10% p.a.) 1,80,000
(Interest at 16% p.a.) (` 3,00,000 - ` 1,80,000) 1,20,000
Total Funds 10,00,000
b) Determination of post-tax average cost of additional debt:
Kd = I (1 - t)
Where,
I = Interest Rate
t = Corporate tax-rate
On ` 1,80,000 = 10% (1 - 0.5) = 5% or 0.05
On ` 1,20,000 = 16% (1 - 0.5) = 8% or 0.08

c) Determination of cost of retained earnings and cost of equity by applying Dividend growth model:

Where,
D0 = Dividend paid = 50% of EPS = 50% x `4 = ` 2
g = Growth rate = 10%
P0 = Current market price per share = ` 44

d) Computation of overall weighted average after tax cost of additional finance:

Amount
Particulars Weights Cost of funds Weighted Cost (%)
(`)
Equity (including retained earnings) 7,00,000 0.70 15% 10.5
Debt 3,00,000 0.30 6.2% 1.86
WACC 10,00,000 12.36
*****
PROBLEM : 10
DETERMINE the cost of capital of Best Luck Limited using the book value (BV) and market value (MV)
weights from the following information:
Book Value Market Value
Sources
(`) (`)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000
Additional information:
(i) Equity: Equity shares are quoted at `130 per share and a new issue priced at `125 per share will be
fully subscribed; flotation costs will be `5 per share.
(ii) Dividend: During the previous 5 years, dividends have steadily increased from ? 10.60 to ? 14.19 per
share. Dividend at the end of the current year is expected to be ? 15 per share.

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.17 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes
(iii)
Preference shares: 15% Preference shares with face value of ? 100 would realise ? 105 per share.
(iv)Debentures: The company proposes to issue 11-year 15% debentures but the yield on debentures of
similar maturity and risk class is 16%; flotation cost is 2%.
(v) Tax: Corporate tax rate is 35%. Ignore dividend tax.
Floatation cost would be calculated on face value. (Similar Question in – May 2022 - RTP)
SOLUTION : 10

*Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures
at discount.
Market price of debentures (approximation method)
= `15/ 0.16 = `93.75
Sale proceeds from debentures = ` 93.75 -`2 (i.e., floatation cost) = `91.75
Market value (P0) of debentures can also be found out using the present value method:
P0 = Annual Interest x PVIFA (16%, 11 years) + Redemption value x PVIF (16%, 11 years)
P0 = ` 15 x 5.029 + ` 100 x 0.195
P0 = ` 75.435 + ` 19.5 = ` 94.935
Net Proceeds = ` 94.935 - 2% of ` 100 = ` 92.935
Accordingly, the cost of debt can be calculated
Total Cost of capital [BV weights and MV weights] (Amount in (`) lakh)
Weights Total cost
Source of capital Specific Cost (K)
BV MV (BV x K) (MV x K)
Equity Shares 120 160* 0.1850 22.2 29.6
Retained Earnings 30 40* 0.1800 5.4 7.2

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.18 9667671155, 9766921860 Cost of Capital
 Chapter – 2 – Revision Notes

Preference Shares 36 33.75 0.1429 5.14 4.82

Debentures 9 10.4 0.1095 0.986 1.139
Total 195 244.15 33.73 42.76
*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings i.e.,
120:30 or 4:1.
Weighted Average Cost of Capital (WACC) :

*****

CA Vinod Kumar Agarwal, A.S. Foundation, Pune CA Intermediate – Financial Management

2.19 9667671155, 9766921860 Cost of Capital