Cost of Capital
Cost of Capital of a firm is the
minimum rate of return expected by
investors.
Cost of Capital for a firm may be
defined as cost of obtaining funds.
The average rate of return that the
investors in a firm would expect for
supplying funds to the firm
Definition
According to Solomon Ezra, “ Cost Capital is
the minimum required rate of earnings or the
cut-off rate of capital expenditures.”
According to Hampton, John J . defines cost of
capital as , “ the rate of return the firm
requires from investment in order to increase
the value of the firm in the market place.”
Significance of Cost of Capital
Cost of capital act as an acceptance
criteria in capital budgeting
It acts as determinant of capital mix in
capital structure decision
Act as basis for evaluating financial
performance
Act as basis for taking other financial
decisions
Component of Cost of Capital
1. Cost of Debt Capital ( )
2. Cost of Preference Share Capital ( )
3. Cost of Equity Share Capital ( )
4. Cost of Retained Earnings ( )
Cost of Debt Capital
Cost of irredeemable debt :
Where Kd is Before tax Cost of Debt
I is Interest
NP is Net proceeds
NP= (Face value ± Premium/Discount-
Floatation cost)
After Tax cost of Debt (1-t)
t = Rate of Tax
Example 1
(a)X Ltd issued Rs.50,000 8% debenture at par. The tax
rate applicable to the company is 50%.Compute the
cost debt capital
(b) Y Ltd issued Rs.50,000 8% debenture at premium of
10%. The tax rate applicable to the company is
60%.Compute the cost debt capital
(c) Z Ltd issued Rs.100,000 9% debenture at premium
of 10%. The cost of floatation are 2%. The tax rate
applicable to the company is 60%.Compute the cost
debt capital
Solution
In all the case , we have compute after tax cost
of debt capital
(a)
Cont..d
(b)
Cont..d
(c)
Cost of Redeemable Debt
Before tax cost of debt
After tax cost of debt
Example 2
A company issues Rs. 10,00,000 10%
redeemable debentures at a discount
of 5%.The cost of floatation
amounting to Rs. 30,000. The
debentures are redeemable after 5
years. Calculate before –tax and
after-tax cost of debt assuming a tax
rate of 50%.
Solution
Before tax cost of debt:
After tax cost debt = Before tax cost of debt × (1-t)
= 12.09(1-0.5)= 12.09 × 0.5= 6.045 %
Cost of Preference share capital
Cost of Irredeemable Preference share capital:
Where, KP = Cost of Preference capital
D = Annual Preference Dividend
NP= Net Proceeds
Example 3
A company issues 10,000 10% Preference
Shares of Rs. 100 each. Cost of issue is
Rs. 2 per share. Calculate cost of
preference capital if these shares are
issued (a) at par (b) at a premium of 10%
(c) at a discount of 5%
Solution
Cost of Preference share capital:
Given 10,000 Preference share capital at
Rs. 100, so total value = 10,000×100=
Rs.10,00,000
10% is the rate of dividend on face value which is
10,00,000(10/100)= Rs.1,00,000
NP= Face Value – Floatation cost
= 10,00,000-20,000= Rs. 9,80,000
Cont..d
(a)
(b)
Cont..d
(c)
Cost of Redeemable Preference Share
Capital
Cost of Redeemable Preference share capital:
Here, Kp is Cost of Redeemable preference share
MV= Maturity Value
NP= Net proceeds
N= Maturity period, D= Annual Dividend
Example 4
A company issues 10,000 10%
Preference Shares 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.
Solution
Given 10 ,000 shares issued at Rs.100 each
Face value = 10000×100= Rs,10,00,000
Maturity period (N)= 10 Years
Maturity value (MV)= 10,00,000+ (5% of
10,00,000)=Rs10,50,000
Net Proceeds(NP) = Face Value – Floatation Cost
= 10,00,000- 20,000
= Rs.9,80,000
Dividend (D) = 10% on 10,00,000= Rs.1,00,000
Cont…d
Cost of Preference Share Capital:
