COST OF CAPITAL

Costs of different sources of finance:

1. Cost of debentures:
It is defined as that discount rate which equates the net
proceeds from issue of debentures to the expected cash
outflows in the form of interest and principal repayments
i. e.
n
P = ∑ I ( 1-t ) + F
t=1 ( I +Kd ) t ( I +Kd )n
Where,
Kd = post-tax cost of debenture capital
I = annual interest payment per debenture capital
t = corporate tax rate
F = redemption price per debenture
P = net amount realizes per debenture
n = maturity period
 An approximate formula as given below can also be used:

Kd = I ( 1 – t ) + (F –P )/n
(F + P )/2
Illustration:
NCD for Rs. 400 lakh by ABC company
Terms: Face value of each debenture Rs. 100
Rate of interest 14% (payable annually
Redemption at premium of 5% after 10 years
If ABC realize Rs. 97 per debenture and the corporate rate is
50%, what is the cost of the debenture to the company?
Solution: Given I = Rs. 14, t = 0.5 P = Rs. 97 and n= 10 years,
F = Rs. 105.

Kd = 14( 1- 0.5) + (105 – 97) / 2 = 7.7%

(105 + 97 )/2
Cost of term loans:
The cost of term loans is equal to the interest rate multiplied
by ( 1 –tax rate).
Cost of preference capital:
The cost of a redeemable preference share (Kp) is defined
as that discount rate which equates the proceeds from
preference capital issue to the payments associated with the
same i. e. dividend payment and principal payments i. e.
t n
P = ∑ D / (1 + Kp ) + F/ ( 1 + Kp)
Where Kp = cost of preference capital
D = preference dividend per share payable annually
F = redemption price
P = net amount realized per share
n = maturity period
Approximate formula:
Kp = D + (F – P ) /n
( F + P ) /2
Illustration: Face value of each preference share = Rs. 100
Rate of dividend = 14% payable annually
Redeemable after 12 years at par
Net amount realized = Rs. 95,
Calculate the cost of the preference share.
Solution:
Given that D = 14, F = 100, P = 95 and n = 12

Kp = 14 + (100 – 95) /12 = 0.148 0r 14.8 %

(100 +95 ) /2
Cost of Equity capital:
According to the dividend forecast approach, the intrinsic
value of equity stock is equal to the present value of the
dividends associated with i.e.
n t Where Pe = price per equity share
Pe = ∑ Dt / ( 1 + Ke ) Dt = expected dividend per
t=1 share at the end of year t
and Ke = net return required by the equity shareholders
 As it is not possible to forecast the dividend stream
completely and accurately over the life of the company,
the formula is modified assuming a constant growth rate (g)
in DPS.
So, Pe = Dt/ (Ke – g) or Ke = Dt/ Pe +g
Illustration: Market price = Rs. 125 and dividend per share is 12%
which is expected to grow at a constant rate of 8 %. Find
the cost of equity.
Ke = 12/ 125 + 0.08 = 17.6%
Realized Yield Approach
The realized return over a n-year period is calculated as
( w1 x W2 x -------------- Wn ) ¹/n -1
Where Wt is referred to as the wealth ratio,is calculated
as under:
Wt =( Dt + Pt )/ Pt –1
T = 1,2 ,3 ----n
Dt = Dividend per share for year t payable at the end of year
Pt = Price per share at the end of year t
Illustration:
Year 1 2 3
DPS (Rs.) 1.50 2.00 1.50
Price per share 10.00 12.00 11.00
at the beginning
Solution:
The wealth ratios are
Year 1 2 3
Wealth ratio 1.35 1.08 1.23
Realized yield = (1.35 x1.08 x 1.23 )¹/3 - 1
= 0.2149 or 21.5%
Exercise : XYZ co. has the following capital structure:
(Rs. in lakh)
Equity share (10 lakh shares at par value ) 100
12% preference share capital ( 10,000 shares) 10
Retained earnings 120
14% NCD ( 70,000 debentures at par value)
!4 % term loan 100
Total 400
The market price of equity is Rs. 25. DPS is Rs. 2.00 and the constant
expected growth is 8%. Redemption period of P. shares is 7 years
at par and are currently quoted at Rs. 75 per share in the market.
The debentures are redeemable after 6 years at par and the current
rate is Rs. 90 per debenture. The tax tare is 50%. Calculate the
weighted average cost of capital.

Ans. WACC = 12.59 %