Cost of capitalIt is the minimum rate of return that a firm must earn on its investments for the market value of the firm to remain unchanged. It is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return or standard return.

Types of cost

• Explicit cost

• Implicit cost

Assumptions to measure cost of capital

• Business risk will remain same.

• Financial risk will remain same.

Specific cost of capital

• Cost of debt

• Cost of preference capital

• Cost of equity capital

• Cost of retained earnings

Cost of Debt

• Cost of perpetual debt:

Ki= Interest payment

Sale proceeds

Kd= Ki(i-t)

• A company has 10 percent perpetual debt of Rs. 1 lac. The tax rate is 35 percent. Determine the cost of capital (before tax as well as after tax) assuming the debt is issued at (1) par, (2) 10 percent discount, and (3) 10 percent premium.

Cost of redeemable debt

Short cut method

Kd= I+ (f + d + Pr - Pi)/Nm(RV+SV)/2

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A company issues 11 percent debentures of Rs. 100 for an amount aggregating Rs. 1 lac at 10 percent premium, redeemable at par after five years. The company’s tax rate is 35 percent. Determine the cost of using method.

Cost of preference of shares

• Perpetual security:

Kp= DpSale proceeds

Dp is dividend on preference sharesSale proceeds is equal to sale proceeds

minus floatation cost

Redeemable preference capital

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ABC Ltd. has issued 11 percent preference shares of the face value of Rs. 100 each to be redeemed after 10 years. Flotation cost is expected to be 5 percent. Determine the cost of preference shares.

Cost of Equity Capital

• Dividend approach

(1) Constant growth model

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• Suppose that dividend per share of a firm is expected to be Rs. 1 per share next year and is expected to grow at 6 percent per year perpetually. Determine the cost of equity capital assuming the market price per share is Rs. 25.

• Answer = 10%

• Z ltd. Is forseeing a growth rate of 12 percent per annum in the next 2 years. The growth rate is likely to fall to 10 percent for the third year and the fourth year. After that, the growth rate is expected to stabilize at 8 percent per annum. If the last dividend was Rs. 1.5 per share and the investors required rate of return is 16 percent, find out the intrinsic value per share of Z ltd. as of date.

• Capital Asset Pricing model approach:

It describes the relationship between the required return or cost of equity capital and the non diversifiable risk of a firm measured by beta coefficient, b.

Ke= Rf + b (Km-Rf)

Cost of Retained Earnings

Overall cost of Capital

It is weighted average of the cost of each specific type of fund.

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Where w is the proportion of specific capital in the capital structureki is specific cost of capital

Assignment of weights

• Historical weights/Marginal weights

• Book value/market value weights

A firm’s after tax cost of capital of the specific sources is as follows:

Cost of debt 8%Cost of preference shares 14%Cost of equity 17%The following is the capital structure:Source book value Market valueDebt 3 lac 270000Preference capital 2 lac 230000Equity capital 5 lac 750000Calculate the weighted average cost of capital

using weights.