Corporate Finance

Prof. Swati Dhawan

COST OF CAPITAL
In this session we shall cover
• Meaning of cost of capital and its
measurement
• Measuring cost of debt
• Measuring cost of preferred stock
• Measuring cost of equity
• Measuring cost of retained earnings
• Determination of weights
• Estimation of WACC
Cost of capital - Explained
• A firm would need funds for different capital budgeting
proposals
• These funds can be procured from different types of
investors
• Each source so used will have a cost attached to it
referred to as COST OF RAISING CAPITAL from that source
• In order to pay return to the investors, sufficient earnings
need to be generated from the projects where such
capital is employed
• Thus, the cost of raising finance becomes the minimum
required rate of return
– Also known as CUT OFF RATE or HURDLE RATE
Cost of capital - Explained
• A firm would need funds for different capital budgeting
proposals
• These funds can be procured from different types of
investors
• Each source so used will have a cost attached to it
referred to as COST OF RAISING CAPITAL from that source
• In order to pay return to the investors, sufficient earnings
need to be generated from the projects where such
capital is employed
• Thus, the cost of raising finance becomes the minimum
required rate of return
– Also known as CUT OFF RATE or HURDLE RATE
Risk return trade off

Equity shares
Preference
shares
Debenture
s
PSU
Bonds
Govt
securities
/ RBI
Bonds
Measurement of Cost of capital
(COC)
• ‘COST OF CAPITAL’ is measured as the weighted average of the
costs of different sources of finance being used

WACC = kewe + kd(1-t)wd + kpwp + krwr

• Here, ke is the cost of equity,

kd is the cost of debt,
kp is the cost of preferred stock, and
kr is the cost of retained earnings
we , wd , wp and wr are the respective proportions in
which the funds have been raised

• To determine the cost of each source being used, a COST-BENEFIT

analysis would be done
Cost of Debt
Cost of debt
• ‘Debt’ refers to fixed income securities like
Bonds or Debentures
• Characteristics of debt:
– Issued for a fixed time period
– Rate of interest (or Coupon rate) is predetermined
and fixed and is paid periodically over the life of debt
irrespective of the level of profits of the corporate
– Debt is redeemed (at a price fixed at the time of
issue) at a predetermined date
– Interest on debt is a tax deductible expense for the
company
From the perspective of the investor

Cost - benefit analysis

Benefits Cost

Redemption value Current market price

Interest payments of debt
(received at a
(received periodically (price that the
predetermined price
at coupon rate) investor shall pay
on maturity)
today to acquire debt)
Example – Cost benefit
analysis
• A 15% bond was issued for 20 years 15 years ago with face value of Rs
1000. It is currently available in the market for Rs 900. This bond is
redeemable at par.
Example – Cost benefit
analysis
• A 15% bond was issued for 20 years 15 years ago with face value of Rs
1000. It is currently available in the market for Rs 900. This bond is
redeemable at par.
Example – Cost benefit
analysis
• A 15% bond was issued for 20 years 15 years ago with face value of Rs
1000. It is currently available in the market for Rs 900. This bond is
redeemable at par.
Example – Cost benefit
analysis

0
5
900 150 1000
Example – Cost benefit
analysis

0
5
900 150 1000
Calculating cost of debt - YTM
• Given a series of cash flows associated with debt, effective return / ‘cost of debt’ is that rate of
discount at which

PV of costs = PV of benefits
Or
PV of cash outflow = PV of cash inflows

• This is known as YTM (Yield to maturity)

– i.e. yield / return that an investor shall earn as expressed in percentage terms on a per annum basis, if he
invests in the debt instrument today and holds it till maturity

• An approximation formula may be used to calculate YTM

Approx. YTM = I + (RV – MP)/n

(RV + MP)/2

Here, ‘I’ is the annual interest, ‘RV’ is the redemption value, ‘MP’ is the current market price,
and ‘n’ are the number of years remaining from now till maturity
 Example –
Calculation of Cost of Debt

A 15% bond was issued for 20 years 15 years ago with face value of
Rs 1000. It is currently available in the market for Rs 900. This
bond is redeemable at par. Calculate its YTM.

Approx. YTM = I + (RV – MP)/n

(RV + MP)/2

Approx. YTM = 150 + (1000-900)/5

(1000+900)/2
= 17.89%
 Example –
Calculation of Cost of Debt

A 15% bond was issued for 20 years 15 years ago with face value of
Rs 1000. It is currently available in the market for Rs 900. This
bond is redeemable at par. Calculate its YTM.

Approx. YTM = I + (RV – MP)/n

(RV + MP)/2

Approx. YTM = 150 + (1000-900)/5

(1000+900)/2
= 17.89%
Cost of debt
• The YTM of existing debt shall become
the ‘coupon rate’ for the new debt issue
with similar characteristics
• The after tax cost of debt shall be lower
than the before tax cost of debt
– ‘Interest’ being a tax deductible expense
Cost of Preference shares
Cost of Preference shares
• ‘Preference shares’ represent a hybrid security
that combines the features of equity and debt.
• Characteristics:
– Like debt, preference shares are redeemable in nature
and offer a fixed periodic return (in form of dividend)
– Like equity, ‘dividend’ is payable on preference shares
– Preference shareholders get a preference over equity
shareholders w.r.t 2 things:
• In payment of dividend
• In return of the capital amount on liquidation of the company
From the perspective of the investor

Cost - benefit analysis

Benefits Cost

Current market price

Redemption value of preference share
Dividend payments
(received at a (price that the
(received periodically
predetermined price investor shall pay
at fixed rate)
on maturity) today to acquire
preferred stock)
Calculating cost of preference
shares
• Given a series of cash flows associated with preferred stock, ‘cost of preference
shares’ is that rate of discount at which

PV of costs = PV of benefits
Or
PV of cash outflow = PV of cash inflows

• The calculation would be in a manner similar to calculation of YTM for debt security.

• An approximation formula may be used to calculate cost of preferred stock as well

Approx. kp = PD + (RV – MP)/n

(RV + MP)/2

Here, ‘PD’ is the annual preferred dividend, ‘RV’ is the redemption value, ‘MP’ is the
current market price, and ‘n’ are the number of years remaining from now till maturity
Perpetual debt / preference
shares
Cost of perpetual debt/
irredeemable preference shares
• Such securities shall not have any
maturity date
• The company shall continue to pay to the
investor, a fixed periodic return, till the
time the company remains in existence
From the perspective of the investor

Cost - benefit analysis

Benefits Cost

Current market price

Redemption value of preference share
Dividend payments
(received at a (price that the
(received periodically
predetermined price investor shall pay
at fixed rate)
on maturity) today to acquire
preferred stock)
Calculating cost of perpetual debt /
preferred stock
Here PV of CO = PV of CI
will take the form of
Current MP = PV of perpetual returns
= Annual return / k
or
k = Annual return In case of debt - Interest

Current MP In case of preferred stock – Preference

dividend
Example –
Calculating cost of perpetual preferred stock

Calculate the kp for 15% preferred stock of face value

of Rs 100 each, its current MP being Rs 96 and it being
irredeemable in nature.

kp = Annual preferred dividend

Current MP
= 15% (100) = 15.63%
96
Cost of equity
Cost of Equity
• ‘Equity’ represents ownership capital
• Equity shares are issued for a lifetime.
– They don’t have a redemption date
– The investors can buy or sell shares in the
secondary market at the prevailing MP
• Return associated with equity shares
come in two forms
– Dividend income
– Capital appreciation
Models to calculate ‘Cost of equity’

• Dividend discount model

• CAPM model
• Earnings based approach
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Example
• A company has just declared a dividend
@ 15% on equity share with face value of
Rs 100 each. It is expected that the
dividend shall grow @ 12% p.a. in future.
Find the ‘cost of equity’ given that the
current market price of share is Rs 168.
Example
• A company has just declared a dividend
@ 15% on equity share with face value of
Rs 100 each. It is expected that the
dividend shall grow @ 12% p.a. in future.
Find the ‘cost of equity’ given that the
current market price of share is Rs 168.
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Dividend discount model
• Here, ke is that rate of discount at which
PV of CO = PV of CI

Series of
dividend
Price of the payments
share today extending till
infinity
Example
• A company has paid a dividend of Rs 1.75 /
share during the current year. It is expected
to pay a dividend of Rs 2 / share during next
year. Investors forecast a dividend of Rs 3 and
Rs 3.50 per share during two subsequent
years. After that it is expected to grow at 10%
p.a. infinitely. If the current MP of the share is
Rs 28, calculate cost of equity.
Example
• D0 = 1.75
• D1 = 2
• D2 = 3
• D3 = 3.5
• P0 = 28
• g = 10% from 4th year
• D4 = 3.5 (1+0.1)
• n=3

28 = 2 + 3 + 3.5 + 3.5(1.1)
(1+ke)1 (1+ke)2 (1+ke)3 (ke-0.1)(1+ke)3

By ‘Hit & Trial’ method, find the IRR and that shall be the k e.
CAPM Model
• This approach looks at return
expectations of investors on account
of
– Time factor &
– Risk assumed by them.
TOTAL RETURN

RISK FREE RETURN RISK PREMIUM

(minimum return expected on (return expected over and above
account of time factor) risk free return, for assuming risk

Systematic risk Unsystematic risk

CAPM Model
• Systematic risk
– Non diversifiable
– Refers to the impact of system wide
factors (like social, economic, political
etc.) on security return
– All securities are exposed to ‘systematic
risk’, though the magnitude may vary.
– It cannot be diversified by holding a
portfolio of investments
 CAPM Model
Systematic
risk

Interest rate Purchasing

Market risk
risk power risk

Variation in bond prices Variation in

caused by a change investor
in interest rate structure Variation in security returns caused
return caused by by inflation
volatility in stock
market impacting
investor sentiments
CAPM Model
• Unsystematic risk
– It is diversifiable
– Refers to variation in security return due
to company specific factors
– An investor can avoid these risks by
selecting one security over the other or
by holding a portfolio
CAPM Model
Unsystematic
risk

Business Financial
risk risk

Variability in operating Presence of debt in the

income caused by the capital structure creating
operating cost structure of fixed interest obligations
the company i.e. presence and thereby impacting
of FCs EPS
CAPM Model
• Under CAPM model, it is assumed
that unsystematic risk would be
reduced to zero through
diversification.
• The investor would then, over and
above Rf (risk free return), expect a
risk premium for
Return = Rf + β (Rm - Rf assuming
systematic risk
)
Example
• A company has a beta of 1.8 and the
Rf = 8%. If the market return is 14%,
calculate cost of equity.

• Return = Rf + β (Rm - Rf )
= 8% + 1.8 (14 – 8) =
18.8%
Cost of retained earnings
Cost of retained earnings
• Earnings generated by the company are usually
distributed amongst the equity shareholders.
• If the entire earnings are not distributed and a part is
retained by the company, then that shall become
available for reinvestment in future.
• As the ‘retained earnings’ belong to equity
shareholders and that is now being used for re-
investment, we consider

kr = k e

in opportunity cost terms.

Determination of weights
Determination of weights

Weights

Market
Book value
value
weights
weights
Weights ascertained Weights
on the basis of ascertained on the
accounting values of basis of current
different sources of market value of
finance each source
Calculation of WACC
• 3 step procedure:
– Determine the cost of individual sources
of finance (i.e. ke, kp, kd and kr)
– Determine the weights (we, wp, wd and wr)
– Use the formula to calculate WACC
WACC = kewe + kd(1-t)wd + kpwp +
krwr
Example
• A company has the following capital structure:
Equity shares (FV=Rs 10) Rs 10,00,000

10% Preference shares (FV=Rs 100) Rs 2,00,000

12% Debentures (FV=Rs 100) Rs 8,00,000

• The company is expected to pay dividend of Rs 2 on equity
shares at the end of the year, which is expected to grow at
7% p.a. The company pays tax @ 30%.
• All these securities are traded in the capital market. The
recent prices are:
– Debt @ Rs 110
– Preference shares @ Rs 120
– Equity shares @ Rs 25

Calculate WACC using Market value weights.

Example
• ke = (D1 / P0 ) + g = (2/25) + 0.07 = 15%
• kd = 12 (1-0.3) * 100 = 7.64%
110
• kp = 10/120 * 100 = 8.33%

Market values:
Equity = 1,00,000 * 25 = 25,00,000
Debentures = 8000 * 110 = 8,80,000
Preference shares = 2000 * 120 = 2,40,000
TOTAL = 36,20,000

WACC = (15% * 25L/36.2L) + (7.64% * 8.8L/36.2L) + (8.33% *

2.4L/36.2L)
= 12.77%
To summarise
• The firm, which requires funds to invest in different
projects, may raise it through different sources
• Each source used for raising finance has a cost attached to
it
• When we consider the respective costs of different sources
on a weighted average basis, it is referred to a WACC
• Cost of debt and preference shares is calculated in terms of
YTM.
• Cost of equity can be determined using different models –
Dividend Discount model, CAPM model etc.
• The individual costs as well as the proportion of finance
raised through that source, shall have an impact on the
overall cost of capital or WACC.