Unit Ii Wcu

UNIT II
VALUATION & COST OF CAPITAL
 Definition of Cost of capital:
According to Solomon Ezra “Cost of capital

is the minimum required rate of earnings or the
cut-off rate of capital expenditure”.
Other names for the cost of capital:
Cost of capital may also be the cost of

obtaining funds. It is also known as cut-off
rate, target or hurdle rate.
Significance or importance of cost of capital:
 A. As an Acceptance criterion in capital

budgeting:
According to present value method of
capital budgeting, if the present value of
expected returns from investment is greater
than or equal to the cost of investment, the
project may be accepted otherwise it is
rejected.
B. As a Determinant of capital Mix:
While designing on optimal capital

structure, the management has to keep in
mind the objective of maximizing the value of
the firm and minimizing the cost of capital.
Measurement of cost of capital from various
sources is very essential in planning the
capital structure.
c. Evaluating the financial performance:
 The actual profitability of the project is

compared to the projected one, if the actual
profitability is more than the projected one,
the performance may be said to be
satisfactory.
d. Taking other financial decision:
 It is also used for other financial

decision such as dividend policy,
capitalization of profits and for working
capital.
Classification of cost of capital:
 1. Historical Cost and Future cost:

Historical Cost is the cost incurred in
the past in procuring funds for the firm.
Future cost is cost estimated for the future. It
is the cost to be incurred in raising new
funds. In financial decisions, future cost is
more relevant than historical cost. Historical
cost is usefulness as a guide for the
estimation of future cost.
 2. Specific Cost and Composite Cost:

Specific cost is the cost of a particular
source of capital. e.g., cost of debentures.
Composite cost is the combined cost of
different sources of capital. It is the weighted
Average cost of capital or Overall cost of
capital.
3. Average Cost and Marginal Cost:

Average Cost of capital is the combined cost
of various sources of long-term finance such as
equity shares, preference shares and debentures. It
is the weighted average of the costs of different
sources.
Marginal cost of capital is the average cost of

new, additional or incremental funds raised by the
firm. Marginal Cost is more relevant in making
investment decisions.
 4. Explicit cost and implicit cost:

Explicit cost refers to the discount rate at
which total present value of cash inflows is
equal to the total present value of cash
outflows. It is also called the Internal Rate of
Return.
Implicit cost is the opportunity cost. It is

defined as the rate of return that will be
foregone if the particular project were
accepted
Computation of Cost of Capital:
 a. Computation of specific source of finance
 b. Computation of Average cost of Capital

a. Computation of specific source of finance
1. Cost of Debt:
 Cost of Debt is the rate of interest
payable on debt. By way of formula, before –
tax-cost is calculated by
Before Tax,
Kdb = 1/NP
Where NP = Net proceeds,
Kda = Kdb (1-t), T = Tax rate.
 Two types of debt or debentures
1. redeemable
2. irredeemable
Cost of Redeemable Debt
 Issued at par, Redeemable at par
prob.1 Philipo firm issues debentures

of Br.100000 and realises Br.98000 after
allowing 2% commission to brokers. The
debentures carry an interest rate of 10% . The
debentures are due for maturity at the end of
the 10th year.
Calculate the effective cost of debt

Prob.2 issued at a premium,
redeemalbe at par
 Banian Ltd. issued 10000 9% debentures of
Br.100 each at 5% premium. The maturity
period is 5 years and the tax rate is 50%.
 compute the cost of debentures to the

company if the debentures are redeemable at
par.
Prob.3 Issued at Discount,
redeemable at par
 Mulukete Ltd Issues Br.5000,000 12%
redeemable debentures at a discount of 10%.
 The floatation costs are 4 % and the
debentures are redeemable after five years.

 Calculate before tax and after tax cost of
debt assuming a tax rate of 40%.

Issued at discount, redeemable at
premium
Prob.4 Dereje company issues Br.1,000,000,

13% debentures at a discount of 5%. The
debentures are redeemable after 5 years at
premium of 5%. Calculate before tax and after
tax cost of debt, if the tax rate is 50%.
Prac.prob
Adis Co. issues 10000 bonds of Br.100
each at 14% p.a. Marketing costs are
Br.20,000. The bonds are to be redeemed
after 10 yrs. And the company is taxed at the
rate of 40%.
Compute the cost of debt if the bonds

are issued:
A. At par
B. At a discount of 5%
C. at a premium of 5%
II cost of irredeemable Debt
◦ Issued at par
◦ Jabuna Ltd. issues 5000 12% debentures of Br.100
each at par. The tax rate is 40% . Calculate before
tax and after tax cost of debt.
Issued at premium
Victory ltd. issued Br.200,000 9% debentrures
at a premium of 10%. The floatation costs
were 2%. The tax rate is 40%.compute the
cost of debt before tax and after tax.
Issued at discount
Jaya ltd. issued Br.60,000 10% debentures at
a discount of 5%.the issue expenses were
Br.2000. Assuming that a tax rate of
40%.calculate the before tax and after tax
cost of debt.
Workout yourself
Sahay company issued 10000 10% debentures
of Birr.100 each. The tax rate is 50%.
Calculate the before tax and after tax cost of
debt if the debentures are issued
A. At par
B. At a discount of 10%
C. at a premium of 10%
1. Dividend yield or D.Price Method:
Cost of Equity share capital
Hoseana Co. issues one million equity shares
of Br.100 each at premium of 10% . The
company has been consistently paying a
dividend of 18% for the past five yrs. It is
expected to maintain the dividend In the
future also.
A. compute the cost of equity capital.
B. What will be the cost of equity capital if the
market price of the share is Br.200.
Formula :
D1
Cost of equity cap. Ke = ----
2. Dividend yield+Growth
 The market price of an equity share of Gennet
Ltd. is Br. 80. The dividend expected a year is
Br.1.60 per share. The shareholders
anticipate a growth of 7% in dividends.
 Calculate the cost of equity capital

Weighted Average Cost of
Capital(WACC)
 It is also called composite cost of capital,

Overall cost of capital and average cost of
capital.
Once the specific cost of finance is
determined, we can compute the weighted
average cost of capital by putting weight to
the specific cost of capital in proportion of
the various sources of funds to total.
wACC
 Prob. The capital structure and after tax cost
of different sources of funds are given below:
Sources of capital Amount BR. Proportion to After Tax
total Cost %
Equity 720,000 .30 15
Retained Earnings 600,000 .25 14
Preference share 480,000 .20 10

capital
Debentures 600,000 .25 8
You are required to compute the WACC.
From the following particulars, calculate the
overall cost of capital using book value weights.
Sources of capital Amount BR. After Tax Cost %
Equity 400,000 14
Retained Earnings 200,000 13
Preference share capital 100,000 10
Debentures 300,000 6
Valuation of bonds and shares
Book Value
 The value at which an asset is carried on a
balance sheet
 Take the cost of an asset minus the
accumulated depreciation
Market Value
 The current quoted price at which investors
buy or sell a share of common stock or a

bond at a given time known as "market price".
Coupon rate or Interest Rate
 A bond Carries a specific interest rate
 It is the return of the bond
Par value
 It is the original value of the share or bond.
 It is stated on the face of the bond.
Yield to maturity
 Compounded rate of return, the investor will
receive from a bond purchased at the current

market and held to maturity
Running yield or current yield

 Periodic coupon payments to the clean price
of the debt instrument is called the running

yield or current yield
Simple yield to maturity
 It considers not only the coupon payment but
also to the capital gains that are realized

from holding the debt instrument over a
period of time
 In short , it is Running yield and plus capital

gain

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UNIT II

VALUATION & COST OF CAPITAL

 Definition of Cost of capital:

According to Solomon Ezra “Cost of capital

Cost of capital may also be the cost of

 A. As an Acceptance criterion in capital

While designing on optimal capital

 The actual profitability of the project is

 It is also used for other financial

 1. Historical Cost and Future cost:

 2. Specific Cost and Composite Cost:

3. Average Cost and Marginal Cost:

Marginal cost of capital is the average cost of

 4. Explicit cost and implicit cost:

Implicit cost is the opportunity cost. It is

 a. Computation of specific source of finance

 b. Computation of Average cost of Capital

prob.1 Philipo firm issues debentures

Calculate the effective cost of debt

 compute the cost of debentures to the

debentures are redeemable after five years.

debt assuming a tax rate of 40%.

Prob.4 Dereje company issues Br.1,000,000,

Compute the cost of debt if the bonds

 Calculate the cost of equity capital

 It is also called composite cost of capital,

Retained Earnings 600,000 .25 14

Preference share 480,000 .20 10

Sources of capital Amount BR. After Tax Cost %

Retained Earnings 200,000 13

Preference share capital 100,000 10

buy or sell a share of common stock or a

receive from a bond purchased at the current

Running yield or current yield

of the debt instrument is called the running

also to the capital gains that are realized

 In short , it is Running yield and plus capital

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