Cost of Capital | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
LEARNING OUTCOMES 
 
 
  
 COST OF CAPITAL 
 
 
? Discuss the need and sources of finance to a business entity. 
? Discuss the meaning of cost of capital for raising fund from 
different sources of finance. 
? Measure cost of individual components of capital 
? Calculate weighted cost of capital and marginal cost of 
capital, Effective Interest rate. 
Cost of 
Capital
Cost of 
Debt
Cost of 
Preference 
Share
Cost of 
Equity
Cost of 
Retained 
Earning
Combination of Cost and Weight of 
each sources of Capital
Weighted Average Cost of 
Capital (WACC)
 
CHAPTER 
4 
Page 2


 
LEARNING OUTCOMES 
 
 
  
 COST OF CAPITAL 
 
 
? Discuss the need and sources of finance to a business entity. 
? Discuss the meaning of cost of capital for raising fund from 
different sources of finance. 
? Measure cost of individual components of capital 
? Calculate weighted cost of capital and marginal cost of 
capital, Effective Interest rate. 
Cost of 
Capital
Cost of 
Debt
Cost of 
Preference 
Share
Cost of 
Equity
Cost of 
Retained 
Earning
Combination of Cost and Weight of 
each sources of Capital
Weighted Average Cost of 
Capital (WACC)
 
CHAPTER 
4 
 
 
4.2 FINANCIAL MANAGEMENT  
 4.1 INTRODUCTION 
We know that the basic task of a finance manager is procurement of funds and its 
effective utilization. Whereas objective of financial management is maximization 
of wealth. Here wealth or value is equal to performance divided by expectations.  
Therefore, the finance manager is required to select such a capital structure in 
which expectation of investors is minimum hence shareholders’ wealth is 
maximum. For that purpose, first he needs to calculate cost of various sources of 
finance. In this chapter we will learn to calculate cost of debt, cost of preference 
shares, cost of equity shares, cost of retained earnings and also overall cost of 
capital. 
 4.2 MEANING OF COST OF CAPITAL 
Cost of capital is the return expected by the providers of capital (i.e. 
shareholders, lenders and the debt-holders) to the business as a compensation 
for their contribution to the total capital. When an entity (corporate or others) 
procured finances from either source as listed above, it has to pay some 
additional amount of money besides the principal amount. The additional money 
paid to these financiers may be either one off payment or regular payment at 
specified intervals. This additional money paid is said to be the cost of using the 
capital and it is called the cost of capital. This cost of capital expressed in rate is 
used to discount/ compound the cashflow or stream of cashflows. Cost of capital 
is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc. It is used 
as a benchmark for: 
? Framing debt policy of a firm. 
? Taking Capital budgeting decisions. 
 4.3 SIGNIFICANCE OF THE COST OF CAPITAL 
The cost of capital is important to arrive at correct amount and helps the 
management or an investor to take an appropriate decision. The correct cost of 
capital helps in the following decision making: 
(i) Evaluation of investment options: The estimated benefits (future 
cashflows) from available investment opportunities (business or project) are 
converted into the present value of benefits by discounting them with the 
relevant cost of capital. Here it is pertinent to mention that every investment 
Page 3


 
LEARNING OUTCOMES 
 
 
  
 COST OF CAPITAL 
 
 
? Discuss the need and sources of finance to a business entity. 
? Discuss the meaning of cost of capital for raising fund from 
different sources of finance. 
? Measure cost of individual components of capital 
? Calculate weighted cost of capital and marginal cost of 
capital, Effective Interest rate. 
Cost of 
Capital
Cost of 
Debt
Cost of 
Preference 
Share
Cost of 
Equity
Cost of 
Retained 
Earning
Combination of Cost and Weight of 
each sources of Capital
Weighted Average Cost of 
Capital (WACC)
 
CHAPTER 
4 
 
 
4.2 FINANCIAL MANAGEMENT  
 4.1 INTRODUCTION 
We know that the basic task of a finance manager is procurement of funds and its 
effective utilization. Whereas objective of financial management is maximization 
of wealth. Here wealth or value is equal to performance divided by expectations.  
Therefore, the finance manager is required to select such a capital structure in 
which expectation of investors is minimum hence shareholders’ wealth is 
maximum. For that purpose, first he needs to calculate cost of various sources of 
finance. In this chapter we will learn to calculate cost of debt, cost of preference 
shares, cost of equity shares, cost of retained earnings and also overall cost of 
capital. 
 4.2 MEANING OF COST OF CAPITAL 
Cost of capital is the return expected by the providers of capital (i.e. 
shareholders, lenders and the debt-holders) to the business as a compensation 
for their contribution to the total capital. When an entity (corporate or others) 
procured finances from either source as listed above, it has to pay some 
additional amount of money besides the principal amount. The additional money 
paid to these financiers may be either one off payment or regular payment at 
specified intervals. This additional money paid is said to be the cost of using the 
capital and it is called the cost of capital. This cost of capital expressed in rate is 
used to discount/ compound the cashflow or stream of cashflows. Cost of capital 
is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc. It is used 
as a benchmark for: 
? Framing debt policy of a firm. 
? Taking Capital budgeting decisions. 
 4.3 SIGNIFICANCE OF THE COST OF CAPITAL 
The cost of capital is important to arrive at correct amount and helps the 
management or an investor to take an appropriate decision. The correct cost of 
capital helps in the following decision making: 
(i) Evaluation of investment options: The estimated benefits (future 
cashflows) from available investment opportunities (business or project) are 
converted into the present value of benefits by discounting them with the 
relevant cost of capital. Here it is pertinent to mention that every investment 
4.3 
COST OF CAPITAL 
option may have different cost of capital hence it is very important to use the cost 
of capital which is relevant to the options available.  
(ii) Financing Decision: When a finance manager has to choose one of the two 
sources of finance, he can simply compare their cost and choose the source which 
has lower cost. Besides cost he also considers financial risk and control. 
(iii) Designing of optimum credit policy: While appraising the credit period to 
be allowed to the customers, the cost of allowing credit period is compared 
against the benefit/ profit earned by providing credit to customer of segment of 
customers. Here cost of capital is used to arrive at the present value of cost and 
benefits received.  
 4.4 DETERMINATION OF THE COST OF CAPITAL 
Cost is not the amount which the company plans to pay or actually pays, 
rather than it is the expectation of stakeholders. Here Stakeholders include 
providers of capital (shareholders, debenture holder, money lenders etc.), 
intermediaries (brokers, underwriters, merchant bankers etc.), and Government 
(for taxes).   
For example, if the company issues 9% coupon debentures but expectation of 
investors is 10% then investors will subscribe it at discount and not at par. Hence 
cost to the company will not be 9%, rather than it will be 10%. Besides giving 
return to investors company will also have to give commission, brokerage, fees 
etc. To intermediaries for issue of debentures. It will increase cost of capital above 
10%. On the other hand, payment of interest is a deductible expense under the 
Income tax act hence it will reduce cost of capital to the company. Cost of any 
sources of finance is expressed in terms of percentage per annum. To calculate 
cost first of all we should identify various cash flows like: 
1. inflow of amount received at the beginning 
2. outflows of payment of interest, dividend, redemption amount etc. 
3. Inflow of tax benefit on interest or outflow of payment of dividend tax. 
Thereafter we can use trial & error method to arrive at a rate where present value 
of outflows is equal to present value of inflows. That rate is basically IRR. In 
investment decisions IRR indicates income, because there we have initial outflow 
followed by series of inflows. In cost of capital chapter this IRR represents cost, 
because here we have initial inflow followed by series of net outflows.  
Page 4


 
LEARNING OUTCOMES 
 
 
  
 COST OF CAPITAL 
 
 
? Discuss the need and sources of finance to a business entity. 
? Discuss the meaning of cost of capital for raising fund from 
different sources of finance. 
? Measure cost of individual components of capital 
? Calculate weighted cost of capital and marginal cost of 
capital, Effective Interest rate. 
Cost of 
Capital
Cost of 
Debt
Cost of 
Preference 
Share
Cost of 
Equity
Cost of 
Retained 
Earning
Combination of Cost and Weight of 
each sources of Capital
Weighted Average Cost of 
Capital (WACC)
 
CHAPTER 
4 
 
 
4.2 FINANCIAL MANAGEMENT  
 4.1 INTRODUCTION 
We know that the basic task of a finance manager is procurement of funds and its 
effective utilization. Whereas objective of financial management is maximization 
of wealth. Here wealth or value is equal to performance divided by expectations.  
Therefore, the finance manager is required to select such a capital structure in 
which expectation of investors is minimum hence shareholders’ wealth is 
maximum. For that purpose, first he needs to calculate cost of various sources of 
finance. In this chapter we will learn to calculate cost of debt, cost of preference 
shares, cost of equity shares, cost of retained earnings and also overall cost of 
capital. 
 4.2 MEANING OF COST OF CAPITAL 
Cost of capital is the return expected by the providers of capital (i.e. 
shareholders, lenders and the debt-holders) to the business as a compensation 
for their contribution to the total capital. When an entity (corporate or others) 
procured finances from either source as listed above, it has to pay some 
additional amount of money besides the principal amount. The additional money 
paid to these financiers may be either one off payment or regular payment at 
specified intervals. This additional money paid is said to be the cost of using the 
capital and it is called the cost of capital. This cost of capital expressed in rate is 
used to discount/ compound the cashflow or stream of cashflows. Cost of capital 
is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc. It is used 
as a benchmark for: 
? Framing debt policy of a firm. 
? Taking Capital budgeting decisions. 
 4.3 SIGNIFICANCE OF THE COST OF CAPITAL 
The cost of capital is important to arrive at correct amount and helps the 
management or an investor to take an appropriate decision. The correct cost of 
capital helps in the following decision making: 
(i) Evaluation of investment options: The estimated benefits (future 
cashflows) from available investment opportunities (business or project) are 
converted into the present value of benefits by discounting them with the 
relevant cost of capital. Here it is pertinent to mention that every investment 
4.3 
COST OF CAPITAL 
option may have different cost of capital hence it is very important to use the cost 
of capital which is relevant to the options available.  
(ii) Financing Decision: When a finance manager has to choose one of the two 
sources of finance, he can simply compare their cost and choose the source which 
has lower cost. Besides cost he also considers financial risk and control. 
(iii) Designing of optimum credit policy: While appraising the credit period to 
be allowed to the customers, the cost of allowing credit period is compared 
against the benefit/ profit earned by providing credit to customer of segment of 
customers. Here cost of capital is used to arrive at the present value of cost and 
benefits received.  
 4.4 DETERMINATION OF THE COST OF CAPITAL 
Cost is not the amount which the company plans to pay or actually pays, 
rather than it is the expectation of stakeholders. Here Stakeholders include 
providers of capital (shareholders, debenture holder, money lenders etc.), 
intermediaries (brokers, underwriters, merchant bankers etc.), and Government 
(for taxes).   
For example, if the company issues 9% coupon debentures but expectation of 
investors is 10% then investors will subscribe it at discount and not at par. Hence 
cost to the company will not be 9%, rather than it will be 10%. Besides giving 
return to investors company will also have to give commission, brokerage, fees 
etc. To intermediaries for issue of debentures. It will increase cost of capital above 
10%. On the other hand, payment of interest is a deductible expense under the 
Income tax act hence it will reduce cost of capital to the company. Cost of any 
sources of finance is expressed in terms of percentage per annum. To calculate 
cost first of all we should identify various cash flows like: 
1. inflow of amount received at the beginning 
2. outflows of payment of interest, dividend, redemption amount etc. 
3. Inflow of tax benefit on interest or outflow of payment of dividend tax. 
Thereafter we can use trial & error method to arrive at a rate where present value 
of outflows is equal to present value of inflows. That rate is basically IRR. In 
investment decisions IRR indicates income, because there we have initial outflow 
followed by series of inflows. In cost of capital chapter this IRR represents cost, 
because here we have initial inflow followed by series of net outflows.  
 
 
4.4 FINANCIAL MANAGEMENT  
Alternatively, we can use shortcut formulas. Though these shortcut formulas are 
easy to use but they give approximate answer and not the exact answer. We will 
discuss the cost of capital of each source of finance separately.  
 
4.5 COST OF LONG-TERM DEBT 
External borrowings or debt instruments do no confers ownership to the 
providers of finance. The providers of the debt fund do not participate in the 
affairs of the company but enjoys the charge on the profit before taxes. Long 
term debt includes long term loans from the financial institutions, capital from 
issuing debentures or bonds etc. (In the next chapter we will discuss in detail 
about the sources of long-term debt.).  
As discussed above the external borrowing or debt includes long term loan from 
financial institutions, issuance of debt instruments like debentures or bonds etc. 
The calculation of cost of loan from a financial institution is similar to that of 
redeemable debentures. Here we confine our discussion of cost debt to 
Debentures or Bonds only.  
4.5.1 Features of debentures or bonds:  
(i)  Face Value: Debentures or Bonds are denominated with some value; this 
denominated value is called face value of the debenture. Interest is 
calculated on the face value of the debentures. E.g. If a company issue 9% 
Weighted Average 
Cost of Capital 
(WACC)
Cost of Equity
Cost of Pref. Share 
Capital
Cost of Long 
term Debt.
Cost of Retained 
Earnings
Page 5


 
LEARNING OUTCOMES 
 
 
  
 COST OF CAPITAL 
 
 
? Discuss the need and sources of finance to a business entity. 
? Discuss the meaning of cost of capital for raising fund from 
different sources of finance. 
? Measure cost of individual components of capital 
? Calculate weighted cost of capital and marginal cost of 
capital, Effective Interest rate. 
Cost of 
Capital
Cost of 
Debt
Cost of 
Preference 
Share
Cost of 
Equity
Cost of 
Retained 
Earning
Combination of Cost and Weight of 
each sources of Capital
Weighted Average Cost of 
Capital (WACC)
 
CHAPTER 
4 
 
 
4.2 FINANCIAL MANAGEMENT  
 4.1 INTRODUCTION 
We know that the basic task of a finance manager is procurement of funds and its 
effective utilization. Whereas objective of financial management is maximization 
of wealth. Here wealth or value is equal to performance divided by expectations.  
Therefore, the finance manager is required to select such a capital structure in 
which expectation of investors is minimum hence shareholders’ wealth is 
maximum. For that purpose, first he needs to calculate cost of various sources of 
finance. In this chapter we will learn to calculate cost of debt, cost of preference 
shares, cost of equity shares, cost of retained earnings and also overall cost of 
capital. 
 4.2 MEANING OF COST OF CAPITAL 
Cost of capital is the return expected by the providers of capital (i.e. 
shareholders, lenders and the debt-holders) to the business as a compensation 
for their contribution to the total capital. When an entity (corporate or others) 
procured finances from either source as listed above, it has to pay some 
additional amount of money besides the principal amount. The additional money 
paid to these financiers may be either one off payment or regular payment at 
specified intervals. This additional money paid is said to be the cost of using the 
capital and it is called the cost of capital. This cost of capital expressed in rate is 
used to discount/ compound the cashflow or stream of cashflows. Cost of capital 
is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc. It is used 
as a benchmark for: 
? Framing debt policy of a firm. 
? Taking Capital budgeting decisions. 
 4.3 SIGNIFICANCE OF THE COST OF CAPITAL 
The cost of capital is important to arrive at correct amount and helps the 
management or an investor to take an appropriate decision. The correct cost of 
capital helps in the following decision making: 
(i) Evaluation of investment options: The estimated benefits (future 
cashflows) from available investment opportunities (business or project) are 
converted into the present value of benefits by discounting them with the 
relevant cost of capital. Here it is pertinent to mention that every investment 
4.3 
COST OF CAPITAL 
option may have different cost of capital hence it is very important to use the cost 
of capital which is relevant to the options available.  
(ii) Financing Decision: When a finance manager has to choose one of the two 
sources of finance, he can simply compare their cost and choose the source which 
has lower cost. Besides cost he also considers financial risk and control. 
(iii) Designing of optimum credit policy: While appraising the credit period to 
be allowed to the customers, the cost of allowing credit period is compared 
against the benefit/ profit earned by providing credit to customer of segment of 
customers. Here cost of capital is used to arrive at the present value of cost and 
benefits received.  
 4.4 DETERMINATION OF THE COST OF CAPITAL 
Cost is not the amount which the company plans to pay or actually pays, 
rather than it is the expectation of stakeholders. Here Stakeholders include 
providers of capital (shareholders, debenture holder, money lenders etc.), 
intermediaries (brokers, underwriters, merchant bankers etc.), and Government 
(for taxes).   
For example, if the company issues 9% coupon debentures but expectation of 
investors is 10% then investors will subscribe it at discount and not at par. Hence 
cost to the company will not be 9%, rather than it will be 10%. Besides giving 
return to investors company will also have to give commission, brokerage, fees 
etc. To intermediaries for issue of debentures. It will increase cost of capital above 
10%. On the other hand, payment of interest is a deductible expense under the 
Income tax act hence it will reduce cost of capital to the company. Cost of any 
sources of finance is expressed in terms of percentage per annum. To calculate 
cost first of all we should identify various cash flows like: 
1. inflow of amount received at the beginning 
2. outflows of payment of interest, dividend, redemption amount etc. 
3. Inflow of tax benefit on interest or outflow of payment of dividend tax. 
Thereafter we can use trial & error method to arrive at a rate where present value 
of outflows is equal to present value of inflows. That rate is basically IRR. In 
investment decisions IRR indicates income, because there we have initial outflow 
followed by series of inflows. In cost of capital chapter this IRR represents cost, 
because here we have initial inflow followed by series of net outflows.  
 
 
4.4 FINANCIAL MANAGEMENT  
Alternatively, we can use shortcut formulas. Though these shortcut formulas are 
easy to use but they give approximate answer and not the exact answer. We will 
discuss the cost of capital of each source of finance separately.  
 
4.5 COST OF LONG-TERM DEBT 
External borrowings or debt instruments do no confers ownership to the 
providers of finance. The providers of the debt fund do not participate in the 
affairs of the company but enjoys the charge on the profit before taxes. Long 
term debt includes long term loans from the financial institutions, capital from 
issuing debentures or bonds etc. (In the next chapter we will discuss in detail 
about the sources of long-term debt.).  
As discussed above the external borrowing or debt includes long term loan from 
financial institutions, issuance of debt instruments like debentures or bonds etc. 
The calculation of cost of loan from a financial institution is similar to that of 
redeemable debentures. Here we confine our discussion of cost debt to 
Debentures or Bonds only.  
4.5.1 Features of debentures or bonds:  
(i)  Face Value: Debentures or Bonds are denominated with some value; this 
denominated value is called face value of the debenture. Interest is 
calculated on the face value of the debentures. E.g. If a company issue 9% 
Weighted Average 
Cost of Capital 
(WACC)
Cost of Equity
Cost of Pref. Share 
Capital
Cost of Long 
term Debt.
Cost of Retained 
Earnings
 
 
4.5 
 
COST OF CAPITAL 
Non- convertible debentures of `100 each, this means the face value is  
` 100 and the interest @ 9% will be calculated on this face value. 
(ii)  Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) 
rate (except Zero coupon bond and Deep discount bond). Interest (coupon) 
rate is applied to face value of debenture to calculate interest, which is 
payable to the holders of debentures periodically.   
(iii)  Maturity period: Debentures or Bonds has a fixed maturity period for 
redemption. However, in case of irredeemable debentures maturity period is 
not defined and it is taken as infinite.  
(iv)  Redemption Value: Redeemable debentures or bonds are redeemed on its 
specified maturity date. Based on the debt covenants the redemption value 
is determined. Redemption value may vary from the face value of the 
debenture.  
(v)  Benefit of tax shield: The payment of interest to the debenture holders are 
allowed as expenses for the purpose of corporate tax determination. Hence, 
interest paid to the debenture holders save the tax liability of the company. 
Saving in the tax liability is also known as tax shield. The example given 
below will show you how interest paid by a company reduces the tax 
liability: 
Example - 1: There are two companies namely X Ltd. and Y Ltd. The capital of the 
X Ltd is fully financed by the shareholders whereas Y Ltd uses debt fund as well. 
The below is the profitability statement of both the companies:  
 
X Ltd. 
(` in lakh) 
Y Ltd. 
(` in lakh) 
Earnings before interest and taxes (EBIT)  100 100 
Interest paid to debenture holders  - (40) 
Profit before tax (PBT)  100 60 
Tax @ 35% (35) (21) 
Profit after tax (PAT)  65 39 
A comparison of the two companies shows that an interest payment of 40 by the 
Y Ltd. results in a tax shield (tax saving) of `14 lakh (` 40 lakh paid as interest × 
35% tax rate). Therefore, the effective interest is ` 26 lakh only.