Computation of Cost of Capital (Part - 1) - Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download

Computation of Cost of Capital

Computation of cost of capital consists of two important parts:

1. Measurement of specific costs
2. Measurement of overall cost of capital

Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:

• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings

Cost of Equity 

Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value

Conceptually the cost of equity capital (K_e) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares”.

Cost of equity can be calculated from the following approach:

• Dividend price (D/P) approach
• Dividendpriceplusgrowth(D/P+g)approach
• Earning price (E/P) approach
• Realized yield approach.

Dividend Price Approach 

The cost of equity capital will be that rate of expected dividend which will maintain the present market price of equity shares.

Dividend price approach can be measured with the help of the following formula:

Where,

K_e = Cost of equity capital

D = Dividend per equity share

N_p = Net proceeds of an equity share

Example 1:

A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The company has been paying 25% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs. 175?

Solution

If the market price of a equity share is Rs. 175.

Dividend Price Plus Growth Approach

The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend. It can be measured with the help of the following formula:

Where,

K_e = Cost of equity capital

D =Dividend per equity share

g =Growthinexpecteddividend

N_p =Net proceeds of an equity share

Example 2

(a) A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share initially and growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares.

(b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity share capital

Solution

(a) 

(b) 

Example 3

The current market price of the shares of A Ltd. is Rs. 95. The floatation costs are Rs. 5 per share amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are required to calculate the cost of equity share capital.

Solution

Market price Rs. 95

Dividend Rs. 4.50

Growth 7%.

Earning Price Approach

Cost of equity determines the market price of the shares. It is based on the future earning prospects of the equity. The formula for calculating the cost of equity according to this approach is as follows.

Where,

K_e = Cost of equity capital

E = Earning per share

N_p = Net proceeds of an equity share

Example 4

A firm is considering an expenditure of Rs. 75 lakhs for expanding its operations. The relevant information is as follows :

Number of existing equity shares =10 lakhs

Market value of existing share =Rs.100

Net earnings =Rs.100 lakhs

Compute the cost of existing equity share capital and of new equity capital assuming that new shares will be issued at a price of Rs. 92 per share and the costs of new issue will be Rs. 2 per share.

Solution

Cost of existing equity share capital:

Earnings Per Share(EPS) = 100 lakhs/10 lakhs = Rs.10

Cost of Equity Capital

Realized Yield Approach

It is the easy method for calculating cost of equity capital. Under this method, cost of equity is calculated on the basis of return actually realized by the investor in a company on their equity capital.

Where,

K_e = Cost of equity capital.

PVƒ= Present value of discount factor.

D =Dividendper share.

Cost of Debt

Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual or redeemable.

Debt Issued at Par

Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with the help of the following formula

Where,

K_d =Cost of debt capital

t = Tax rate

R = Debenture interest rate

Debt Issued at Premium or Discount

If the debt is issued at premium or discount, the cost of debt is calculated with the help of the following formula.

Where,

K_d = Cost of debt capital

I = Annual interest payable

N_p=Netproceedsofdebenture

t = Tax rate

Example 5

(a) A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital.

(b) B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute the cost of debt capital.

(c) A Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute the cost of debt capital.

(d) B Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%. The tax rate applicable is 50%. Compute the cost of debt-capital.

In all cases, we have computed the after-tax cost of debt as the firm saves on account of tax by using debt as a source of finance.

Solution

(a)  

(b) N_p = Face Value + Premium = 1,00,000+10,000=1,10,000

(c) 

(d)  

Cost of Perpetual Debt and Redeemable Debt

It is the rate of return which the lenders expect. The debt carries a certain rate of interest

Where,

I = Annual interest payable

P = Par value of debt

N_p=Net proceeds ofthe debenture

n =Number of years to maturity

K_db = Cost of debt before tax.

Cost of debt after tax can be calculated with the help of the following formula:

Where,

K_da = Cost of debt after tax

K_db = Cost of debt before tax

t = Tax rate

Example 6

A company issues Rs. 20,00,000, 10% redeemable debentures at a discount of 5%. The costs of floatation amount to Rs. 50,000. The debentures are redeemable after 8 years. Calculate before tax and after tax. Cost of debt assuring a tax rate of 55%.

Solution

Note N_p = 20,00,000 – 10,00,000 – 50,000

After Tax Cost of Debt K_db

= K_da (1 – t)

=11.36 (1– 0.55)

=5.11%.