Computation Of Cost Of Capital (Part - 2), Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download

Cost of Preference Share Capital

Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share.

There are two types of preference shares irredeemable and redeemable. Cost of redeemable preference share capital is calculated with the help of the following formula:

Where,

K_p = Cost of preference share

D_p = Fixed preference dividend

N_p = Net proceeds of an equity share

Cost of irredeemable preference share is calculated with the help of the following formula:

Where,

K_p = Cost of preference share

D_p = Fixed preference share

P = Par value of debt

N_p= Net proceeds ofthe preference share

n = Number of maturity period.

Example 7

XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per share. Calculate cost of preference share capital if these shares are issued (a) at par, (b) at a premium of 10% and (c) of a debentures of 6%.

Solution

Cost of preference share capital 

(a) 

(b)

Example 8

ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Redeemable after 8 years at a premium of 10%. The cost of issue is Rs. 2 per share. Calculate the cost of preference share capital.

= 9.13%

where

D_p = 20,000 x 100 x 8%=1,60,000

P = 20,00,000+2,00,000 =22,00,00

N_p = 20,00,000 – 40,000 =19,60,000

n = 8 years

Example 9

ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each at a premium of 5% redeemable after 8 years at par. The cost of issue is Rs. 2 per share. Calculate the cost of preference share capital.

Solution

= 7.51%

where,

D_p = 20,000 x 100 x 8%=1,60,000

P =20,00,000

n = 8 years

N_p = 20,00,000 + 10,00,000 – 40,000 =20,60,000

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment proposal; it is different from other sources like debt, equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital. Cost of retained earnings can be calculated with the help of the following formula:

Where,

K_r =Cost of retained earnings

K_e =Cost of equity

t = Tax rate

b = Brokerage cost

Example 10

A firm’s Ke (return available to shareholders) is 10%, the average tax rate of shareholders is 30% and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings?

Solution

Cost of Retained Earnings, K_r = K_e (1 – t) (1 – b)

Where,

K_e=rateof returnavailabletoshareholders

t = tax rate

b = brokerage cost

So, K_r=10% (1–0.5) (1–0.02)

= 10% x 0.5 x 0.98

= 4.9%

Measurement of Overall Cost of Capital It is also called as weighted average cost of capital and composite cost of capital. Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firms capital structure. The computation of the overall cost of capital (K_o) involves the following steps.

(a) Assigning weights to specific costs.

(b) Multiplying the cost of each of the sources by the appropriate weights.

(c) Dividing the total weighted cost by the total weights.

The overall cost of capital can be calculated with the help of the following formula;

K_o = K_d W_d + K_p W_p + K_e W_e + K_r W_r

Where,

K_o=Overall cost of capital

K_d = Cost ofdebt

K_p =Cost of preference share

K_e = Cost ofequity

K_r = Cost of retained earnings

W_d= Percentage of debt of total capital

W_p=Percentageofpreferencesharetototal capital

W_e=Percentageofequitytototalcapital

W_r = Percentage of retained earnings

Weighted average cost of capital is calculated in the following formula also:

Where,

K_w = Weighted average cost of capital

X = Cost of specific sources of finance

W = Weight, proportion of specific sources of finance.

Example 11

A firm has the following capital structure and after-tax costs for the different sources of funds used :

You are required to compute the weighted average cost of capital.

Example 12

A company has on its books the following amounts and specific costs of each type of capital.

Determine the weighted average cost of capital using:

(a) Book value weights, and

(b) Market value weights.

How are they different? Can you think of a situation where the weighted average cost of capital would be the same using either of the weights?

Solution

Computation of Weighted Average Cost of Capital

A. BookValue

Computation Weighted Average Cost of Capital

B. Market Value

Example 13

ABC Ltd. has the following capital structure

You are required to calculate the weighted average cost of capital, assuming 50% as the rate of income-tax, before and after tax.

Solution

Solution showing weighted average cost of capital:

Weight average cost of capital = 7.66%