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Financial Management Unit 5
Sikkim Manipal University Page No. 87
Unit 5 Cost of Capital
Structure:
5.1 Introduction
Learning objectives
5.2 Design of an Ideal Capital Structure
5.3 Cost of Different Sources of Finance
Cost of debentures
Cost of term loans
Cost of preference capital
Cost of equity capital
Cost of retained earnings
Capital asset pricing model approach
Earnings price ratio approach
5.4 Weighted Average Cost of Capital
Assignment of weights
5.5 Summary
5.6 Solved Problems
5.7 Terminal Questions
5.8 Answers to SAQs and TQs
5.1 Introduction
Capital structure is the mix of long-term sources of funds like debentures,
loans, preference shares, equity shares and retained earnings in different
ratios.
It is always advisable for companies to plan their capital structure. Decisions
taken by not assessing things in a correct manner may jeopardise the very
existence of the company. Firms may prosper in the short-run by not
indulging in proper planning but ultimately may face problems in future. With
unplanned capital structure, they may also fail to economise the use of their
funds and adapt to the changing conditions.
Financial Management Unit 5
Sikkim Manipal University Page No. 88
5.1.1 Learning objectives
After studying this unit, you should be able to,
Define cost of capital.
Bring out the importance of cost of capital.
Explain how to design an ideal capital structure.
Compute Weighted Average Cost of Capital.
5.2 Design of an Ideal Capital Structure
The design of an ideal capital structure requires five factors to be
considered (see in figure 5.1)
Figure 5.1: Design of an ideal capital structure
Return
The capital structure of a company should be most advantageous. It
should generate maximum returns to the shareholders for a considerable
period of time and such returns should keep increasing.
Risk
Debt does increase equity holders‘ returns and this can be done till such
time that no risk is involved. Use of excessive debt funds may threaten
the company‘s survival.
Flexibility
The company should be able to adapt itself to situations warranting
changed circumstances with minimum cost and delay.
Capacity
The capital structure of the company should be within the debt capacity.
Debt capacity depends on the ability for funds to be generated.
Revenues earned should be sufficient enough to pay creditors‘ interests,
principal and also to shareholders to some extent.
Financial Management Unit 5
Sikkim Manipal University Page No. 89
Control
An ideal capital structure should involve minimum risk of loss of control
to the company. Dilution of control by indulging in excessive debt
financing is undesirable.
With the above points on ideal capital structure, raising funds at the appropriate
time to finance firm‘s investment activities is an important activity of the Finance
Manager. Golden opportunities may be lost for delaying decisions to this effect.
A combination of debt and equity is used to fund the activities. What should be the
proportion of debt and equity? This depends on the costs associated with raising
various sources of funds.
The cost of capital is the minimum rate of return of a company, which must earn to
meet the expenses of the various categories of investors who have made
investment in the form of loans, debentures and equity and preference shares.
A company now being able to meet these demands may face the risk of investors
taking back their investments thus leading to bankruptcy.
Loans and debentures come with a pre-determined interest rate. Preference shares
also have a fixed rate of dividend while equity holders expect a minimum return of
dividend, based on their risk perception and the company‘s past performance in
terms of pay-out dividends.
The following graph on risk-return relationship of various securities summarises the
above discussion.
Financial Management Unit 5
Sikkim Manipal University Page No. 90
Figure 5.2: Risk return relationship
5.3 Cost of Different Sources of Finance
The various sources of finance and their costs are explained in this section.
5.3.1 Cost of debentures
The cost of debenture is the discount rate which equates the net proceeds
from issue of debentures to the expected cash outflows.
The expected cash outflows relate to the interest and principal repayments.
Kd =
2/)PF(
n/PF)T1(I
Where Kd is post tax cost of debenture capital,
I is the annual interest payment per unit of debenture,
T is the corporate tax rate,
F is the redemption price per debenture,
P is the net amount realised per debenture,
n is maturity period.
Risk free
security
Govt bonds
Debt
Preference
share
Equity
share
Risk-Return relationship of various securities
Re
qu
ired
ra
te o
f re
turn
Financial Management Unit 5
Sikkim Manipal University Page No. 91
5.3.2 Cost of Term Loans
Term loans are loans taken from banks or financial institutions for a
specified number of years at a pre-determined interest rate. The cost of term
loans is equal to the interest rate multiplied by 1-tax rate. The interest is
multiplied by 1-tax rate as interest on term loans is also taxed.
Kt = I (1—T)
Where I is interest,
T is tax rate
Solved Problem - 2
Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9%
interest. What is the cost of term loan if the tax rate is 40%?
Solution:
Kt = I (1—T) = 9(1—0.4) = 5.4%
The cost of term loan is 5.4%
Solved Problem - 1
Lakshmi Enterprise wants to have an issue of non-convertible
debentures for Rs. 10 Cr. Each debenture is of a par value of Rs. 100
having an interest rate of 15%. Interest is payable annually and they are
redeemable after 8 years at a premium of 5%. The company is planning
to issue the NCD at a discount of 3% to help in quick subscription. If the
corporate tax rate is 50%, what is the cost of debenture to the company?
Solution
2/)PF(
n/)PF()T1(IKd
2/)97105(
8/)97105()5.01(15
101
15.7
%4.8r0084.0
Financial Management Unit 5
Sikkim Manipal University Page No. 92
5.3.3 Cost of Preference Capital
The cost of preference share Kp is the discount rate which equates the proceeds
from preference capital issue to the dividend and principal repayments. It is
expressed as:
Kp = (D + {(F – P) / n} / ((F + P) / 2)
Where Kp is the cost of preference capital,
D is the preference dividend per share payable,
F is the redemption price,
P is the net proceeds per share,
n is the maturity period.
5.3.4 Cost of Equity Capital
Equity shareholders do not have a fixed rate of return on their investment.
There is no legal requirement (unlike in the case of loans or debentures
where the rates are governed by the deed) to pay regular dividends to them.
Solved Problem - 3
C2C Ltd. has recently come out with a preference share issue to the tune
of Rs. 100 lakhs. Each preference share has a face value of 100 and a
dividend of 12% payable. The shares are redeemable after 10 years at a
premium of Rs. 4 per share. The company hopes to realise Rs. 98 per
share now. Calculate the cost of preference capital.
Solution:
2/)PF(
n/)PF(DKp
2/)98104(
10/)98104(12
101
6.12
Kp = 0.1247 or 12.47%
The cost of preference capital now will be 12.47%
Financial Management Unit 5
Sikkim Manipal University Page No. 93
Measuring the rate of return to equity holders is a difficult and complex
exercise.
There are many approaches for estimating return – the dividend forecast
approach, capital asset pricing approach, realised yield approach etc.
According to dividend forecast approach, the intrinsic value of an equity
share is the sum of present values of dividends associated with it.
Ke = (D1/Pe) + g
This equation is modified from the equation, Pe= {D1/Ke-g}.
Dividends cannot be accurately forecasted as they may sometimes be nil or
have a constant growth or sometime have supernormal growth periods.
Is Equity Capital free of cost?
Some people are of the opinion that equity capital is free of cost as a
company is not legally bound to pay dividends and also as the rate of equity
dividend is not fixed like preference dividends. This is not a correct view as
equity shareholders buy shares with the expectation of dividends and capital
appreciation. Dividends enhance the market value of shares and therefore
equity capital is not free of cost.
5.3.5 Cost of Retained Earnings
A company‘s earnings can be reinvested in full to fuel the ever-increasing
demand of company‘s fund requirements or they may be paid off to equity
holders in full or they may be partly held back and invested and partly paid
Solved Problem - 4
Suraj Metals are expected to declare a dividend of Rs. 5 per share and
the growth rate in dividends is expected to grow @ 10% p.a. The price of
one share is currently at Rs. 110 in the market. What is the cost of equity
capital to the company?
Solution
Ke = (D1/Pe) + g
= (5/110) + 0.10
= 0.1454 or 14.54%
Cost of equity capital is 14,54%
Financial Management Unit 5
Sikkim Manipal University Page No. 94
off. These decisions are taken keeping in mind the company‘s growth
stages.
High growth companies may reinvest the entire earnings to grow more,
companies with no growth opportunities return the funds earned to their
owners and companies with constant growth invest a little and return the
rest. Shareholders of companies with high growth prospects utilising funds
for reinvestment activities have to be compensated for parting with their
earnings.
Therefore the cost of retained earnings is the same as the cost of
shareholders‘ expected return from the firm‘s ordinary shares. So,
Kr = Ke
5.3.6 Capital Asset Pricing Model Approach
This model establishes a relationship between the required rate of return of
a security and its systematic risks expressed as ―β‖. According to this model,
Ke = Rf + β (Rm — Rf)
Where Ke is the rate of return on share,
Rf is the risk free rate of return,
β is the beta of security,
Rm is return on market portfolio
The CAPM model is based on some assumptions, some of which are:
Investors are risk-averse.
Investors make their investment decisions on a single-period horizon.
Transaction costs are low and therefore can be ignored. This translates
to assets being bought and sold in any quantity desired. The only
considerations that matter are the price and amount of money at the
investor‘s disposal.
All investors agree on the nature of return and risk associated with each
investment.
Financial Management Unit 5
Sikkim Manipal University Page No. 95
5.3.7 Earnings Price Ratio Approach
Under the case of earnings price ratio approach, the cost of equity can be
calculated as:
Ke = E1/P
Where E1 = expected EPS per one year
P = current market price per share
E1 is calculated by multiplying the present EPS with (1 + Growth rate).
Cost of Retained Earnings and Cost of External Equity
As we have just learnt that if retained earnings are reinvested in business for growth
activities, the shareholders expect the same amount of returns and therefore
Ke=Kr
However, it should be borne in mind by the policy makers that floating of a new
issue and people subscribing to the new issue will involve huge amounts of money
towards floating costs which need not be incurred if retained earnings are utilised
towards funding activities. From the dividend capitalisation model, the following
model can be used for calculating cost of external equity.
Ke = {D1/P0(1—f)} + g
Where, Ke is the cost of external equity,
D1 is the dividend expected at the end of year 1,
P0 is the current market price per share,
g is the constant growth rate of dividends,
f is the floatation costs as a % of current market price
The following formula can be used as an approximation:
K‘e = Ke/(1—f)
Solved Problem - 5
What is the rate of return for a company if its β is 1.5, risk free rate of
return is 8% and the market rate or return is 20%
Solution:
Ke = Rf + β (Rm — Rf)
= 0.08 + 1.5(0.2-0.08)
= 0.08 + 0.18
= 0.26 or 26%
The rate of return is 26%
Financial Management Unit 5
Sikkim Manipal University Page No. 96
Where K‘e is the cost of external equity,
Ke is the rate of return required by equity holders,
f is the floatation cost.
5.4 Weighted Average Cost of Capital
In the previous section, we have calculated the cost of each component in
the overall capital of the company. The term cost of capital refers to the
overall composite cost of capital or the weighted average cost of each
specific type of fund. The purpose of using weighted average is to consider
each component in proportion of their contribution to the total fund available.
Use of weighted average is preferable to simple average method for the
reason that firms do not procure funds equally from various sources and
Key Point
Dividends cannot be accurately forecasted as they might sometimes
become nil or have a constant growth or sometimes have supernormal
growth periods.
Solved Problem - 6
Alpha Ltd. requires Rs. 400 Cr to expand its activities in the southern
zone of India. The company‘s CFO is planning to get Rs. 250 Cr through
a fresh issue of equity shares to the general public and for the balance
amount he proposes to use ½ of the reserves which are currently to the
tune of Rs. 300 Cr. The equity investors‘ expectations of returns are
16%. The cost of procuring external equity is 4%. What is the cost of
external equity?
Solution
We know that Ke=Kr, that is Kr is 16%
Cost of external equity is
K‘e = Ke/(1—f)
0.16/(1– 0.04) = 0.1667 or 16.67%
Hence, cost of external equity is 16.67%
Financial Management Unit 5
Sikkim Manipal University Page No. 97
therefore simple average method is not used. The following steps are
involved to calculate the WACC
Step I: Calculate the cost of each specific source of fund, that of debt,
equity, preference capital and term loans.
Step II: Determine the weights associated with each source.
Step III: Multiply the cost of each source by the appropriate weights.
Step IV: WACC = We Ke + Wr Kr + Wp Kp + Wd Kd + Wt Kt
Assignment of weights
Weights can be assigned based on any of the following methods
The book value of the sources of the funds in capital structure
Present market value of funds in the capital structure and
Adoption of finance planned for capital budget for the next period
As per the book value approach, weights assigned would be equal to each source‘s
proportion in the overall funds. The book value method is preferable. The market
value approach uses the market values of each source and the disadvantage in this
method is that these values change very frequently.
Financial Management Unit 5
Sikkim Manipal University Page No. 98
Solved Problem -7
The capital structure of Prakash Packers ltd. is as shown in table 5.1
Table 5.1 : Capital structure in lakhs
Equity capital (Rs. 10 par value) 200
14% Preference share capital Rs. 100 each 100
Retained earnings 100
12% debentures (Rs. 100 each) 300
11% Term loan from ICICI bank 50
Total 750
The market price per equity share is Rs. 32. The company is expected to
declare a dividend per share of Rs. 2 per share and there will be a growth of
10% in the dividends for the next 5 years. The preference shares are
redeemable at a premium of Rs. 5 per share after 8 years and are currently
traded at Rs. 84 in the market. Debenture redemption will take place after 7
years at a premium of Rs.5 per debenture and their current market price Rs.90
per unit. The corporate tax rate is 40%. Calculate the WACC.
Solution
Step I is to determine the cost of each component.
Ke = ( D1/P0) + g
= (2/32) + 0.1
= 0.1625 or 16.25%
Kp = [D + {(F—P)/n}] / {F+P)/2}
= [14 + (105—84)/8] / (105+84)/2
=16.625/94.5
= 0.1759 or 17.59%
Kr = Ke which is 16.25%
Kd = [I(1—T) + {(F–P)/n}] / {F+P)/2}
= [12(1—0.4) + (105—90)/7] / (105+90)/2
= [7.2 + 2.14] / 97.5
= 0.096 or 9.6%
Kt = I(1–T)
= 0.11(1–0.4)
= 0.066 or 6.6%
Financial Management Unit 5
Sikkim Manipal University Page No. 99
Solved Problem - 8
Johnson Cool Air Ltd would like to know the WACC. The following
information is made available to you in this regard.
The after tax cost of capital are
Cost of debt 9%
Cost of preference shares 15%
Cost of equity funds 18%
The capital structure is as follows
Debt Rs.6,00,000
Preference capital Rs. 4,00,000
Equity capital Rs. 10,00,000
Step II is to calculate the weights of each source.
We = 200/750 = 0.267
Wp = 100/750 = 0.133
Wr = 100/750 = 0.133
Wd = 300/750 = 0.4
Wt = 50/750 = 0.06
Step III Multiply the costs of various sources of finance with
corresponding weights and WACC is calculated by adding all these
components
WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt
= (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) +
(0.06*0.066)
= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004
= 0.1304 or 13.04%
The value of WACC is 13.04%
Financial Management Unit 5
Sikkim Manipal University Page No. 100
Solved Problem - 9
Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds
next year for which it requires Rs. 20 Cr. to purchase new equipment.
The CFO has made available the following details based on which you
are required to compute the weighted marginal cost of capital
The amount required will be raised in equal proportions by way of
debt and equity (new issue and retained earnings put together
account for 50%)
The company expects to earn Rs.4Cr. as profits by the end of the
year after which it will retain 50% and pay-off rest to the shareholders.
The debt will be raised equally from two sources- loans from IOB
costing 14% and from the IDBI costing 15%.
The current market price per equity share is Rs.24 and the dividend
pay-out one year hence will be Rs.2.40. Tax rate is 50%
Solution
Ke =( D1/P0)
= (2.40 / 24) = 0.1 or 10%
Cost of equity Ke = cost of retained earnings
Kt = I(1 – T) [14% loan from IOB]
= 0.14(1 – 0.5) = 0.07 or 7%
Kt = I(1 – T) [15% IDBI loan]
= 0.15(1 – 0.5) = 0.075 or 7.5%
Solution
WACC is calculated from the table 5.2
Table 5.2: WACC
Fund source Amount Ratio Cost Weighted
cost
Debt Rs. 600000 0.3 0.09 0.027
Preference capital Rs. 400000 0.2 0.15 0.030
Equity capital Rs. 1000000 0.5 0.18 0.090
Total Rs. 2000000 1.0 0.147
WACC is 14.7%.
Financial Management Unit 5
Sikkim Manipal University Page No. 101
Computation of weighted marginal cost of capital is as shown in table 5.3
Table 5.3 Weighted cost of capital
Source of funds Weights After tax cost Weighted cost
Equity capital 0.4 0.1 0.040
Retained earnings 0.1 0.1 0.010
14% loan from IOB 0.25 0.07 0.0175
15% IDBI loan 0.25 0.075 0.0188
Total 0.0863
Weighted average cost of capital 8.63%
WACC = 8.63%
Solved Problem - 10
Canara Paints has paid a dividend of 40% on its share of Rs. 10 in the
current year. The dividends are growing @ 6% p.a. The cost of equity
capital is 16%. The company‘s top Finance Managers of various zones
recently met to take stock of the competitors‘ growth and dividend
policies and came out with the following suggestions to maximise the
wealth of the shareholders. As the CFO of the company, you are
required to analyse each suggestion and take a suitable course keeping
the shareholders‘ interests in mind.
Alternative 1: Increase the dividend growth rate to 7% and lower Ke to 15%
Alternative 2: Increase the dividend growth rate to 7% and increase Ke to 17%
Alternative 3: Lower the dividend growth rate to 4% and lower Ke to 15%
Alternative 4: Lower the dividend growth rate to 4% and increase Ke to 17%
Alternative 5: increase the dividend growth rate to 7% and lower Ke to 14%
Solution
We all know that
P0 = D1/(Ke – g)
Present case = 4/(0.16-0.06) = Rs 40
Alternative 1 = 4.28/(0.15 – 0.07) = Rs. 53.5
Alternative 2 = 4.28/(0.17 – 0.07) = Rs. 42.8
Alternative 3 = 4.16/(0.15 – 0.04) = Rs. 37.8
Alternative 4 = 4.16/(0.17 – 0.04) = Rs. 32
Alternative 5 = 4.28/(0.14 – 0.07) = Rs. 61.14
Recommendation
The last alternative is likely to fetch the maximum price per equity share
thereby increasing the wealth.
Financial Management Unit 5
Sikkim Manipal University Page No. 102
5.5 Summary
Any organisation requires funds to run its business. These funds may be
acquired from short-term or long-term sources. Long-term funds are raised
from two important sources – capital (owners‘ funds) and debt. Each of
these two has a cost factor, merits and demerits.
Having excess debt is not desirable as debt-holders attach many conditions
which may not be possible for the companies to adhere to. It is therefore
desirable to have a combination of both debt and equity which is called the
‗optimum capital structure‘. Optimum capital structure refers to the mix of
different sources of long term funds in the total capital of the company.
Cost of capital is the minimum required rate of return needed to justify the use of
capital. A company obtains resources from various sources – issue of debentures,
availing term loans from banks and financial institutions, issue of preference and
equity shares or it may even withhold a portion or complete profits earned to be
utilised for further activities.
Retained earnings are the only internal source to fund the company‘s future plans.
Weighted Average Cost of Capital is the overall cost of all sources of finance. The
debentures carry a fixed rate of interest. Interest qualifies for tax deduction in
determining tax liability. Therefore the effective cost of debt is less than the actual
interest payment made by the firm.
Self Assessment Question
Fill in the blanks:
1. ________ is the mix of long-term sources of funds like debentures,
loans, preference shares, equity shares and retained earnings in
different ratios.
2. The capital structure of the company should generate _______ to the
shareholders.
3. The capital structure of the company should be within the _____.
4. An ideal capital structure should involve _____ to the company.
5. _______ do not have a fixed rate of return on their investment.
6. According to dividend forecast approach, the intrinsic value of an equity
share is the sum of ______ associated with it.
Financial Management Unit 5
Sikkim Manipal University Page No. 103
The cost of term loan is computed keeping in mind the tax liability. The cost
of preference share is similar to debenture interest. Unlike debenture
interest, dividends do not qualify for tax deductions.
The calculation of cost of equity is slightly different as the returns to equity
are not constant. The cost of retained earnings is the same as the cost of
equity funds.
5.6 Solved Problems
11. Deepak Steel has issued non-convertible debentures for Rs. 5 Cr.
Each debenture is of a par value of Rs. 100 carrying a coupon rate of
14%. Interest is payable annually and they are redeemable after 7
years at a premium of 5%. The company issued the NCD at a
discount of 3%. What is the cost of debenture to the company? Tax
rate is 40%.
Solution:
2/)PF(
n/)PF()T1(IKd
2/)97105(
7/)97105()4.01(14
101
14.14.8 = 0.094 or 9.4%
12. Supersonic industries Ltd. has entered into an agreement with Indian Overseas
Bank for a loan of Rs. 10 Cr with an interest rate of 10%. What is the cost of the
loan if the tax rate is 45%?
Solution:
Kt=I(1 – T) = 10(1 – 0.45) = 5.5%
13. Prime group issued preference shares with a maturity premium of
10% and a coupon rate of 9%. The shares have a face a value of
Rs. 100. and are redeemable after 8 years. The company is planning
to issue these shares at a discount of 3% now. Calculate the cost of
preference capital.
Solution :
2/)PF(
n/)PF(DKp
10.27%5.103
625.1.9
2/)97110(
8/)97110(9
Financial Management Unit 5
Sikkim Manipal University Page No. 104
5.7 Terminal Questions
1. The following data is available in respect of a XYZ company. The market
value of Equity is Rs.10 lakhs and the cost of equity is 18%. The market
value of debt is Rs.5 lakhs, cost of debt 13%. Calculate the weighted
average cost of funds as weights assuming tax rate as 40%
2. Bharat chemicals has the following capital structure as shown in
table 5.4
Table 5.4: Capital structure
Rs. 10 face value equity shares Rs. 400000
Term loan @ 13% Rs.150000
9% Preference shares of Rs. 100, currently traded at Rs. 95 with 6 years maturity period
Rs. 100000
Total Rs. 650000
The company is expected to declare a dividend of Rs. 5 next year and the
growth rate of dividends is expected to be 8%. Equity shares are currently
traded at Rs. 27 in the market. Assume tax rate of 50%. What is WACC?
3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs. 60 lakhs. The
cost of equity and debt are 15% and 12%. What is the WACC if the tax rate is 50%?
4. A company has 3 divisions – X, Y and Z. Each division has a capital structure with debt,
preference shares and equity shares in the ratio 3:4:3 respectively. The company is
planning to raise debt, preference shares and equity for all the 3 divisions together.
Further, it is planning to take a bank loan at the rate of 12% interest. The preference
shares have a face value of Rs. 100, dividend at the rate of 12%, 6 years maturity and
currently priced at Rs. 88. Calculate the cost of preference shares and debt if taxes
applicable are 45%
5. Tanishk Industries issues partially convertible debentures of face value of Rs. 100 each
and retains Rs. 96 per share. The debentures are redeemable after 9 years at a
premium of 4%, taxes applicable are 40%. What is the cost of debt if the coupon
interest is 12%
5.8 Answers to SAQs and TQs
Financial Management Unit 5
Sikkim Manipal University Page No. 105
Answers to Self-Assessment Questions
1. Capital structure
2. Maximum returns
3. Debt capacity
4. Minimum risk of loss of control
5. Equity shareholders
6. Present values of dividends
Answers to Terminal Questions
1. Hint: Use the equation
WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt
Ans = 14.57%
2. Hint: Use the equation
WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt
3. Hint: Use the equation
WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt
Ans = 8.97%
4. Hint: Apply the formula
2/)PF
n/)PF(DKp
5. Hint: Apply the formula
2/)(
/)()1(
PF
nPFTIKd
Ans 8.09%
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