LESSON: 7

COST OF CAPITAL

STRUCTURE

7.0 Objectives

7.1 Introduction

7.2 Meaning of Cost of Capital

7.3 Significance of Cost of Capital

7.4 Classification of Cost

7.5 Computation of Cost of Capital for Various Sources of Finance

7.6 Summary

7.7 Keywords

7.8 Self Assessment Questions

7.9 Suggested Readings

7.0 OBJECTIVES

After reading this lesson, you will be able to:

 Recognize the significance of cost of capital

 Categorize the costs
 Make the computation of cost of capital for various sources of finance.

7.1 INTRODUCTION

The cost of capital of a firm represents the minimum rate of return required or expected by
its investors. It only refers to the weighted average cost of various sources of finance employed by
a firm. The capital employed by a firm normally comprises equity shares, preference shares, debts

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borrowed from Commercial Banks and financial institutions and also its retained earnings. The
concept of cost of capital is very important in the realm of financial management. At the same
time, it is also one of the most difficult and disputed topics in the financial management, since
conflicting opinions have been expressed by the financial experts and wizards as regards the way
in which the cost of capital can be computed.

7.2 MEANING OF COST OF CAPITAL

The items on the liability side of the balance sheet are called capital components. The major
capital components are equity, preference and debt. Capital, like any other factor of production,
has a cost. A company’s cost of capital is the average cost of the various capital components (or
securities) employed by it. Putting differently, it is the average rate of return required by the
investors who provide capital to the company. The cost of capital of a firm is the minimum rate of
return expected by its investors. It is the weighted average cost of various sources of finance used
by the firm, viz., equity, preference and debt. The concept of cost of capital is very important in
financial management. It is used for evaluating investment projects, for determining capital
structure, for assessing leasing proposals etc.
"Cost of Capital", according to Solomon Ezra "is the minimum required rate of earning or
the cut-off rate for capital expenditures." In the words of Milton H. Spencer, "cost of capital is the
minimum rate of return which a firm requires as a condition for undertaking an investment".
It is well known that the final selection of any capital project from among the various
alternatives mainly depends on the cost of the capital of a firm or the cut-off rate representing the
minimum rate of return required on investment projects. It is the cut-off or the target or the hurdle
rate. In case a firm is not able to achieve the cut-off or the target or the hurdle rate the market value
of its shares remains constant at a particular level. Moreover, to achieve the objective of the
financial management, viz., wealth maximisation, a firm has to necessarily earn a rate of return
more than its cost of capital. The cost of capital in turn depends on the risk involved in the firm.
Generally, higher the risk involved in a firm, the higher will be the cost of capital.

7.3 SIGNIFICANCE OF COST OF CAPITAL

The concept of cost of capital is very important and the central concept in financial
management decisions. The decisions in which it is useful are as follows:

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 a) Criterion in capital budgeting decision: Any capital budgeting decision involves
the consideration of the cost of capital. According to the net present value method of capital
budgeting, if the present value of expected returns from the investment throughout its life period
is greater than or equal to the cost of investment, the project may be accepted; otherwise the project
may be rejected. The present value of expected returns is calculated by discounting the expected
cash inflows at the cut-off rate which is the cost of capital. It is clear from the above that the cost
of capital serves as a very useful tool in the process of making capital budgeting decisions.

b) Determinant of capital mix in designing of capital structure: The cost of capital

acts as a determinant of capital mix in the designing of a balanced and appropriate capital structure.
As a rule there should be a proper mix of debt and equity capital in financing a firm’s assets. While
designing an optimal capital structure of a firm, the management has to consider the objective of
maximising the value of the firm and minimising the cost of capital. Computation of a weighted
average cost of various sources of finance is very essential in planning and designing the capital
structure of a firm.

c) Basis for evaluating the financial performance: The cost of capital can be used
as a tool to evaluate the financial performance of top management. The actual profitability of any
project is compared to the actual cost of capital funds raised to finance the project. If the actual
profitability of the project is on the higher side when compared to the actual cost of capital raised,
the performance can be evaluated as satisfactory.

b) Basis for making financial decisions: The cost of capital can be conveniently
employed as a tool in making other important financial decisions such as dividend policy,
capitalisation of profits, rights issue and working capital.

7.4 CLASSIFICATION OF COST

Cost of capital can be classified in many ways. Some of them are discussed below:

a) Historical cost and future Cost: Historical cost represents the cost which has
already been incurred for financing a project. It is computed on the basis of past data collected.
Future cost represents the expected cost of funds to be raised for financing a project. Historical
cost is significant since it helps in projecting the future cost and in providing an appraisal of the

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past financial performance by comparing with the standard or predetermined costs. In financial
decisions, future costs are more relevant than the historical costs.

b) Explicit Cost and Implicit Cost: Explicit cost refers to the discount rate which
equates the present value of cash inflows with the present value of cash outflows. Thus the explicit
cost is the internal rate of return which a company pays for procuring the required finances. The
explicit cost of a specific source of finance may be determined with the help of the following
formula:

Io = O1 + O2 +...................+ On

(1+k) (1+k) 2 (1+k) n

= Ot
Σ
(1+k) t

t=1
Where,
Io = is the net cash inflow at zero point of time.
Ot = is the outflow of cash in periods 1 to n.
k = is the explicit cost of capital.
Implicit cost represents the rate of return which can be earned by investing the capital in
alternative investments. The concept of opportunity cost gives rise to the implicit cost. The implicit
cost represents the cost of opportunity foregone in order to take up a particular project. For
example, the implicit cost of retained earnings is the rate of return available to the shareholders by
investing the funds elsewhere.

c) Specific Cost and Composite Cost: Capital can be raised by a firm from various
sources and each source will have a different cost. Specific cost refers to the cost of a specific
source of capital, while composite cost of capital refers to the combined cost of various sources of
capital. It is the weighted average cost of capital. It is also termed as overall cost of capital. When
more than one type of capital is employed in the business, it is the composite cost which should be
considered for decision-making and not the specific cost of that capital alone be considered.

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 d) Average Cost and Marginal Cost: Average cost of capital refers to the weighted
average cost calculated on the basis of cost of each source of capital funds. Marginal cost of capital
refers to the average cost of capital which has to be incurred to obtain additional funds required by
a firm. Marginal cost of capital is considered as more important in capital budgeting and financing
decisions.

7.5 COMPUTATION OF COST OF CAPITAL FOR VARIOUS SOURCES OF

FINANCE

For calculating the overall cost of capital of a firm, the specific costs of different sources
of finance raised by it have to be computed. These sources are:

(i) Debt (borrowed) Capital,

(ii) Preference Share Capital,

(iii) Equity Share Capital, and

(iv) Retained Earnings.

1. Cost of Debt

It is relatively easy to calculate the cost of debt. The cost of debt is the rate of interest
payable on debt. Debt capital is obtained through the issue of debentures. The issue of debentures
involves a number of floatation charges, such as printing of prospectus, advertisement,
underwriting, brokerage, etc. Again, debentures can be issued at par or at times below par (at
discount) or at times above par (at premium). These floatation charges and modes of issue have an
important bearing on the cost of debt capital.

The formula adopted or calculating the cost of debt capital is given below:

(i) Kd = I/P

Where,
Kd = cost of debt (before tax)

I = Interest
P = Principal

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 In case the debt is raised by issue of debentures at premium or discount, one should
consider P as the amount of net proceeds from the issue and not the face value of debentures. The
formula may be modified as:

(ii) Kd = I/NP (where NP = New Proceeds)

When debt is used as a source of finance, the firm saves considerable amount in payment
of tax since interest is allowed as a deductible expense in computation of tax. Hence, the effective
cost of debt is reduced. In other words, the effective cost of debt, i.e., the after-tax cost of debt
would be substantially less than the before-tax cost. The after-tax cost of debt may be calculated
with the help of the following formula:

(iii) After-tax cost of debt = Kd (1-t)

Where, t is the tax rate.

Illustration I

(a) A Ltd. issues ₹ 1,00,000, 8% debentures at par. The tax rate applicable to the company is
50%. Compute the cost of debt capital.

(b) B Ltd. issues ₹ 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) C Ltd. issues ₹ 1,00,000, 8% debentures at a discount of 5%. The tax rate is 50%. Compute
the cost of debt capital.

(d) D Ltd. issues ₹ 1,00,000, 9% debentures at a premium of 10%. The costs of floatation are
2%. The tax rate applicable is 60%. Compute costs of debt-capital.

Solution

I
(a) Kd = (1-t) NP

= 8,000 (1-0.5)
1,00,00

= 8000 x 0.5
1,00,000

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 = 4%

(b) Kd = I/( 1 - t ) N P

= 8,000 (1-0.6)
1,10,000

= 8,000 × 0.4
1,10,000

= 2.95%

I
(c) Kd = (1-t) NP
= 8,000 (1-0.5)
95,000
= 4.21%

(d) Kd = I (1-t) NP
= 9,000 × 0.4
1,07,000

= 3.34%
Usually, the debt issued is to be redeemed after the expiry of a certain period during the
life time of a firm. Such a debt issue is known as Redeemable Debt. The cost of redeemable debt
capital may be computed as:

(iv) Before-tax cost of debt:

K bd =

I + 1/n (P-NP)

½ (P+ NP)

Illustration 2
XYZ Ltd. issues ₹5,00,000, 10% redeemable debentures at a discount of 5%. The cost of
floatation amount to ₹15,000. The debentures are redeemable after 5 years. Calculate before-tax
and after-tax cost of debt assuming a tax rate of 50%.

Solution
Before-tax cost of debt,
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 Kdb = 1+1/n (P - NP)
½ ( P+ NP)

= 50,000 + 1/5 (5,00,000 - 4,60,000)

½ (5,00,000 + 4,60,000)

= 50,000 + 8,000

4,80,000
= 58,000 × 100

4,80,000
After-tax cost of debt,
Kda = Kdb (1 - t)
= 13.09 ( 1 - 0.5)
= 12.09 × 0.5
= 6.045%
Illustration 3: ABC Ltd. issues 5,000, 8% debentures of ₹ 100 each at a discount of 10%
and redeemable 10 years. The expenses of issues amounted to ₹ 10,000. Find out the cost
of debt capital.

Solution
Kdb = 1 + 1/n (P - NP)

½ ( P + NP)

= 40,000 + 1/10 (5,00,000 - 4,40,000)

½ (5,00,000 + 4,40,000)

= 40,000+ 6 ,000
4,70,000

= 46,000 × 100
4,70,000

= 9.79%

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2. Cost of Preference Capital

Normally, a fixed rate of dividend is agreed payable by a company on its preference shares.
Though dividend is declared at the discretion of the Board of directors and there is no legal binding
on the payment of dividend, yet it does not mean that Preference Share Capital is cost free. The
cost of preference share capital is the dividend expected by its investors. Moreover, preference
shareholders have a priority to dividend over the equity shareholders. In case dividends are not
paid to preference shareholders, it will affect the fund raising capacity of the firm. Hence,
dividends are usually paid regularly on preference shares except when there are no profits to pay
dividends.

The cost preference capital can be calculated as:

Kp = D/P

Where, Kp = Cost of Preference Capital

D = Annual Preference Dividend

P = Preference Share Capital
(Proceeds)
Further, when preference shares are issued at premium or discount or when cost of
floatation is incurred to issue preference shares, the nominal or par value of preference share capital
has to be adjusted to find out the net proceeds from the issue of preference shares. In such a case,
the cost of preference capital can be computed with the following formula:

Kp = D/NP

When Redeemable Preference Shares are issued by a company, they can be redeemed or
cancelled on maturity date. The cost of redeemable preference share capital can be calculated as:

D+ MV - NP

N Kpr
=½ (MV + NP)

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Where, Kpr = Cost of Redeemable Preference Shares

D = Annual Preference Dividend

MV = Maturity Value of Preference Shares

NP = Net Proceeds of preference Shares

Illustration 4: Coca Cola Ltd. issued 1000 9% preference shares of ₹ 100 each at a premium of
10% redeemable after 5 years at par. Compute the cost of preference capital

Solution

Kpr = D + 1/n (MV - NP)

× 100
½ (MV + NP)

= 9,000 + 1/5 (1,00,000 - 1,10,000)

× 100
½ (1,00,000 + 1,10,000)

= 9,000 - 2,000 × 100

1,05,000

= 6.7%

3. Cost of Equity Share Capital

As the payment of dividend on equity shares is not legally binding and the rate of dividend
is not predetermined, some financial experts hold the opinion that equity share capital does not
carry any cost. But this is not true. The shareholders invest their surplus in equity shares with an
expectation of receiving dividends and the company must earn this minimum rate so that the
market price of the shares remains unchanged. Therefore, the required rate of return which equates
the present value of the expected dividends with the markets value of share is the cost of equity
capital.

For the purpose of measuring the cost of equity capital will be divided into two parts: (a)
the external equity of the new issues (of shares) and (b) the retained earnings because of the

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floatation costs involved in the former. It is very difficult to measure the cost of equity in practice,
since it is difficult to estimate the future dividends expected by the equity shareholders.

Moreover, the earnings and dividends on equity share capital are generally expected to
grow. The cost of equity capital can be computed in the following ways:

(a) Dividend Yield Method or Dividend Price Ratio Method: Under this method,
the cost of equity capital is the ’discount rate that equates the present value of expected future
dividends per share with the net proceeds (or current market price) of a share’. Symbolically,

Ke = D or D
NP MP

where, Ke = Cost of Equity Capital

D = Expected Dividend per share

NP = Net Proceeds per share

and MP = Market Price per share

The basic assumptions underlying this method are that the investors give utmost
importance to dividends and the risk in the firm remains constant.

The dividend price ratio method cannot be considered as a sound one for the following
reasons: (i) it does not consider the growth in dividend (ii) it does not consider future earnings or
retained earnings and (iii) it does not take into account the capital. It is suitable only when the
company has stable earnings and stable dividend policy over a period of time.

Illustration 5: Maruti Ltd. issues 5,000 equity shares of ₹ 100 each at a premium of 10%. The
company has been paying 20% 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 ₹ 160?

Solution

Ke = D
NP

170
 = 20
× 100
110
= 18.18%
if the market price of a equity share is ₹ 160.
D MP
Ke =
20 × 100
=
160
= 12.5%
where, Ke = Cost of equity capital

D = Expected Dividend per share

Np = Net proceeds per share

G = Rate of growth in dividends.

(b) Dividend Yield plus growth in dividend method: When the dividends of the firm
are expected to grow at a constant rate and the dividend pay-out ratio is constant, this method may
be the cost of equity capital is based on the dividend and the growth rate.

Ke = D + G NP
Further, in case cost of existing equity share capital is to be calculated, the NP should be
changed with MP (market price per share) in the above equation.

Ke = D + G MP
Illustration 6

(a) Hero Honda Ltd. issues 2000 new equity shares of ₹ 100 each at par. The floatation costs
are expected to be 5% of the share price. The company pays a dividend of ₹ 10 per share
initially and the growth in dividends is expected to be 5%. Compute the cost of new issue
equity share.

(b) If the current market price of an equity share is ₹ 160, calculate the costs of existing equity
share capital.

Solution

(a) Ke = 10 + 5% = 15.33%
= 100-5

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 (b) Ke = D + G MP

= 10 + 5% = 11.25%
160
(c) Earning yield method: Under this method, the cost of equity capital is the discount
rate that equates the present value of expected future earnings per share with the net proceeds (or
current marketing price) of a share. Symbolically:

Ke = Earnings per Share

Net Proceeds

= EPS NP

Where, the cost of existing capital is to be calculated.

Ke = Earnings per Share Market

Price per Share

= EPS MPS
This method of computing cost of equity capital may be employed in the following cases:

(a) When the earnings per share are expected to remain unchanged.

(b) When the dividend pay-out ratio is 100 per cent or when the retention ratio
is zero, i.e., all the available profits are fully distributed as dividends.

(c) When a firm is expected to earn an amount of new equity share capital, which is
equal to the current rate of earnings.

(d) The market price of share is influenced by the earnings per share alone.

Illustration 7: Jindal Ltd. is considering an expenditure of ₹ 80 lakhs for expanding its operations.
Other particulars are as follows:

Number of existing equity shares = 10 lakhs

Market value of existing share = ₹ 60
Net earnings = ₹ 90 lakhs

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 Compute the cost of existing equity share capital and of new equity capital assuming that
new shares will be issued at a price of ₹ 54 per share and the cost of new issue will be ₹ 2 per
share.

Solution

Cost of existing equity share capital

Ke = EPS

MPS
EPS, or Earnings per share = 90 =₹9

10
Ke = 9 x 100

60

= 15%
Cost of New Equity Capital

Ke = EPS

NP
= 9 x 100
54 – 2
= 9 x 100
52

= 17.30%
(d) Realised Yield Method: The main drawback of the dividend yield method or
earnings yield method lies in the estimation of the investors’ expected future dividends on
earnings. It is very difficult, if not impossible, to estimate future dividends and earnings precisely,
since both of them depend on many uncertain factors. To overcome this shortcoming, realised
yield method which takes into consideration the actual average rate of return realised in the past,
is employed to compute the cost of equity share capital. While calculating the average cost of
return realised, dividends received in the past along with the gain realised at the time of sale of
shares, should be considered. The cost of capital is equal to the realised rate of return by the
shareholders.

This method is based upon the following limitations:

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 (a) The firm will continue to remain and face the same risk, over the period:

(b) The investors’ expectations are based upon the past realised yield;

(c) The investors get the same rate of return as the realised yield even when
invested elsewhere; and

(d) The market price of shares remains unchanged.

4. Cost of Retained Earnings

It is generally misunderstood that retained earnings do not involve any cost since a firm is
not required to pay dividends on retained earnings. However, the shareholders expect a return on
retained profits. Retained earnings accrue to a firm only because of the sacrifice made by the
shareholders in not getting the dividends declared out of the available profits fully. The cost of
retained earnings is equal to the rate of return which the existing shareholders will obtain by
investing the after-tax dividends in alternative investments. It thus represents the opportunity cost
of dividends foregone by the shareholders. Cost of retained earnings can be computed with the
help of following formula:

Kr = D +G

NP
Further, it important to note that shareholders, usually, cannot obtain the entire amount of
where, Kr = cost of retained earnings
retained profits by way of dividends even if there is 100 per cent pay-out ratio. It is so because the
D
shareholders are required to =pay tax.
Expected
However,Dividend
tax adjustment in determining the cost of retained
N Pproblem
earnings is a difficult = because
Net proceeds of equity
all shareholders issue
do not fall under the same tax bracket.
Moreover, if the G = wish
shareholders Ratetoofinvest
growththeir after-tax dividend income in alternative
investments securities, they may have to incur some additional costs towards purchasing the
securities such as brokerage. Hence, the effective rate of return realised by the shareholders from
the new investment will be somewhat lesser than their present return from the firm. To make
adjustment in the cost of retained earnings for tax and costs of purchasing new securities, the
following formula may be adopted:

Kr = ( D + G) X(1-t)X(1-b)
NP

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 or, Kr = Ke (1-t) (1-b)

Where,
Kr = Cost of retained earnings
D = Expected dividend
G = Growth rate
NP = Net Proceeds of Equity Issue
t = tax rate
b = Cost of purchasing new securities, or brokerage costs.
ke = Rate of return available to shareholders
Illustration 8: A firm’s K e (return available to shareholders) is 12%, the average tax rate of
shareholders is 50% 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, Ke = rate of return available to shareholders

t = tax rate
b = brokerage cost
so, kr = 12% x (1-5) (1-02)
= 12% x .5 x .98
= 5.88%
5. Weighted Average Cost of Capital

The term weighted average cost of capital is generally used in composite or overall sense,
especially in financial decision making. It is used only to refer to the costs of specific forces of
capital such as cost of equity, etc. Before implementing any capital expenditure project, it is
common experience to compare the cost of the specific source of fund raised to finance a particular
project with its profitability. But this is rather fallacious. For, a firm’s decision to use debt capital
adversely affects its potential using low cost debt in future and also makes the position of the
existing shareholders more risky. This increases the risk to the shareholders which is turn increases

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the cost of equity. Again, the firm’s decision to use equity capital to finance its projects will enlarge
its potential for borrowing, in future. Because of this linkage between the methods of financing
and their costs, the term cost of capital should be used in a composite term. Thus, the composite
cost or overall cost of capital is the weighted average cost of various sources of funds, weights
being the proportion of each source of funds in the capital structure. It should also be remembered
that it is the weighted average concept and not the simple average, which is more relevant in
calculating the overall cost of capital. As the firms do not use various sources of funds in equal
proportion, the simple average cost of capital will not be appropriate to use, in the capital structure
decision-making.

The following steps are involved in calculating the weighted average cost of capital:

i) To calculate the cost of the specific sources of funds individually (i.e., cost of debt, cost of
equity, cost of preference capital, etc.).

ii) To multiply the cost of each source by its proportion in the capital structure and

iii) Add the weighted costs of all courses of funds to get the weighted cost of capital.

The cost of capital should always be calculated on the after-tax basis, in financial decision-
making. Hence, the component costs one used for calculating the weighted average cost of capital.

Illustration 9: The following is the capital structure of a TATA Ltd.

Sources of Finance Amount Proportion Cost
Equity Share capital (4000 Share of ₹ 100/-each)
Retained earnings (Reserves) ₹ 4,00,000 40% 14.0%
Preference capital 2,00,000 20% 13.0%
Debt 1,00,000 10% 12.0%
3,00,000 30% 9.0%

Calculate the weighted average cost of capital of the company.

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 Solution

The weighted average cost of TATA Ltd. is computed as follows:

Source Amount (2) Proportion After-tax Weighted
(1) (3) (4) cost (5)
Equity capital 4,00,000 (4,000 Share of
₹ 100/- each)
Retained Earnings 4,00,000 40% 14.0 5.60
Pref. Capital 2,00,000 20% 13.0 2.60
Debt 1,00,000 10% 12.0 1.20
Weighted Average cost of capital 3,00,000 30% 2.70
12.1

The weighted average cost of TATA Ltd. can also be calculated as follows:

Alternative Method
Source (1) Amount (2) Proportion(3) After-tax (4)
Equity Capital 4,00,000 14.0% 56,000
Retained 2,00,000 13.0% 26,000
Pref. capital 1,00,000 12% 12,000
Debt 3,00,000 9.0% 27,000
₹ 10,00,000 ₹1,21,000

₹ 1,21,000 x 100

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 Weighted Average Cost of Capital= ₹ 10,00,000

= 12.1%

Book Value Vs. Market Value Weights

The weighted cost of capital can be calculated by using either the book value or market
value weights. If there is any difference between book value and market value weights, the
weighted average cost of capital would also differ according to the weights used. When the market
value of the share is higher than book value, the weighted average cost of capital calculated by
using the book value weight will be much lower and vice versa

Computation of Weighted Average Cost of Capital (Market Value weight)

Source Amount Proportion After-tax Weighted cost

Equity capital
(4,000 Share of
₹ 22.50) ₹9,00,000 69.2% 14.0% 9.69%
Pref. capital 1,00,000 7.7% 12.0% 0.92
Debt 3,00,000 23.1% 9.0% 2.08
₹ 13,00,000 12.69%

It can be observed that the total market value of the equity shares outstanding takes into
account the retained earnings also. It is obvious that the market value of cost of capital (12.69%)
is higher than book value cost of capital (12.1%) since market value of equity share capital (₹
9,00,000) is higher than its book value (₹ 6,00,000). From the above it is clear that the market
value weight should be preferred over the book value weights since the market values reflect the
expectation of investors. At the same time, market value fluctuates very widely and frequently and
there is difficulty in using the market value weights in the computation of weighted cost of capital.
In practice, the use of the book value weights is always preferred for the following reasons:

(a) the firm determines the capital structure targets in terms of book value only.

(b) the book value particulars can be easily obtained from the published statement of the
company.

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(c) moreover, the debt-equity ratio based on book values alone are analysed by the investors
to evaluate the risk involved in their investment.

7.6 SUMMARY

The cost of capital is viewed as one of the corner stones in the theory of financial
management. Cost of capital may be viewed in different ways. The cost of capital is useful in
designing optimal capital structure, investment evaluation, and financial performance appraisal.
The financial manager has to compute the specific cost of each type of funds needed in the
capitalisation of a company. Retained earnings are one of the internal sources to raise equity
finance. Cost of equity capital, is the minimum rate of return that a firm must earn on the equity
financed portions of an investment project in order to leave unchanged the market price of the
shares.

7.7 KEYWORDS

Cost of Capital: It is that minimum rate of return, which a firm must earn on its investments so
as to maintain the market value of its shares.

Implicit Cost: It is the cost of opportunity which is given up in order to pursue a particular action.

Opportunity Cost: The benefit that the shareholder foregoes by not putting his/her funds
elsewhere because they have been retained by the management.

Specific Cost: It is the cost associated with particular component or source of capital.

7.8 SELF ASSESSMENT QUESTIONS

1. How is Cost of debt computed?

2. What is mean by opportunity cost?

3. How is cost of preferred stock computed?

4. How is the weighted average cost of capital calculated? What is its importance?

5. Define the term ‘Cost of Capital’.

6. "The equity cost is free". Do you agree? Give reasons.

7. "Debt is the cheapest source of funds". Comment.

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8. The following is the capital structure of Saras Ltd. As on 31-12-2018:
9. ₹
Equity Shares-20,000 shares of ₹ 100 each 20,00,000
10% Preference Shares of ₹ 100 each 8,00,000
12% Debentures 12,00,000
40,00,000
The market price of the company’s share is ₹ 110 and it is expected that a dividend of ₹ 10
per share would be declared after 1 year. The dividend growth rate is 6%.

i. If the company is in the 50% tax bracket, compute the weighted average cost of capital.
ii. Assuming that in order to finance an expansion plan, the company intends to borrow a fund
of ₹ 20 lacs bearing 14% rate of interest, what will be the company’s revised weighted
average cost of capital? This financing decision is expected to increase dividend from ₹ 10
to ₹ 12 per share. However, the market price of equity share is expected to decline from ₹
110 to ₹ 105 per share.

10. The following is the capital structure of a company:

Source of Capital Book Value Market Value

(₹) (₹)
Equity Shares @ ₹ 100 each 8,00,000 16,00,000
9% Cumulative Preference Shares 2,40,000
@ ₹ 100 each 2,00,000
11% Debentures 6,00,000 6,60,000
Retained Earnings 4,00,000 —
20,00,000 25,00,000
The current market price of the company’s equity share is ₹ 200. For the last year the company
had paid equity dividend at 25% and its dividend is likely to grow 5% every year. The corporate
tax rate is 30% and shareholders personal income tax rate is 20%.
You are required to calculate:
i. Cost of Capital for each source of capital.
ii. Weighted average cost of capital on the basis of book value weights.

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7.9 SUGGESTED READINGS
29. M Y Khan & P K Jain: Basic Financial Management; McGraw Hill Education (India) Pvt
Ltd., New Delhi.
30. R. P. Rustagi: Financial Management–Theory, Concepts and Problems; Taxmann
Publications (P) Ltd., New Delhi.
31. Prasanna Chandra: Investment Analysis and Portfolio Management; McGraw Hill
Education (India) Pvt. Ltd., New Delhi.
32. I M Pandey: Financial Management; Vikas Publication House Ltd., New Delhi.
33. Eugene F Brigham & Michael C Ehrhardt: Financial Management– Theory and Practice;
Cengage Learning (India) Pvt. Ltd., New Delhi.

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