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Meaning of cost of capital Importance of cost of capital Classification of cost Computation of Cost of capital Computation of specific cost •Cost of Debt •Cost of Preference share •Cost of Equity share •Cost of Retained Earnings •Overall cost of capital Meaning of Cost of Capital In other words, COC means that rate which is paid for the use of capital. Each source of funds has different cost, such as cost of equity share capital, cost of preference share capital, cost of debt, cost of retained earning From the view point of investor:-COC is the reward for the amount he is investing which could have other wise been used for consumption or for investment at some other place Importance of Cost of Capital COC is very important in the area of financial management:Capital Budgeting Capital Structure Decision Dividend Policy Decision Efficiency of Top mgt Comparative Analysis Classification of Cost Specific or component cost :-refers to the cost of individual components of capital viz. equity share, preference share ,debentures, retained earning. Combined cost/WACC : refers to the combined cost (or weighted avg COC) of the various individual components. It is also called the average /weighted cost of capital or overall cost of capital. Computation of Cost of Capital Computation of cost of specific source of finance. Cost of Debt Cost of Preference share capitalCost of Equity share capitalCost of Retained Earnings combined cost Computation of weighted average cost of capital Cost of Debt Debt fund can be in the form of debentures or loans from financial institution. Debt can be of 2 types: Irredeemable or perpetual Debt Redeemable Debt Cost of Irredeemable Debt Calculation of Irredeemable Debt, before tax : Kd = I / NP where Kd = Cost of Debt before tax I = Interest NP = Net Proceeds Example of Cost of Debt, before tax: X Ltd. issues Rs 1000 , 8%debentures face value 100 each (a) at par, (b) at a discount of 7 % and ( c) at a premium of 10% You are required to calculate the cost of Debt to the company. Cost of Irredeemable debt,after tax Formula:-Kda = Int/NP(1-t) * 100 Example:-X Ltd has 8% perpetual debt of Rs20 Lakh. The tax applicable to the company is 40%. Determine the cost of capital after tax assuming the debt is issued (a) at par, (b) at 10% discount, © at 10% premium X ltd issues 50000 8% debentures at par the tax rate applicable to the company is 50% Yltd issues 50000 8% debentures at a premium of 10% the tax rate applicable to the company is 60% Altd issues 50000 8% debentures at a discount of 5% the tax rate applicable to the company is 50% Bltd issues 100000 9% debentures at a premium of 10% the floatation costs are 2% the tax rate applicable to the company is 60% Example of Cost of Irredeemable Debt X Ltd. issues 40,000, 8% debentures of Rs 100each and incurred the following expenditure : Underwriting Commission 2% of issue price Brokerage 0.5% of issue price Printing and other expense Rs 20,000Calculate cost of Debt assuming debt is issued At 10% premium At 10% discount Tax rate is 40% Cost of Redeemable Debt Before tax :- Kd = I + ( RV-NP) /n _____________ ½(RV+ NP) RV: Redeemable value NP: Net proceeds N: Net proceeds I: Interest After tax :-Kda = kd X (1-t) Example of Redeemable debt A company issues Rs 5,00,000 , 10%redeemable debentures redeemable at par after 5 years .The cost of Floatation amount to 4% of face value. Tax rate is 35% You are required to calculate before tax and after tax cost of debt if debentures are issued at par, at a discount of 10%, at a premium of 5% Example A company issues 20,000, 7%debentures of Rs. 100 each at a discount of 2% t be redeemed after 10years at a premium of 5% .The cost of floatation amount to Rs 50,000..Calculate cost of debt assuming tax rate at 40% Cost of Preference Share Capital Irredeemable Preference share Redeemable Preference share Kp=D/NP D = Dividend Redeemable Preference share Formula of computing:-Kpr = D+ (MV-NP)/ n --------------------½ ( MV + NP ) where:-Kpr= cost of redeemable preference Share D = Dividend MV = Market value n = no of years Example of preference share A company issues 10,000, 10%preference share of Rs 100 each. Cost of issue is Rs 2 per share. Calculate cost of preference capital if these are issued at par, at a premium of 10 % , at a discount of 5% A company issues 10,000 , 10%preference share of Rs 100 each redeemable after 10 years at a premium of 5%. The cost of issue is Rs2 per share. Calculate the cost of preference capital. Cost of Equity share capital The cost is difficult to measure, as therate of return fluctuates every year Its not legally binded to pay dividend to equity share holder. As the future earning and dividend are expected to grow overtime. Cost of Equity Share Capital Formula of computing Cost of Equity Ke=D/MP +G where:ke=cost of equity D=Dividend Per share MP=Market Price X Ltd pays a dividend of Rs 12 per share initially and the growth in dividend is expected to be 5 % . Compute the cost of equity share if the current market price of anequity share is Rs 150. Cost of Retained Earnings Kr=Ke (1-t)(1-B) Ke: cost of retianed earnings T:tax rate of shareholders B:brokerage or commission The A company has net earnings of Rs100lakhs and all of its shareholders are in 40% tax bracket. The mgt estim,ates the under present conditions stock holders required rate of return is 10%. The brokerage @3% is paid on investment compute the cost of retained earnings..10(.6)(.97)=5.8% The Weighted Average Cost of Capital The weighted cost of capital is just the weighted average cost of all of the financing sources Example Equity shares 200000 share 4000000 7% Preference shares 10,00,000 8% Debentures 30,00,000 ___________ 80,00,000 The company sells equity shares at 20 and it will pay dividend of 2 per share which will grow at 7% for ever Tax rate 50%compute weighted average cost of captial Compute new weighted average cost of capital if company raises additional debentures at 9% 2000000 This would result in increasing equity divided to 3 per share and growth rate unchanged price of share will fall to 15 per share