fm csjm 2

1. INSTITUTE OF BUSINESSMANAGEMENT
C.S.J.M. UNIVERSITY, KANPUR
GUIDED BY:-
PROF. J.V VAISHAMPAYAN
VICE-CHANCELLOR
SUBMITED BY:-
ABHISHEK AWASTHI
ABHISHEK GUPTA
AKSHAY PANDEY
ASHISH SHUKLA
PRASHANT GUPTA
RAJAT SINGH
VAIBHAV SAXENA
9/4/2016 6:00:44 AM

3. CONTENT
CONCEPT OF COST OF CAPITAL
SIGNIFICANCE OF THE COST OF CAPITAL
CALULATION METHOD OF COST OF CAPITAL
WACC

4. COST OF CAPITAL
 Cost of capital is defined as the minimum
rate of return expected by its investors.
It is like a rate of interests, is also a
percentage rate and not any absolute amount.
It represents the burden on the borrower as a
given percentage of the funds borrowed, usually
on an annual basis.
Cost of capital includes the cost of debt and
the cost of equity

5. CALCULATION OF COST OF
CAPITAL
Cost of a
term Loan
Cost of
Preference
shares
Cost of
Equity
Capital
Debentures
/Bonds
Risk Based
Model of
cost of
capital
Retained
Earnings

6. SIGNIFICANCE OF THE COST OF
CAPITAL
Helpful in designing the capital structure
Helpful in taking capital budgeting decisions
Helpful in evaluation of financial effciency of top
management
Helpful in making other financial decision such
as-
Dividend policy
Right issue
Working capital Decisions

7. COST OF A TERM LOAN
• It is the simplest form of borrowing, where a
borrower contacts a lender, asks for a rate of
interest which is demanded by the lender and
agrees to pay it.
Kd= Interest Amount * 100
Loan Amount
• After tax cost= Before Tax cost*(1-t) t= tax rate

8. EXAMPLE,
COST OF A TERM LOAN
A firm has borrowed a sum of Rs.5lacs and agrees to
pay 8% i.e. Rs40,000 as interest amount every year.
The cost of capital is..
Kd= 40,000 * 100
5,00,000
= 8%
After tax cost=8*(1-0.4)=8*0.6=4.8%

9. COST OF CAPITAL OF
DEBENTURES/BONDS
Kd= I(1-t) + (F + D + Pr – Pi)/N
(S+R)/2
I= Annual interest amount
T= Tax rate
F= Floatation cost(Issue expenses)
D= Discount on Issue
Pr= Premium on redemption
Pi= Premium on issue
N= tenure of debentures
S= Net sale amount
R= Net redemption amount

10. EXAMPLE, COST OF CAPITAL OF
DEBENTURES/BONDS
QUESTION:- Issue dentures=500 @ Rs1,000 each coupon rate=12%
Tenure of debenture=5years
Premium of redemption=5%, issue
expenses=Rs20,000 Discount=Rs20 on the face value tax rate=40%
SOL:- Issue Price = Rs1,000 , Annual Interest=Rs120
Issue expenses 20,000/500 = Rs40
Discount on issue=Rs20,
PREMIUM on redemption 5%of1,000=Rs50
Net sale amount 1,000-(40+20) = Rs940
Net redemption amount = Rs1,050
Kd= 120(1-0.4) + (40+ 20 + 50)/5
(940+1050)/2
=9.447%

11. COST OF PREFERENCE SHARES
The preference share capital is different from
debentures capital on account of basic features :
1)the preference shares are entitled to receive
dividends at a fixed rate in priority over equity
shares.
2)in case of liquidation of the company ,the
preference shareholders will get the capital
repayment in priority over the distribution among
the equity share holders.
It is denoted by Kp.
Kp= Dividend + (F + D + Pr – Pi)/N
(S+R)/2

12. EXAMPLE,
COST OF PREFERENCE SHARES
Issue Preference share=Rs1,00,000 Face value=Rs100
with coupon rate=14%, Issue of Premium=3%, Issue
expenses =5% of issue size N=8years
Div= 14*100000/100=14,000
Pr=5*100000/100=5,000 Pi=3*100000/100=3,000
Kp= 14,000 + (5,000-3,000)/8
(98,000+1,00,000)/2
= 0.14394*100
= 14.39%

13. COST OF EQUITY CAPITAL
Cost of equity is more challenging to estimate than
the cost of debt or the cost of preferred stock
because common stockholder’s rate of return is not
fixed as there is no stated coupon rate or dividend.
Furthermore, the costs will vary for two sources of
equity (i.e. retained earnings and new issue).
There is no flotation costs on retained earnings but
the firm incurs costs when it sells new common
stock.

14. COST ESTIMATION TECHNIQUES
Two commonly used methods for
estimating common stockholder’s
required rate of return are:
The Dividend Growth Model
The Capital Asset Pricing Model

15. THE DIVIDEND GROWTH MODEL
• It can be said that the minimum total return
expected by an equity investor is the cost of equity
in the company:
• D1 = Dividend per share for the coming year
• Pcs = Present market price
• g = growth rate of dividend

16. EXAMPLE,
THE DIVIDEND GROWTH MODEL
QUE- A company issue equity share of face value of Rs10
each @ premium ofRs40.The rate of dividend next year
is expected to be 30% and in future this dividend is
expected to grow @ rate of 10%per annum.
SOLUTION- D=Rs3, The price of the share(Pcs )=10+40=50
g=0.10
The cost of capital will be:-
Kcs = D1/Pcs + g
= 3/50 +0.10
= 0.06 +0.10=0.16

17. THE CAPITAL ASSET PRICING
MODEL
• CAPM is a tool to find out the required rate of
return on an investment, depending upon the risk
free rate of interest and the risk of the stock
involved.
rf = Risk Free rate
= Beta it represent the relative riskiness of a
particular stock
rm = Market rate of return

18. THE CAPITAL ASSET PRICING
MODEL
Example: If beta is 1.25, risk-free rate is
1.5% and expected return on market is 10%
kc = rrf + (rm – rf)
= .015 + 1.25(.10 – .015)
= 12.125%

19. COST OF RETAINED EARNINGS
In accounting, retained earnings
refers to the portion of net income
which is retained by the corporation
rather than distributed to its owners
as dividends.
Retained earnings are not a free
source of capital. There is an
opportunity cost.

20. WEIGHTED AVERAGE COST OF
CAPITAL
This gives us the overall cost of capital. Weight age
is given to the cost of each source of funds by
assessing the relative proportion of each source of
fund to the total, and is ascertained by using the
book value or the market value of each type of
capital.
A calculation of a firm's cost of capital in which each
category of capital is proportionately weighted.
If the cost of capital of individual source is high, but
its share in the total is low, it will have little impact
on the total and vice-versa

21. STEPS IN CALCULATION OF
WACC
Assigning weights to specific costs.
Multiplying the cost of each sources by the
appropriate weights.
Dividing the total weighted cost by the total
weights.

22. QUE- A company is planning an investment of Rs10,00,000 in a project. Tax rate=40%
EXAMPLE OF WACC
NO. PARTICULARS AMOUNT(RS.)
(1) Term loan of 5years from SBI@13% 2,00,000
(2) Issue of 4000 Non-convertible debentures of
Rs.100 each at a coupon rate 12%.The issue
expenses are Rs.20,000. The NCDs are to be
redeemed at 5% premium after 5years
4,00,000
(3) 100 Prepetual Preference shares of the face
value=Rs1,000 with dividend rate=14%.Issue
expenses=Rs4,000
1,00,000
(4) Issue 5,000 equity share of Rs10each
@premium Rs40.The dividend rate in the
coming year is rs5/share but expected to
grow at 8%per annum
2,50,000
(5) Retained EArnings 50,0000
TOTAL 10,00,000

23. 1. Term Loan
kf = 26,000*(1-0.4) = 7.8%
2,00,000
2. NCDs
Kd = 12(1-0.4)+(5+5)/5 = 9.2%
( 95+105)/2
3. Prepetual Preference shares
Kp = 14/196 = 14.58%
4. Equity Shares
Ke = 5/50 + 0.8 =18.00%
5. Retained Earnings = 18.00%

24. The weighted of each source is as follows-
Term Loan 2,00,000/10,00,000 = 0.20
NCDs 4,00,000/10,00,000 = 0.40
Perpetual preference shares 100000/1000000 = 0.10
Equity shares 2,50,000/10,00,000 = 0.25
Retained Earnings 50,000/10,00,000 = 0.05
TOTAL = 1.00

25. SOURCE COST OF CAPITAL WEIGHTAGE
CAPITAL%
WEIGHTAGE COST
%
Term Loan 7.80 0.20 1.56
NCDs 9.20 0.40 3.68
Preference Shares 14.98 0.10 1.46
Equity Capital 18.00 0.25 4.50
Retained Earnings 18.00 0.05 0.90
TOTAL 12.10
IF we use IRR method, Then the WACC calculated above,
should be compared with the IRR of the project.
If IRR< this rate, its show the cost is higher than the return
and project is nit acceptable and vice-versa.