Well! Capital like any other factor of production involves a cost. The cost of capital is an important element in capital expenditure management. The cost of capital of a company is the average cost of various components of capital of all long term sources of finance. Understanding the concept of the Cost of capital is very helpful in making investment and financing decision. For e.g. if a company is in need of Rs.30 crore, cost of capital will be the major factor determining whether the same should be financed by debt or equity capital.
There are three types of capital costs, namely, (i) Cost of Debt, (ii) Cost of preferred Shares and (iii) Cost of Equity.
Cost of Debt
The debt capital can be broadly classified as Perpetual Debt Capital or redeemable debt capital. The cost of perpetual debt capital (Kdp) is calculated by
Kdp= (1 tx)
SV
I
Where
I= Annual Interest Rate
SV= Sales proceed of the bond/debenture
tx = tax rate
Kdp is the tax adjusted cost of capital (i.e. the cost of debt is on after tax basis). To calculate before tax cost of debt (1-tx) will not be considered. The cost of debt is generally the lowest among all sources partly because the risk involved is low but mainly because interest paid on debt is tax deductible.
Cost of Preference Shares
The preference capital can be broadly classified as perpetual preference capital or redeemable preference capital. The cost of perpetual preference capital (Kpsp) is calculated by
Kpsp=
(1 )
(1 )
p f
d tx
Where
d = constant annual dividend
p = expected sale price of preference share
f = floatation cost
tx = Tax on preference dividend
Kpsp is the tax adjusted cost of preference capital. To calculate before tax cost of preference capital (1+tx) will not be considered. It may be noted that while assessing tax liability, the preference dividend paid to the preference shareholders is not allowed as a deductible item of expense.
Cost of Equity
There are two approaches to compute cost of equity capital: (1) Dividend growth Model approach which is discussed in this section and (2) Capital Asset Pricing Model which is discussed in section 2.1.3.
Dividend growth Model approach: Dividend growth Model approach assumes that the price of equity stock depends ultimately on the dividend expected from it.
Dividend Growth Model:
Ke = g
P
D
e
Where
Ke = Cost of Equity Capital
D = Dividend
g = rate at which dividends are expected to grow
Pe = Price of equity shares
Example-1:
Stock price of XYZ Ltd. is trading at Rs. 66. The firm is expected to declare dividend of Rs. 7 per share and is expected to grow at rate of 10 per cent per year. What is the cost of equity under dividend growth model?
31
Ke = g
P
D
e
Ke = (7/66) + .10
= .10606 +.10
= .20606 x 100 = 20.61%
The Weighted Average Cost of Capital
The weighted average cost of capital is the weighted average of the after-tax cost s of each of the sources of capital used by a firm to finance a project where the weights reflect the proportion of total financing raised from each source.
Kwacc = Wd Kd (1- Tc) + Wps Kps + We Ke
W = Weight
Kd = cost of Debt Capital
Kps = Cost of Preference Share Capital
Ke = Cost of Equity capital
Example-2:
What is the average cost of capital of XYZ Ltd.?, if the cost of capital from each source such as debt, preferred stock and equity is 7%, 16% and 23% respectively and being financed with 40% from the debt, 10% from the preferred stock and 50% from the equity.
Kwacc = 40% *7% + 10%*16% + 50%*23% = 15.9%
Information collected from www.nseindia.com
Answered by
Kumaar
, an ibibo Master,
at
5:43 PM on October 20, 2008
