Cost of Capital

Cost = Investor’s Exception or Return to Investor’s

Return is expressed in percentages and on per annum basis

Return = Income

Amount Invested

Effective Return = Realised Income + Unrealised Income

Net Amount Invested

Realised Income = Dividend

Unrealised Income = Market Price (MP) – Amount Invested

(MP – Amount Invested) is Capital Appreciated or Depreciated

Cost of Debentures (Kd)

Debentures

Redeemable Debentures Irredeemable Debentures

The cost of the debentures which are The cost of the debentures which are
redeemed by the issuer after expiry of not redeemed by the issuer of debenture
specified period [i.e. the period and [i.e. Cost of debentures not redeemable
redeemable amount is known in advance]. during the life time of the company].

Redeemable Debentures

Cost = Investor’s Exception or Return to Investor’s

Return = Realised Income + (Redeemable Value – Amount Invested)

No. of Years (i.e. Life of Debentures)

Average Fund

Average Fund = Amount Invested + Redeemable Value

2
 Realised Income = Interest

Effective Return = Interest After Tax + (Redeemable Value – Amount Invested)

No. of Years (i.e. Life of Debentures)

Average Fund

Note: It is assumed that the appreciation for each year is uniform

Benefit of tax shield: The payment of interest to the debenture holders are allowed as
expenses for the purpose of corporate tax determination. Hence, interest paid to the
debenture holders save the tax liability of the company. Saving in the tax liability is also known
as tax shield. The example given below will show you how interest paid by a company reduces
the tax liability:

Example: There are two companies namely X Ltd. and Y Ltd. The capital of the X Ltd is fully
financed by the shareholders whereas Y Ltd uses debt fund as well. The below is the
profitability statement of both the companies:

X Ltd Y Ltd
(` in Lakhs) (` in Lakhs)
Earnings before interest and taxes (EBIT) 100
100

Interest paid to debenture holders - (40)

Profit Before Tax (PBT) 100 60

Tax @40%
(40) 24

Profit After Tax (PAT) 60 36

A comparison of the two companies shows that an interest payment of 40 by the Y Ltd. results

in a tax shield (tax saving) of `14 lakh ( `40 lakh paid as interest × 35% tax rate). Therefore the

effective interest is ` 26 lakh only.

Irredeemable Debentures

Cost = Realised Income

 Amount Invested

Here appreciation and depreciation not considered because of uncertainty of redemption.

Effective Cost = Interest After Tax

Amount Invested

Expenses on Issue of Debenture

The expenses on issue of debentures will be adjusted from the amount invested by
the investor. The effective return will be based on the net amount invested.

Preference Shares

Redeemable Preference Shares Irredeemable Preference Shares

Cost of Redeemable Preference Shares (Kp)

Cost = Return

Return = Realised Income + Capital Appreciation / Depreciation

No. of years

Average Capital

= Dividend + ( Redeemable Value – Amount Invested )

No of Years

Average Capital

* Dividend Distribution Tax (Paid by the company) is ignored

* Capital Appreciation / Depreciation is uniform throughout the year

Cost of Irredeemable Preference Shares (Kp)

Cost = Divinded

Amount Invested
 Cost of Equity

Yield Approach Dividend Approach EPS Approach Risk Approach

Normal Approach Growth Approach

Amount invested in equity shares = Market Price because share are traded

Dividend is calculated on Face Value of Shares

Yield Approach

Return = Realised Income + Capital Appreciation / Depreciation

Amount Invested

= Dividend +( Mp now - Mp Investment )

Mp Investment

Dividend Approach

o Normal Approach

Return = Dividend Per Share

Market Price Per Share
o Growth Approach

Return = Dividend Per Share  Growth

Market Price Per Share
EPS Approach

EPS and DPS are different. Earning to Equity Shareholders

o Retained Earnings
+
o Dividend Distributed

Return = Dividend + Retained Earnings

Market Price

= EPS

Market Price per share

Risk Approach

Under risk approach the risk aspect of investment in equity shares also considered. Here
risk is change in security return due to change in market return

3 types of investors in a market

o Aggressive = High Risk

o Moderate = Parity
o Conservative = Risk Free

While investing equity shares investors will have two objectives

o To achieve risk free rate

o To achieve market rate - So there is risk involved

Cost = Risk Free Rate + Risk Adjusted Rate

= Risk Free Rate + Risk Premium

= Risk Free Rate + Risk (Market Rate – Risk Free Rate)

Risk = β (Change in security return due to change in market return )

Cost = Risk Free Rate + β (Market Rate – Risk Free Rate)

This approach is also called Equity Pricing Model or Capital Asset Pricing Model