Computation of Specific Cost of Capital

Principle & Practice of Management

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Computation of Specific Cost of Capital

Specific Capital Cost Computation

The financial manager has to compute the specific cost of each type of funds needed in the capitalisation of a company. The company may resort to different financial sources (equity share, preference share, debentures, retained earning public deposits; or it may prefer internal source (retained earnings) or external source (equity, preference and public deposits). Generally, the component cost of a specific source of capital is equal to the investors’ required rate of returns. Investors required a rate of returns are interesting, discount on debt, dividend, capital appreciation, earnings per share on equity shareholders, dividend and share of profit on preference shareholders funds. But investors’ required rate of returns should be adjusted for taxes in practice for calculating the cost of a specific source of capital, to the firm. [ Capital Cost Computation ]
Capital Cost Computation
Compensation of specific source of finance, viz., equity, preference shares, debentures, retained earnings, public deposits is discussed below:

Cost of Equity

Firms may obtain equity capital in two ways (a) retention of earnings and (b) issue of additional equity shares to the public. The cost of equity or the returns required by the equity shareholders is the same in both the cases, since in both cases, the shareholders are providing funds to the firm for financing their investment proposals. Retention of earnings involves an opportunity cost. The shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable risk to earn returns. So, irrespective of whether a firm raises equity finance by retaining earnings or issue of additional equity shares, the cost of equity is same. But the issue of additional equity shares to the public involves a floatation cost whereas, there is no floatation cost for retained earnings. Hence, the issue of additional equity shares to the public for raising equity finance involves a bigger cost when compared to the retained earnings. [ Capital Cost Computation ]
In the following cost of equity is computed in both sources point of view (i.e., retained earnings and issue of equity shares to the public).

Cost of Retained Earnings (Kre)

Retained earnings are one of the internal sources to raise equity finance. Retained earnings are those part of (amount) earnings that are retained by the form of investing in capital budgeting proposals instead of paying them as dividends to shareholders. Corporate executives and some analysts too normally consider retained earnings as cost-free, because there is nothing legally binding the firm to pay dividends to equity shareholders and the company has its own entity different from its stockholders. But it is not so. They involve the opportunity cost. The opportunity cost of retained earning is the rate of return the shareholder forgoes by not putting his/her funds elsewhere because the management has retained the funds. The opportunity cost can be well computed with the following formula. [ Capital Cost Computation ]


Ke = Cost of equity capital [D ÷ P or E/P + g].
Ti = Marginal tax rate applicable to the individuals concerned.
Tb = Cost of purchase of new securities/broker.
D = Expected dividend per share.
NP = Net proceeds of equity share/market price.
g = Growth rate in (%).

Cost of Issue of Equity Shares (Ke)

Calculation of cost of equity (Ke) capital cost brings forth, a host of problems. It is the most difficult and controversial cost to measure because there is no one common basis for computation. For calculation of the cost of debt (Kd), the interest charge is the base and preference dividend is the base for calculation of the cost of preference shares (Kp). Interest on debentures/debt and dividend on preference shares are fixed in terms of the stipulations following the issue of such debentures and shares. In contrast, the return on equity shareholders solely depends upon the discretion of the company management. Apart from this, there is no stipulation for payment of dividend to equity shareholders. They are ranked at the bottom as claimants on the assets of the company at the time of liquidation. Though it is quite evident from the above discussion that, equity capital does not carry any cost. However, this is not true, equity capital has some cost. [ Capital Cost Computation ]
The cost of equity capital (Ke), may be defined as the minimum rate of returns 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. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid the dividend at a fixed rate every year.

Cost of Capital under Variable Growth Rate

The computation cost of equity after a specific period is based on the estimation of growth rate in dividends of a company.
Expected growth rate will be calculated based on the past trend in the dividend. It may not be unreasonable to project the trend into the future, based on the past trend. The financial manager must estimate the internal growth rate in dividends on the basis of long-range plans of the company. Expected growth rate in the internal context requires being adjusted. The compound growth rate in dividends can be computed with the following formula.
gr = Do (1 + r)n = Dn
gr = Growth rate in dividends.
Do = First year dividend payment.
(1 + r)n = Present value factor for ‘nth’ year.
Dn = Last year dividend payment.

Cost of Preference Shares

The preference share is issued by companies to raise funds from investors. Preference share has two preferential rights over equity shares, (i) preference in payment of dividend, from distributable profits, (ii) preference in the payment of capital at the time of liquidation of the company.
Computation of cost of preference share capital has some conceptual difficulty. Payment of the dividend is not legally binding on the company and even if dividends are paid, they are not a charge on earnings, they are distributed from distributable profits. This may create an idea that preference share capital is cost free, which is not true.
The cost of preference share capital is a function of the dividend expected by the investors. Generally, preference share capital is issued with an intention (a fixed rate) to pay dividends. In case dividends are not paid, it will affect the firm’s fundraising capacity. For this reason, dividends on preference share capital should be paid regularly except when the firm does not make profits.
There are different types of preference shares, cumulative and non-cumulative, redeemable and irredeemable, participating and non-participating, and convertible and non-convertible. But computation of cost of preference share will be only for redeemable and irredeemable.[ Capital Cost Computation ]

Cost of Irredeemable Preference Share/Perpetual Preference Share

The share that cannot be paid till the liquidation of the company is known as irredeemable preference share. The cost is
measured by the following formula:
K (without tax) = D/CMP or NP
Kp = Cost of preference share.
D = Dividend per share.
CMP = Market price per share.
NP = Net proceeds.
Cost of irredeemable preference stock (with dividend tax)
K ( with tax) =D( 1 + Dt)/CMP or NP
Dt = tax on preference dividend

Cost of Debentures/Debt/Public Deposits

Companies may raise debt capital through the issue of debentures or loan from financial institutions or deposits from the public. All these resources involve a specific rate of interest. The interest paid on these sources of funds is a charge on the profit & loss account of the company. In other words, interest payments made by the firm on debt issue qualify tax deduction in determining net taxable income. Computation of cost of debenture or debt is relatively easy because the interest rate that is payable on debt is fixed by the agreement between the firm and the creditors. Computation of cost of debenture or debt capital depends on their nature. The debt/debentures can be perpetual or irredeemable and redeemable cost of debt capital is equal to the interest paid on that debt, but from company’s point of view, it will be less than the interest payable when the debt is issued at par, since the interest is tax deductible. Hence, computation of debt is always after tax cost. [ Capital Cost Computation ]