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Formulas of Cost of Capital

Cost of Debt Capital

Debt is of Two types - Irredeemable Debt and Redeemable Debt.where Irredeemable Debt also know as perpetual is the debt which is not to be repaid and Redeemable Debt is the debt which is to be repaid after a certain period of time. Interest on debt is tax deductible, so the cost of debt is calculated on an after-tax basis. Interest is paid on the face value of debt, so the cost of debt is calculated on the basis of face value of debt.

Abbreviations

\(k_{db}\) = Cost of Debt before tax,

\(k_{da}\) = Cost of Debt after tax,

\(I\) = Annual Interest,

\(P\) = Market Price of Debt,

\(NP\) = Net Proceeds,

\(RV\) = Redemption Value,

\(n\) = Number of Years to Maturity,

\(t\) = Tax Rate.

Irredeemable Debt

  • Before Tax:

    • \(k_{db} = \frac{I}{P}\)
    • \(k_{db} = \frac{I}{NP}\)

  • After Tax:

    • \(k_{da} = \frac{I(1-t)}{NP}\)

Redeemable Debt

  • Before Tax:

    • \(k_{db} = \frac{I + \frac{1}{n}(RV - NP)}{\frac{1}{2}(RV + NP)}\)

  • After Tax:

    • \(k_{da} = \frac{I(1-t) + \frac{1}{n}(RV - NP)}{\frac{1}{2}(RV + NP)}\)

Cost of Preference Share Capital

Preference shares are of Two types - Irredeemable Preference Shares and Redeemable Preference Shares. Preference shareholders have a priority claim on dividends before ordinary shareholders but after debt-holders. They are also subject to certain risks. Preference shareholders are entitled to a fixed dividend, so the cost of preference share capital is calculated on the basis of fixed dividend.

Abbreviations

\(k_{p}\) = Cost of Preference Share Capital,

\(D\) = Annual Dividend,

\(P\) = Market Price of Preference Share,

\(NP\) = Net Proceeds,

\(RV\) = Redemption Value,

\(n\) = Number of Years to Maturity.

  • Irredeemable Preference Shares:

    • \(k_{p} = \frac{D}{P}\)
    • \(k_{p} = \frac{D}{NP}\)

  • Redeemable Preference Shares:

    • \(k_{p} = \frac{D + \frac{1}{n}(RV - NP)}{\frac{1}{2}(RV + NP)}\)

Cost of Equity Capital

Ordinary shareholders' required rate of return depends on their investment opportunities in the financial markets. They are the residual owners of the firm and bear the highest risk. Equity shareholders are entitled to a variable dividend, so the cost of equity capital is calculated on the basis of Expected Annual Dividend and Market Price of Equity Share.

Abbreviations

\(k_{e}\) = Cost of Equity Capital,

\(D\) = Expected Annual Dividend,

\(NP\) = Net Proceeds,

\(MP\) = Market Price of Equity Share,

\(EPS\) = Earning Per Share,

\(G%\) = Growth Rate.

  • Dividend Yield Method / Dividend Price Method / Price Ratio Method:

    • \(k_{e} = \frac{D}{NP}\)
    • \(k_{e} = \frac{D}{MP}\)

  • with Growth:

    • \(k_{e} = \frac{D}{NP}+G%\)
    • \(k_{e} = \frac{D}{MP}+G%\)

  • Earning Price Ratio / Earned Yield Method:

    • \(k_{e} = \frac{EPS}{NP}\)
    • \(k_{e} = \frac{EPS}{MP}\)

Net Proceeds

Net Proceeds = Total Proceeds + Premium issued - Discount issued - Underwriting Commission - Brokerage - Other Expenses

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