SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.

S [All Levels] Page 1 of 13

11th 12th (Eng. Med)

F.Y S.Y. T.Y. B.COM
C.A. & C.S (All levels)
31-32 JashRaj Complex , Besides Crystal School , Near Parivar Char Rasta , W.rd M : 82384 48020

E-107, Vrundavan Township, Harni Road, Near Sangam, Vadodara. M : 99989 84152, 82384 48020

T.Y.B.Com [ Sem 5 ] -: Financial Management [F. M.] :- Unit 4

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(Chapter-1). COST OF CAPITAL

# INTRODUCTION :-
:- A business firm can raise capital from various sources
such as Equity Shares, Preference Shares, Debentures and retained earning etc.
:- This capital is invested in different projects of the firm for generating revenue.
:- On the other hand, its is necessary for a firm to pay a minimum rate of return on each source of Capital,
therefore each project must earn so much of the income that a minimum return can be paid
to its suppliers of capital.
:- What should be this minimum return? The concept used to determine
this minimum return is called cost of capital.

[Topic – 1]. Give the Meaning and Importance of Cost Of Capital.

# Meaning :-
:- The cost of capital refers to the minimum rate of return a firm must earn on its investment (i.e., Assets)
in order to maintain the present market value of shares.
:- Cost of capital is the Weighted Average Cost of Capital of various sources of funds used by the firm.
# Importance of Cost Of Capital :-
:- The concept of cost of capital is very much important in the financial management.
:- It is important from the point of view of both, capital budgeting and capital structure planning decision.
:- The basic reason behind running a business undertaking is to earn a return at least equal to its cost of
capital.
:- Therefore, cost of capital constitutes an important factor in various business decisions.
:- For example, in analyzing financial implications of capital expenditure proposals, cost of capital may be
taken as the discounting rate.
:- Obviously, if a particular project gives an internal rate of return higher than its cost of capital, it should
be accepted.
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[Topic – 2]. Explain the relationship between Cost of capital and Risk.
:- The cost of capital has a direct relation with the risk involved in the firm.
:- Generally, higher the risk higher the cost of capital and lower the risk lower the cost of capital.
:- In case of Government securities for example, investment in NSC, the rate of return is fixed and assured,
so there is less risk and therefore less cost of capital. In contrast to this, in case of investment in
equity shares of any company, the rate of return is not fixed and assured, so there is more risk and
therefore, its cost of capital is also very high.
# There are two types of risk involved in investment in company or a firm : one is business risk or
operating risk and another is financial risk.
:- Business risk or operating risk is the risk for variability in EBIT due to variability in sales, or variability in
fixed cost or variability in variable cost of the firm.
:- If business risk is high, the cost of capital will also high.
:- This is determined by capital budgeted decision.
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 SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.S [All Levels] Page 2 of 13
:- Financial risk is the due to use of debt in the capital structure of a firm.
:- If proportion of debt is higher than equity in capital structure, the firm is more risky.
:- The risk arises because of payment of interest and principal amount on maturity.
:- If debt is high, a firm principal amount on maturity.
:- If operating profit is not sufficient for debt service, the possibility of cash insolvency exists in case of
such firm.
:- As a result, the investor will except a higher rate of return and therefore, the cost of capital will increase.
# The cost of capital comprises of Three important components :
1) Expected normal rate of return at Zero Risk Level : ro
2) The premium for business risk or operating risk : b
3) The premium for financial risk : f
Cost of Capital : ro + b + f
:- The cost of capital is also an important consideration in capital structure planning decision.
:- While raising funds from different sources of funds for financing the assets, the finance manager must
keep in mind of minimizing the risk and cost of capital and maximise the value of firm and wealth of
the shareholders.
:- By employing more debt in the capital structure of a firm, it will not only increase EPS and wealth of the
shareholders, but at the same time, it will also increase the risk and cost of capital of the firm, so a
finance manager should try to design the optimal capital from various sources is very essential in
planning the capital structure of the firm.
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[Topic – 3]. Explain the Classification of Cost of Capital.

# Historical Costs and Future Cost :-

:- Historical costs are books costs, which are already incurred for financing a particular project.
:- They are related with the past.
:- Future costs are the expected cost for financing a particular project.
:- They are related with financial decisions.
:- In capital budgeting decisions, relevant costs are future costs and not historical costs.
# Explicit Costs and Implicit Cost :-
:- Explicit cost is the discount rate that equates the present value of cash inflows and present value of cash
outflows (PVCI = PVCO).
:- These outflows may be interest payment, repayment of principal amount or dividend etc.
:- Explicit cost is the Internal Rate of Return the firm pays for financing.
:- Implicit cost is the opportunity cost.
:- If the earnings are retained by the company, the opportunity is lost by the shareholders for investing it in
another better alternative for earning higher income.
:- The opportunity foregone by the shareholders is called implicit cost.
# Specific Cost and Composite Cost :-
:- Specific Cost is the individual cost of each source of the fund i.e., cost of equity share (Ke), cost of
preference share (Kp), cost of debenture (Kd), cost of long – term loan (Kd) etc.
:- Composite cost of combined cost is total of all cost of different sources of finance.
:- In capital budgeting decision, the composite cost of capital is taken as basis for accepting or rejecting the
proposal.
:- This is because; it is overall misc. of financing over time, which is important in valuing the firm as an
ongoing overall entity.
# Average Cost and Marginal Cost :-
:- Average cost means Weighted Average Cost of various sources of funds used by the firm.
:- The weights are in proportion of the share of each source of funds in total funds of capital structure.
:- Marginal cost is additional cost for obtaining additional fund.
:- In capital budgeting decisions, it should be the marginal cost which should be taken into consideration.
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 SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.S [All Levels] Page 3 of 13
:- While in capital structure decision, the weighted average cost of capital should be taken into
consideration.
LIST OF FORMULAS

(I) COST OF DEBT (DEBENTURES) (Kd) :-

(A) Cost of Irredeemable Debt (Debentures/Bonds) issued at Par, M = 82384 48020 , 99989 84152
Premium or Discount Cost of Debt After Tax Karelibaug Waghodia Road
𝐼
Kd = {𝑁𝑃 𝑋 100}(1-t)
Where,
Kd = Cost of Debt NP = Net proceeds realized on Issue of Debt
I = Annual Interest payment t = Tax Rate
(B) Cost of Redeemable (Debentures/Bonds) issued at Par, Premium or Discount Cost of Debt after Tax
𝐼(1−𝑡)+(𝑅𝑉−𝑁𝑃)/𝑛
Kd = x 100
(𝑅𝑉+𝑁𝑃)/2
Where,
• NP = Net Proceeds • r = rate of interest • n = Number of Years
• t = Tax Rate percentage • I = Interest • RV = Redemption Value
(II) COST OF PREFERENCE SHARE CAPITAL (KP) :-
(A) Cost of Irredeemable Preference share
𝑃𝐷
Kp= 𝑁𝑃 x 100
Where,
• Kd = Cost of preference capital • PD = Annual preference dividend
• NP = Net proceeds of issue of Pref. shares
(B) Cost of Redeemable preference share
𝑃𝐷+(𝑅𝑉−𝑁𝑃)/𝑛
Kp = x 100
(𝑅𝑉+𝑁𝑃)/2
Where
• RV = Redemption value of Preference shares • n = Life of Preference Shares
(III) COMPUTATION OF COST OF EQUITY : (Ke) :-
Methods of Cost of Equity

(1) Dividend Price Ratio (2) Dividend Price + Growth

Dividend Yield Method

(1) Dividend Price Ratio Method (2) Dividend Price + Growth Method
New issue of Eq. Share Existing Equity Share New Issue of Existing Eq. Share
at Market Price Eq. Share at Market Price
𝐷𝑃𝑆 𝐷𝑃𝑆 𝐷𝑃𝑆 𝐷𝑃𝑆
Ke = 𝑁𝑃𝑆 x 100 Ke = 𝑀𝑃𝑆 x 100 Ke = {𝑁𝑃𝑆 𝑥 100} + g Ke = {𝑀𝑃𝑆} + g
DPS = Dividend Per Share NPS = Net Proceeds per share
MPS = Market Price Per Share EPS = Earnings Per share
G = % of growth rate in expected dividend
(IV) COMPUTATION OF COST OF RETAINED EARNINGS : (Kr) : = Ke
M = 82384 48020 , 99989 84152

(METHOD-1) COST OF DEBT Karelibaug Waghodia Road

(A) COST OF IRREDEEMABLE DEBT (DEBENTURES / BONDS) :

:- The cost of debt is the interest paid to be creditors or debentures / bonds holders.in case of
debentures/bonds issued at par, premium or discount.
:- the cost of debt is calculated on the basis net proceeds realized on the issue of such debt.

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 SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.S [All Levels] Page 4 of 13
:- Moreover, since interest payable on debt is treated as expenses while computing the firm’s income for
income tax purpose, the tax is deducted out of the interest payable to find out the effective cost of
capital.
:- So, cost of debt (Kd) is interest cost adjusted for tax and cost of rising the debt.
 EXAMPLES :-
Ex.1) (Col.) A company issues Rs. 1,00,000, 10% Debentures of Rs. 100 each. The company is in 50% tax
bracket. You are required to calculate the cost of debt after tax if debentures are issued at par, or @
premium or @ premium or @ 10 discount. [(i)5%; (ii) 4.55%; (iii) 5.55%]
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Ex. 2) (Col.) A company issues 10% Debentures for Rs. 2,00,000. The rate of tax is 50%. calculate the cost
of debt after tax if debentures are issued @ par, @ 10% premium and 10% discount.
[(i)5%; (ii) 4.55 %; (iii) 5.55%]
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Ex.3) (Col.) A company issues Rs. 1000, 6% Bonds sold at Rs. 950 less 2% under writing commission. The
company is in 30% tax bracket. you are required to calculate the cost of dent after tax. [4.51%]
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Ex. 4) X Ltd. Issued Debentures of Rs. 5,00,000 at par carrying interest rate 14%. The tax rate is 40%.
Calculate cost of capital (debt). [8.4%]
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Ex. 5) A company issue 10% irredeemable debentures of Rs. 1,00,000. The company is in 50% tax bracket.
Calculate the cost of debit if the debenture is issued at par, 10% premium, 10% discount.
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Ex. 6) A company issue 10% irredeemable debentures of Rs. 1,00,000. The company is in 50% tax bracket.
Calculate the cost of debit of the debenture is issued at par, 10% premium, 10% discount.
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Ex. 7) An issue of 15% irredeemable debentures is currently price at Rs. 112 assume the rate of corporate
tax is (a) 10% & (b) 40%. calculate the cost of debt.
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(B) COST OF REDEEMABLE DEBT (DEBENTURES / BONDS) :-
:- While calculating cost of debt, we had assumed that debentures or bonds are irredeemable.
:- A present the debentures or bonds are redeemable after the expiry of fixed period.
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Ex. 8) (Col.) A company issues 10% Debentures of Rs. 1,00,000 10 premiums. The cost of issue is Rs. 20,000
and debentures are redeemable at par after 10 years. What would be the cost of debt after tax.
Assume tax rate 50% [6.31%]
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Ex. 9) (Col.) A company issues 10% debentures of Rs. 2,00,000. The cost of floatation amount to Rs. 30,000.
The debentures are redeemable after 10 years. Calculate the cost of debt after tax if debentures
are issued @ par, A 10% premium and @ 1% discount and redeemable at par. Assume income tax
rate is 50% [(i) 7.03%; (ii) 5.64; (iii) 8.57%]
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Ex. 10) (Col.) A company issued 5,000 12% debentures of Rs. 100 each at 3% discount for 7 years. Calculate
the cost of debenture if company is in 30% tax bracket. [8.96%]
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Ex. 11) B Ltd. Issued 12,000 11% debentures of Rs. 100 each at par and redeemable at 5% premium at the
end of 8th year. Company is in tax bracket of 30%. Calculate cost of debenture. [8.12%]
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Ex. 12) AB Ltd. Issued 20,000 debentures of Rs. 100 each carrying 14% interest at premium of Rs. 2 per
debenture. Debentures issued for 5 years and will be redeemed at par; company is in 40% tax
bracket. [7.92%]
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Ex. 13) X Ltd. Issued 20,000 14% debentures of RS. 100 each redeemable after 10 years. The cost of issue
debenture is Rs. 40,000. calculate the cost of debenture. Tax bracket 40%. [8.69%]
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 SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.S [All Levels] Page 5 of 13
Ex. 14) A Ltd. Raise Rs. 10,00,000 from the bank of Baroda repayable at the end of 9 th year and rate of
interest agreed by 15% p.a. expenses incurred on agreement etc. Rs. 30,000. Calculate the cost of
debt/loan. Tax rate is 40%. [9.47%]
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Ex. 15) BC Ltd. Issued 10% debentures of Rs. 100 each at a discount of Rs. 2 per debenture. The company Is
in 30%tax bracket and debentures are redeemable after 8 years at 1% premium under writer
commission paid Rs. 1 per debenture. Calculate cost of debentures. [7.58%]
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Ex. 16) A firm Issued debenture of Rs. 1,00,000 and realize Rs. 98,000 after allowing 2% commission. The
debenture carry on interest rate of 10% debenture are due maturity at the end of 10 the years.
You are required to calculate effective cost of debt after tax. Tax rate is 50%
(METHOD-2) COST OF PREFERENCE SHARE CAPITAL
:- The cost preference shares is the dividend expected by its shareholders i.e. its stated dividend.
:- The cost of preference shares is the dividend excepted by its share’s holders issued at par,
premium and discount.
:- Its calculation is made on the basis of the net proceeds it realizes, from issue of such shares.
:- Moreover, dividends are not allowed to be deducted in compilation of firm’s taxable income
for income tax purposes.
:- Hence, its cost before tax and after tax remains the same.
:- Since, tax is not deduced from dividend on preference shares, its cost is always more than cost of debt.
(A) COST OF IRREDEEMABLE PREFERENCE SHARES :-
 EXAMPLES :-
Ex. 17) (Col.) A Company issues 10,000 10% Preference shares of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate the cost of preference shares is they are issued at par or at 10% premium or at
5% discount. [(i) 10.20%; (ii) 9.26%; (iii) 10.75%]
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Ex. 18) A Co. issues 10% irredeemable preference shares at Rs. 105 each having face value of Rs. 100.
Company is in 50% tax bracket.
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Ex. 19) A Co. issued 14% irredeemable preference shares of 100 each at par, calculate the cost of
preference share. [14%]
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Ex. 20) B Ltd. Issued 10,000 13% irredeemable preference shares of 100 each at 4% discount. Calculate the
cost of preference share capital. (13.54%)
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Ex. 21) If the cost of preference capital is 13.54% and the face value is Rs. 100 each at 4% discount.
Calculate the dividend percentage on preference capital. (13 %)
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Ex. 22) A An issue 12% preference share value of Rs. 100 has a current share price of Rs. 60. Commute the
cost of preference share of company. (17.65%)
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Ex. 23) In 2018 X Ltd. Sold preference share of Rs. 65 per share X Ltd. Paid yearly dividend of Rs. 7.60 per
share. It received Rs. 62 per share. determine cost of preference share. (12.26%)
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Ex. 24) A company issued 10% irredeemable preference shares Rs. 10,000 of Rs. 10 each. Calculate the
cost of preference capital when they are issued.
i) 10% premium ii) 10% discount [(i) 9.09%; (ii)11.11%]
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(B) PREFERENCE SHARE (DEBENTURES / BONDS) :-
Ex. 25) (Col.) A company issues 10,000, 10% preference shares of Rs. 100 each.
Cost of issue is Rs. 2 per share. Calculate the cost of preference shares.
(A) If they are issued at par and redeemable after 10 years at a par.
(B) If they are issue at par and redeemable after 10 years at 10% premium.

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(C) If they are issued at 10 % premium and redeemable after 10 years at 15% premium.
[(i) 10.30%; (ii) 10.77%; (iii) 9.59%]
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Ex. 26) AB Ltd. Issued 14% preference shares of Rs. 100 each at a discount of Rs. 8 per share redeemable
after 12 years. Calculate the cost of preference capital.
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Ex. 27) A company issued 20,000 3% preference shares capital of Rs. 100 each at a discount of 5.5 and
redeemable after 10 years. Calculate cost of preference share capital. [13.93%]
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Ex. 28) AB Ltd. Issued 30,000 of Rs. 100 preference shares with 10% dividend and redeemable after 10
years. Company issued preference shares at 2% discount and expenses incurred to issue the
preference share is Rs. 45,000. Calculate the cost of preference shares. [10.53%]
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Ex. 29) XY Ltd. raised Rs. 1,00,000 by issuing 10% preference shares of shares of Rs. 10 each. Find out the
cost of preference capital. If company offers preference shares at expenses incurred Rs. 5,000.
redeemable after 5 years (I) At par (II) At 8% premium (III) At 10% Discount.
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Ex. 30) ABC Ltd. Issued 10% preference shares at Rs. 100 each to 3% discount and cost to issue preference
shares Rs. 1 per shares are redeemable after 10 years. calculate cost of capital. Also calculate cost
of preference share capital.
(I) If preference shares redeemed after 14 years.
(II)Preference shares redeemed at 5% discount.
(III) Preference share redeemed at 2% premium. [(I) 10.5%; (II) 10.37%; (III) 10.71%]
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Ex. 31) A company has 10% Rs. 1,00,000 redeemable preference share redeemable at the end of 10 th year,
from the year of the issue the underwriting cost is 2%. Calculate effective cost of preference share
capital. [10.30%]
(METHOD-3) COST OF EQUITY SHARE CAPITAL
:- Some people argue that equity capital does not involve any cost.
:- It is argued that, it is not legally binging on the company to pay dividend to equity shareholders.
:- This is not a correct approach because equity shareholders invest money in shares with the expectation
of getting dividend from the company.
:- The company does not issue shares without having any intention to pay dividend to equity shareholders.
:- So, the company must earn minimum rate of return i.e., expected by the shareholders to maintain the
present market value of equity shares.
:- Thus, the cost of equity capital is defined as “the minimum rate of return that a firm must earn on the
equity finance portion of its investment in project, so that present market value of equity shares
unchanged.
(A) DIVIDEND YIELD METHODS :-
(i) DIVIDEND PRICE (D/P) RATIO METHOD :-
Profit After tax xxxxx
Equity Dividend xxx
Retained earnings xxxxx Rs. 20 EPS
“:- According to this method, the cost of equity is the expected
Rate of dividend per share (DPS) that maintains the present 10 DPS
market value of equity shares. The dividend per share Constant / stable/ Fixed)
(DPS = Dividend / No. of equity shares) is expected to remain
0 0 0 0 0
Constant.
Years
:- It determines the market price per share.
:- DPS does not consider the retained earnings and the growth in dividend It is used in case of stable
earning and stable rate of dividend.

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Ex. 32) (Col.) A Co. issues 1,000 Eq. shares of Rs. 100 each at a premium of 10%. The company has been
paying 20% dividend for last five years and expects to maintain the same in future also. Compute
the cost new Equity Capital. Also calculate the cost of existing equity capital assuming that market
price per share is Rs. 160. [(i) 18.18%; (ii) 12.50 %]
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Ex. 33) (Col.) The current market price of share having face value of Rs. 100 is Rs. 90. Company expects
dividend at the rate 10%.
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Ex. 34) A co. issued 2,00 equity shares of Rs. 100 each and the expected dividend is 15% expenses incurred
to issue equity share at Rs. 1 per share. [15.15%]
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Ex. 35) X Ltd. Issued 50,000 equity shares of Rs. 100 each at 2% discount. Company is about to pay dividend
at the rate 11%. Calculate cost of equity. [11.22%]
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Ex. 36) Y Ltd. Issued 70,000 equity shares of Rs. 100 each at a premium Rs. 5 per share. Company expects
dividend on equity share at the rate 12% [11.43%]
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Ex. 37) AB Ltd. issued 40,000 equity shares at the rate of Rs. 10 per share and expenses incurred @ Rs. 3
per share. Company declares dividend at the constant rate 15% every year. [21.43 %]
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Ex. 38) The current market price of share is Rs. 100. The company expects constant dividend at Rs. 20 per
shares. [20%]
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Ex. 39) The current market price of share having face value of Rs. 100 is Rs. 160. The company excepts
constant dividend at the rate 20%. [12.5%]
(B) DIVIDEND GROWTH RATE METHOD :-
:- According to this method, the cost of equity is the
Expected rate of dividend plus rate of growth in
dividend that maintains the present market value
of equity share.
:- The dividend per share(DPS) is expected to grow at a constant
(DPO = DPS/ EPS). the rate of growth in dividend is
determined on the basis of amount paid by the company
for the last few years.
:- This method is used in case of rise in earnings and rise of
dividend.
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Ex. 40) (Col.) A company plans to issue 1,000 new equity shares of Rs. 100 each at par. The floatation cost
are excepted to 5% of the share price. The company pays a dividend of Rs. 10 per share initially and the
growth in dividend is expected to be 5. compute the cost of new equity capital.
If the current market price of an equity share is Rs. 150, calculate the cost of existing equity capital.
[(i) 15.52 %; (ii) 11.66%]
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Ex. 41) (Col.) A company is considering an expenditure of Rs. 60 lakhs for expanding its operations. The
relevant information is as follows:
Net earnings (EAT) Rs. 90 Lakhs
Number of existing equity shares Rs. 10 Lakhs
Compute the cost of new equity assuming that costs of new issue will be Rs. 10 per share, if the current
market price of and equity shares is Rs. 60, calculate the cost of existing equity capital.
[(i) 18 %; (ii) 15%]
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Ex. 42) (Col.) The market price of equity share is Rs. 25 for a share of Rs. 10. The net expected dividend is at
the rate 20% and the dividend per share is expected to grow at a constant rate of 8%

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Ex. 43) The shares of the company are been currently sold out at Rs. 20 per share. Company is going to pay
dividend for current year Rs. 2 per share and is expected to show a growth of 10%. [20%]
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Ex. 44) The market price of equity shares of XY Ltd. Is Rs. 40 per share. Dividend to be paid at the end of
the coming year is Rs. 4 and is expected to grow at a constant annual rate of 6%. [16%]
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Ex. 45) A co. issued equity share of Rs. 10 each at premium 10%. the company pays 5% as underwriting
commission. Rate of dividend excepted by shareholders in 20%. calculate cost of capital. [19.14%]
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Ex. 46) The current market price of share having face value of Rs. 100 is Rs. 160. The company excepts
constant dividend at the rate 20% [12.5%]
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Ex. 47) A firm expected to take Rs. 12 per share dividend during the coming year. The company’s dividend
and share price have earning growth above 12% per year. This growth is expected to continue.
Current price of equity share is Rs. 100 per share what cost of retain equity earning. [24%]
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Ex. 48) Current market price of an equity share of a company is Rs. 90. The current dividend per share is Rs.
4.5. in case the dividend are expected to grow at the rate of 7%. Calculate the cost of equity
earning. [12%]
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Ex. 49) The market price of Y Ltd. Is Rs. 25 per share. If the dividend is Rs. 2.5 and has been growing at
average rate of 4%. determine cost of equity. [14%]
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Ex. 50) A company is about to pay a dividend of Rs. 1.4 per share and has current share price of Rs. 19.5.
the excepted future growth is dividends is estimated at 12%. find out cost of equity. [19.18%]
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Ex. 51) Uttras Ltd. Is attempting determine the cost of new equity shares. The issue will be made at Rs. 64
per share and the floatation cost Rs. 2.5 per share. The firm expected to pay a dividend on new
issue of Rs. 3 at the first year. find the cost of new equity if the dividend is expected to grow at 4%
[8.88%]
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Ex. 52) (Col.) A co.’s share is quoted in the market at Rs. 20 currently. The company pays a dividend of
Rs. 1 per share and investor excepts a growth rate of 5% per share.
 Compute :-
(1) Company’s cost of equity capital.
(2) If the anticipated growth rate is 6% p.a. calculate the indicated market price per share.
(3) If the company’s cost of capital is 8% and anticipated growth rate is 5% p.a.,
⇨ calculate the indicated market price, if the dividend of Rs. 1 per share is to be maintained.
[(i) 10%; (ii) 25; (iii) 33.33]
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(METHOD-4) COST OF RETAINED EARNINGS
:- It is sometimes argued that retained earnings do not involve any cost because a firm is not required to
pay sometimes on retained earnings.
:- However, the shareholders except a return on retained profits because it is their investment of
accumulated undistributed profits.
:- They accrue to firm is sacrifice made by the shareholders is not receiving the dividends out of the
available profits.
:- Hence, retained earnings forgone by the shareholders by investing it in alternative investment.
:- In other words, retained earnings is the opportunity cost of dividends forgone by the shareholders.
 WEIGHTED AVERAGE COST :-
:- After calculating the cost of each component of capital, the average cost of capital is generally calculated
on the basis of weighted method.
:-This may also be termed as overall cost of capital.

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:- This computation of the weighted average cost of capital involves the following steps:
(1) Calculation of the cost of each specific source of funds :-
:- This involves the determination of the cost of debt, equity capital, preference capital, etc. as explained in
the preceding page.
:-This can be done either on “before tax” basis of “after tax” basis. However, it will be more appropriate to
measure the cost of capital on “after tax basis”.
:- However, it will be more appropriate to measure the cost of capital on “after tax basis”.
:- This is because the return to the shareholders is an important figure in determining the cost of capital
and they can get dividends only after the taxes have been paid.
(2) Assigning weights to specific cost :-
:- This involves determination of the proportion of each source of funds in the total capital structure of the
company.
# This may be done according to any of the following methods:
Book value Weight : Historical Weights
Market value Weight : Current Weights.
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Ex. 52) (Col.) From the following capital structure of a company, calculate the overall cost of capital, using
(a) book value weights and (b) market value weights.
Source Book value Market value
Equity shareholders’ funds (Rs.) 5,00,000 7,25,000
Preference share Capital 3,00,000 3,50,000
Debentures 2,00,000 1,75,000
# The after-tax cost of different cost of different sources of finance is as follows.
• Equity share capital: 15.6%; • Retained earnings: 15%;
• Preference share capital: 10.50%’ • Debentures: 4.5%
• Ratio of Equity share capital and retained earnings is 4: 1
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Ex. 53) From the following capital structure of a company, calculate the overall cost of capital, using
(a) book value weights and (b) market value weights.
Source Book value Market value
Equity share capital (Rs. 10 shares) (Rs.) 45,000 90,000
Retained earning 15,000 -
Preference share Capital 10,000 10,000
Debentures 30,000 30,000
# The after-tax cost of different cost of different sources of finance is as follows.
• Equity share capital: 14%; • Retained earnings: 13%;
• Preference share capital: 10%; • Debentures: 5%
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Ex. 54) The following information extracted from the Balance of XYZ Ltd. As on 31-3-17.
Particulars Rs.
Equity share capital (Share @ Rs. 10) 4,00,000
Reserves and Surplus 1,00,000
10% Redeemable preference share capital (Shares of Rs. 100 each) 2,00,000
12% Debentures 5,00,000
14% Bank loan 4,00,000
The company is in 40% tax bracket. Current level of equity dividend 12% and expected growth rate is 6%.
Calculate weighted average cost of capital if debentures are redeemable after 10 years at 3% discount
and preference share redeemable after 5 years at 5% premium. Market price of equity share is Rs. 18.
[(A) (i) 12.67%; (ii) 10.73%; (iii) 7.01%; (iv) 8.4% (B) (i) 0.25; (ii) 0.125; (iii) 0.3125; (iv) 0.25; (v) 0.625]
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Ex. 55) Calculate the WACC for following capital structure of ABC Ltd. Tax Rate @ 30%.
Particulars Rs.
Equity share capital (Share @ Rs. 100 each) 10,00,000
12% preference share Rs. 100 each 1,80,000
E-107, Vrundavan township, Besides Tasty Restaurant ,Near sangam char rasta, – 82384 48020 , 99989 84152
 SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.S [All Levels] Page 10 of 13
General reserve 80,000
Profit and Loss Account 40,000
13% Debentures 8,00,000
15% Bank loan 7,00,000
Debenture issued for 7 years will be redeemed at 5% premium. Preference share redeemable at 10 Years
at 3% premium. Market price of equity shares Rs. 180 and expected net dividend Rs. 30 per share and
constant growth rate for dividend per share is expected at 10% Tax@ 30%. [16.8155%]
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Ex. 56) A firm has the following capital structure and after-tax costs for the different sources of funds used.
Source of fund Book value After tax cost
Equity share capital 4,00,000 15.60%
Preference share capital 3,00,000 10.50%
Retained Earnings 1,00,000 15.60%
Debt 2,00,000 04.50%
Total Book value of Funds 10,00,000 ---
# Calculate weighted average cost using:
(i) Book value (Balance sheet Value) Weights
(ii) Market value Weights assuming market value of different sources of funds are as follows:
Source of fund Market value
Equity share Capital & Retained earnings 7,25,000
Preference share Capital 3,50,000
Debt 1,75,000
Total Market Value Rs. 12,50,000
[(i) 11.85%; (ii) 12.6618%]
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Ex. 57) Following are the details of A Ltd.
Source Amount (B.V.) Cost (%) Amount (M.V.)
Equity Capital 10,00,00 20% 14,00,000
Preference Capital 5,00,000 16% 6,00,000
Debentures 5,00,000 8% 5,00,000
20,00,000 25,00,000
On the basis above information weighted average cost of capital using.
(1) Market value weights (2) Book value weights
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Ex. 58) Gajanan has the following book value capital structure:
Particulars Rs.
Equity share Capital (Share Rs. 10 each) 1,50,000
11.00% preference share Capital (Share Rs. 100 each) 1,00,000
Retained Earning 20,00,000
13.50 Debentures (Rs. 100 each) 10,00,000
15.00% Tem loans 12,50,000
Total RS. 58,50,000
The next expected dividend on equity shares is Rs. 3.60 per share. The dividend is expected to grow at the
rate of 7%. The market price per share is Rs. 40. Preference shares are redeemable at par after 10 years
and are currently selling at Rs. 75 per share. Debentures are redeemable at par after 6 years and currently
selling at Rs. 80 per debenture. The income tax for the company is 40%.
# Calculate the weighted average cost of Capital (WACC) using.
(1) Book Value weights and (2) Market value weights.
=======================================================================================
Ex. 59) (Col.) The following information has been extracted from the balance sheet of Gauri Ltd.
Particulars Rs.
Equity Share Capital (Share Rs. 10 each) 4,00,000
12.00% Debentures (Rs. 100 each) 4,00,000

E-107, Vrundavan township, Besides Tasty Restaurant ,Near sangam char rasta, – 82384 48020 , 99989 84152
 SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.S [All Levels] Page 11 of 13
18.00% Term Loan 12,00,000
Total Rs. 20,00,000
Company had been paying dividend at a consistent rate of Rs. 20% p.a. and current market price of
share Rs. 160. Determine the WACC of the company assuming tax rate @ 30%.
=======================================================================================
Ex. 60) (Col.) Three companies Om, Jay and Jagdish are in the same type of business and hence have similar
operating risks. However, the capital structure of each of them is different and the following are the
details :
Particulars OM (Rs.) Jay (Rs.) Jagdish (Rs.)
Equity share capital (Share of Rs. 10 each) (Rs.) 4,00,000 2,50,000 5,00,000
Number of equity shares 40,000 25,000 50,000
Dividend per share (DPS) (Rs.) 2.70 4.00 2.88
Market price per share (MPS) (Rs.) 15.00 20.00 12.00
Debentures (Rs. 100 each) - 1,00,000 2,50,000
Number of Debentures - 1,000 2,500
Rate of interest on Debentures - 10.00% 8.00%
Market Price per Debentures (Rs.) - 125 80
Assume that the current level of dividends are generally expected to continue indefinitely and the
income tax rate 50%. you are required to compute the WACC using market value weights of each
company.
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Ex. 61) (Col.) Vinayak Ltd. Has the following capital structure.
Particulars Rs.
Equity share Capital (Rs. 100 each) 80,00,000
12% Preference Shares (Rs. 100 each) 20,00,000
14.00% Debentures (Rs. 100 each) 60,00,000
Total 1,60,00,000
The Market price of equity share is RS. 200. It is expected that the company will pay a current dividend of
Rs. 20 per share, which is expected to grow at 5% p.a. forever. Assume 30% corporate tax rate.
# You are required to calculate :
(A) WACC based on the existing capital structure.
(B) The new WACC, if company raises an additional Rs. 40,00,000 debt by borrowing 16% of term
loan. This would result in increasing the expected dividend to Rs. 24 and leave the growth
rate unchanged but price of equity share will fall to Rs. 160 per share.
=======================================================================================
Ex. 62) (Col.) Ganesh Ltd. Has the following capital structure:
Particulars Rs.
10,000 Equity shares (Rs. 100 each) 10,00,000
10 % Preference Shares (Rs. 100 each) 4,00,000
12 .00% Debentures (Rs. 100 each) 6,00,000
Total 20,00,000
The market price of equity share is Rs. 110 and it is expected that a dividend of Rs. 10 per share would be
declared next year. The dividend growth rate is 6% p.a. corporate tax rate is 50%. You are required
to calculate :
(A) WACC based on the existing capital structure.
(B) Assume that in order to finance an expansion plan, the company intends to borrow a fund of Rs.
10,00,000 bearing 14% rate of interest. What would be the company’s revised WACC? This
finance decision is expected to Rs. 12 per share. However, the market price is expected to fall Rs.
110 to Rs. 105 per share.
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Ex. 63) (Col.) A company is considering the following to raise additional capital for its expansion schemes:
Option Equity Debt Cost of equity % Cost to debt
(% of total capital (% of total capital (pre-tax) %
I 75 25 16 12
E-107, Vrundavan township, Besides Tasty Restaurant ,Near sangam char rasta, – 82384 48020 , 99989 84152
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II 50 50 18 14
III 25 75 24 18
Tax rate is 30%. which option would you recommend? show workings.
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Ex. 64) (Col.) The share of Axe Ltd. Is presently trades at Rs. 50 and the company is expected to pay
dividends of Rs. 4 per share with a growth rate expected at 8% p.a. it plans to raise fresh equity
share capital. The merchant banker has suggested that underpricing of Rs. 1 is necessary in pricing
the new issue besides involving the fixed cost of 50 paise per share as miscellaneous expenses. Find
out the cost of existing equity shares as well as the new equity given that the dividend and growth
rate are not exacted to change.
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Ex. 65) (Col.) An electronic equipment manufacturing company wishes to determine the weighted average
cost of capital on the basis of Book value weights for evaluating capital budgeting projects. You
have been supplied with the following information.
Liabilities Rs. Assets Rs.
Equity share Capital 12,00,000 Fixed Assets 25,00,000
Preference share Capital 4,50,000 Current Assets 15,00,000
Retained Earning 4,50,000
Debentures 9,00,000
Current Liabilities 10,00,000
Total Rs. 40,00,000 Total Rs. 40,00,000
# Additional information :
(a) 20 years 14% debentures of Rs. 2,500 face value, redeemable at 5% premium can be sold at par.
2% flotation costs.
(b) 15% preference shares: Sale price Rs. 100 per share 2% flotation costs.
(c) Equity shares: Sale price Rs. 115 per share flotation costs Rs. 5 per share.
The corporate tax rate is 35% and the expected growth in equity dividend is 8% per year is Rs. 11 per share.
Assume that the company is satisfied with its present capital structure and intends to maintain it.
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Ex. 66) (Col.) Akshay Ltd. Has the following capital structure:
Particulars Proportion in Total Funds
Equity shares (2,00,000 shares) 50.00%
10.00% preference shares capital 12.50%
14.00% Debentures 37.50%
The equity shares of the company sell for Rs. 20. It is expected that the company will pay next year a
dividend of Rs. 2 per share, which will grow at 7% forever. assume tax rate at 50%.
# You are required to :
(i) WACC based on existing capital structure.
(ii) The new WACC id company desires to raise a fund of an additional Rs. 2,00,000 debt
by issuing 15% debentures. This would result in increasing the expected dividend to Rs. 3 and
leave the growth rate unchanged but price of the share will fall to Rs. 15 per share.
(iii) WACC if capital structure in (b) above remains same and the growth rate of dividend increased
to 10%.
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Ex. 67) (Col.) Following is the capital structure of SONY Ltd. As on 31-3209. (Rs. In lakhs)
Equity share capital (Rs. 100 each) 400
12% Debenture 400
18% term Loan 1,200
Total 2,000
Tax Rate is 40%. Determine the WACC of the company. It had been paying dividends at a consistent rate
of 20% p.a. and current market price of share of Rs. 160/-
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E-107, Vrundavan township, Besides Tasty Restaurant ,Near sangam char rasta, – 82384 48020 , 99989 84152
 SAHAS Institute :- 11th 12th Comm // F.Y – S.Y, - T.Y. B.Com // C.A & C.S [All Levels] Page 13 of 13
Ex. 68) (Col.) ABC Ltd. Has the following book value capital structure as on March 31, 2019.
Equity share capital (Rs. 100 each) 40,00,000 Rs.
11.5% Preference shares 10,00,000 Rs.
10% Debenture 30,00,000 Rs.
Total 80,00,000 Rs.
The equity share of the company sells for Rs. 20, it is expected that the company will pay next year a
dividend of Rs. 2 equity shares, which is expected to grow at 5% p.a. forever. Assume a 35%
corporate tax rate. Required.
(1) Compute weighted average cost of capital (WAC) of the company based on the existing
capital structure.
(2) Compute the new WACC, if the company raises an additional Rs. 20 lakhs debt by issuing 1%
debentures. This would result in increasing the excepted equity dividend to Rs. 2.40 and leave the
growth rate unchanged but the price of equity share will fall to Rs. 16 per share .
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