Page 110 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

The trial and error method is used here, for the computation of the cost of preference share. Notes
PV factor Present Values
Year Cash outflow ( )
10% 12% 10% 12%
1 - 10 10 6.145 5.650 61.45 56.5
10 100 0.386 0.322 38.60 32.2
Total PV of Cash outflow 100.05 88.70
(- ) PV of Cash inflow 90.00 90.00
10.05 (-) 1.3
In trials, PV of cash outflow did not equal to the PV of cash inflow ( 100). Hence, cost of
preference share is calculated by using interpolation formula.

 LDFPV PV of CIF 

K  LDF(%)   (HDF LDF) 
 LDFPV HDFPV 

Where,
LDF = Lower discounting factor in %.
LDFPV = Lower discounting factor present value ( ).
HDFPV = Higher discounting factor present value ( ).
PV of CIF = Present value of cash inflows.

Kp = 10% +    12% - 10%  100.05 - 90  
 100.05 - 88.7 

 10.05 
= 10% + 2× 

 11.35 
= 10% + 2 × 0.886 = 10% + 1.772
= 11.77 per cent
Short cut formula:
D + (f + d + p – p )/N
K = r i m
p
(RV + NP)/2
Where,
D = Dividend per share.
f = Flotation cost ( ).

d = Discount on issue of preference share ( ).
p = Premium on redemption of preference shares ( ).
r
p = Premium on issue of preference share ( ).
i
N = Term of preference shares.
m
RV = Redeemable value of preference share.
NP = Net proceeds realized.

10 +(10 + 0 + 0 - 0)/10
K =
p (100+90)/2
10 +(1)
= = 11.579 per cent
95

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