Page 116 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

(b) Costs of the specific resources of funds that constitute the capital structure of the Notes
firm, are calculated by keeping in mind the prevailing market prices.
Disadvantages of Market Value Weights:

(a) Market values may not be available when a firm is not listed or when the securities
of the firm are very thinly traded.
(b) Market value may be distorted when securities prices are influenced by manipulation
loading.
(c) Equity capital gets greater importance.

Did u know? Most of the financial analysts prefer to use market value weights because it is
theoretically consistent and sound.
Illustration 24: A firm has the following capital structure as the latest statement shows:
Source of F unds After T ax Cost ( % )
Debt 30,00,000 4

Preference shares 10,00,000 8.5

Equity share 20,00,000 11.5

Retained earnings 40,00,000 10

Total 100,00,000

Based on the book values compute the cost of capital.
Solution:
Source of Finance Weights Specific Cost (%) Weighted Cost
Debt 0.30 0.04 0.012

Preference shares 0.10 0.08 0.008
Equity share 0.20 0.11 0.022
Retained earnings 0.40 0.10 0.040

1.00 0.082

Overall cost of capital (K ) = Total Weighted Cost × 100
o
= 0.082 × 100 = 8.2 per cent

Cost of Weight
Debt capital 30,00,000
Debt weight = = = 0.30
Total capital 1,00,00,000
Illustration 25: XYZ company supplied the following information and requested you to compute
the cost of capital based on book values and market values.

Source of Finance Book Value ( ) Market Value ( ) After Tax Cost (%)
Equity capital 10,00,000 15,00,000 12

Long term debt 8,00,000 7,50,000 7
-
Short term debt 2,00,000 2,00,000 4
-
Total 20,00,000 24,50,000

Solution:
Computation of Cost of Capital based on Book Value

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