Page 109 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

Notes
10 10 100
90 =  t + 10
t=1  1+ K p   1+ K p 

The trial and error method is used here, for the computation of the cost of preference share.

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.

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

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