Page 116 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management
Source of Finance Weights Specific Cost (%) Weighted Cost
Debt 0.30 0.04 0.012
Notes 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 (Ko) = Total Weighted Cost × 100
= 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 23:
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

Source of Finance Book Value ( ) Weights Specific cost Weighted cost
(1) (2) (3) (4) (5) = (3) × (4)
Equity capital 10,00,000 0.50 0.12 0.060
Long-term debt 8,00,000 0.40 0.07 0.028
Short-term debt 2,00,000 0.10 0.04 0.004
Total 20,00,000 1.00 0.092

Cost of capital = 0.092 × 100 = 9.2 per cent

Cost of Capital based on Market Value Weight

Source of Finance Book Value ( ) Weights Specific cost Weighted cost
(1) (2) (3) (4) (5) = (3) × (4)
Equity capital 15,00,000 0.613 0.12 0.074
Long-term debt 7,50,000 0.307 0.07 0.022
Short-term debt 2,00,000 0.080 0.04 0.003
24,50,000 1.000 0.099

Cost of capital = 100 × 0.099 = 9.9 per cent

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