Page 74 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

Where, Notes

I = Interest.
t = Tax rate.
f = Flotation cost.

d = Discount.
p = Premium on redemption.
r
p = Premium on issue.
i
RV = Redeemable value.
NP = Net proceed.
N = Maturity period of debt.
m
15 (1 0.45− ) (3 0 0 0+ − + − )/7
K =
p (100 97− )/2
8.68
K = = 8.81%
p 98.5

Task Sam’s company manufactures specialty chemicals. Its debt equity ratio is 0.8. Its
overall costs of capital is 15 per cent and 30 per cent tax rate.
1. If Sam’s cost of equity is 20%, what is pre-tax cost of debt?

2. If Sam can use debt at an interest rate of 13%, what is cost of equity?

4.4 Weighted Average Cost of Capital (WACC)

A company has to employ a combination of creditors and fund owners. The composite cost of
capital lies between the least and most expensive funds. This approach enables the maximisation
of profits and the wealth of the equity shareholders by investing the funds in projects earning in

excess of the overall cost of capital.
The composite cost of capital implies an average of the costs of each of the source of funds

employed by the firm property, weighted by the proportion they hold in the fi rm’s capital
structure.

Note Steps involved in computation of WACC

1. Determination of the type of funds to be raised and their individual share in the total
capitalisation of the fi rm.
2. Computation of cost of specific source of funds.

3. Assignment of weight to specifi c costs.

4. Multiply the cost of each source by the appropriate assigned weights.
5. Dividing the total weighted cost by the total weights to get overall cost of capital.

LOVELY PROFESSIONAL UNIVERSITY 67