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Unit 4: Cost of Capital

Illustration 18: XYZ company supplied the following information and requested you to compute Notes
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) X (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 x 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) X (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 X 0.099 = 9.9 per cent

Weighted average cost of capital (alternative method)
Source of Finance Market Value (`) Cost (%) Total Cost
(1) (2) (3) (4) = (2) X (3)
Equity capital 15,00,000 0.12 1,80,000
Long term debt 7,50,000 0.07 52,500
Short term debt 2,00,000 0.04 8,000
24,50,000 2,40,500

Nike, Inc. – Cost of Capital

n July, Kimi-ford, a portfolio manager at North Point Group, a mutual-fund-

management ﬁrm, pored over analysts’ write-ups of Nike, Inc., the athletic-shoe
Omanufacturer. Nike’s share price had declined signiﬁ cantly from the start of the
year. Ford was considering buying some shares for the fund she managed, the North Point
Large-Cap Fund, which invested mostly in fortune 500 companies, with an emphasis on
value investing. Its top holdings included Exxon Mobile. General Motors, McDonald’s, 3M,
and other large-cap. It had performed extremely well. In 2000, the fund earned a return of
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