Cost of Capital:
-the minimum return that investors expect for providing capital to the company.
How to Calculate Cost of Capital:
Formula:
1. Tax-adjusted cost of loan capital = Pre-tax cost of loan capital x (1- Tax Rate)
2. Cost of Preference Share = Dividend per share/ Market Price of Share
3. Cost of Ordinary Share = Dividend per share/ Market Price of Share
When dividend increase,
Cost of Ordinary Share = Dividend 1/ Share Price 0+ Rate of Increase
Where, Dividend 1 = Dividend 0 (1+ Rate of Increase)
Share Price 0 = Present Market Price of Shares
Rate of Increase = Rate of Increase of Dividend
Example:
A company has- 2000 million Ordinary Share Capital
2000 million Loan Capital
1000 million Preference Share Capital
Interest rate on loan capital = 10%
Rate of Dividend in Priority Share = 8%
Face Value of each share = Taka 100
Market Price of Ordinary Share = Taka 255
Market Price of Preference Share = Taka 110
Dividend this year = Taka 13 per share
Dividend has increased from earlier = 4%
Income Tax Rate = 40%
Calculate the weighted average cost of capital of the company.
Solution:
Cost of Capital:
Tax-adjusted cost of loan capital = Pre-tax cost of loan capital x (1- Tax Rate)
= 0.10 x (1-.40)
= 0.06
Cost of Preference Share = Dividend per share/ Market Price of Share
= (0.08 x 100)/ 110
= 0.0727
Cost of Ordinary Share = Dividend 1/ Share Price 0+ Rate of Increase
= {13 (1.04)/ 255} + .04
= 0.0930
Weight:
Tax-adjusted cost of loan capital: 2000/ (2000+2000+1000) = 0.40
Cost of Preference Share: 1000/ (2000+2000+1000) = 0.20
Cost of Ordinary Share: 2000/ (2000+2000+1000) = 0.40
Weighted Average Cost of Capital = (0.06 x 0.40)+ (0.0727 x 0.20)+ (0.0930 x 0.40)
= 0.024+ 0.01454+ 0.0372
= 0.07574
i.e. 7.57%