by Specific Cost of Capital refers to the cost of obtaining funds from a particular source of finance. Since a company can raise capital through equity shares, preference shares, debt, and retained earnings, each source has its own specific cost. The computation of specific cost is important because it helps management determine the cost associated with each individual component before calculating the Weighted Average Cost of Capital (WACC).
1. Computation of Cost of Debt
Cost of Debt is the effective cost incurred by a company for obtaining funds through debentures, bonds, loans, or other forms of debt. Since interest paid on debt is generally tax-deductible, the after-tax cost of debt is important for financial decision-making. Cost of debt may be calculated for both irredeemable debt and redeemable debt.
For irredeemable debt, the basic formula is:
Kd = I / NP × (1 – T) × 100
Where:
Kd = After-Tax Cost of Debt
I = Annual Interest
NP = Net Proceeds
T = Tax Rate
Example: A company issues debentures of Rs. 1,000 at 10% interest for Rs. 950. The corporate tax rate is 30%.
Annual Interest = Rs. 1,000 × 10% = Rs. 100
Kd = 100 / 950 × (1 – 0.30) × 100
Kd = 7.37%
Therefore, the After-Tax Cost of Debt is 7.37%.
For redeemable debt, the redemption amount and period are also considered:
Kd = [I + (RV – NP) / n] / [(RV + NP) / 2] × (1 – T) × 100
Where RV = Redemption Value and n = Number of Years.
The cost of debt is important because it helps determine the financing cost, capital structure, WACC, and investment decisions of the company.
2. Computation of Cost of Preference Share Capital
Cost of Preference Share Capital represents the return expected by preference shareholders for providing funds to the company. Preference shares generally carry a fixed rate of dividend. The computation of this cost depends on whether the preference shares are irredeemable or redeemable. Unlike interest on debt, preference dividend is generally not treated as a tax-deductible expense.
For irredeemable preference shares, the formula is:
Kp = Dp / NP × 100
Where:
Kp = Cost of Preference Share Capital
Dp = Annual Preference Dividend
NP = Net Proceeds from Preference Shares
Example: A company issues 10% preference shares of Rs. 100 each at Rs. 95. The annual dividend is Rs. 10.
Kp = 10 / 95 × 100
Kp = 10.53%
Therefore, the Cost of Preference Share Capital is 10.53%.
For redeemable preference shares, the redemption value and period are also considered:
Kp = [Dp + (RV – NP) / n] / [(RV + NP) / 2] × 100
Where RV = Redemption Value and n = Number of Years.
The computation of preference share cost helps management compare preference financing with other sources. It is also necessary for calculating the Weighted Average Cost of Capital (WACC). A higher preference dividend or lower net proceeds increases the specific cost of preference capital.
3. Computation of Cost of Equity Capital
Cost of Equity Capital refers to the minimum rate of return expected by equity shareholders from their investment in the company. Equity is a relatively risky source of finance because shareholders receive dividends only after other financial obligations are met. Therefore, the cost of equity is an important component of the company’s overall cost of capital.
One commonly used method is the Dividend Growth Model.
Ke = D1 / P0 + g
Where:
Ke = Cost of Equity
D1 = Expected Dividend per Share
P0 = Current Market Price per Share
g = Expected Growth Rate in Dividend
Example: Suppose the current market price of a share is Rs. 100, the expected dividend is Rs. 8 per share, and the expected growth rate is 5%.
Ke = 8 / 100 + 0.05
Ke = 0.08 + 0.05
Ke = 0.13 or 13%
Therefore, the Cost of Equity is 13%.
Another important method is the Capital Asset Pricing Model (CAPM):
Ke = Rf + β(Rm – Rf)
Where Rf = Risk-Free Rate, β = Beta, and Rm = Expected Market Return.
The cost of equity is used in investment appraisal, business valuation, capital structure decisions, and WACC calculation. Accurate estimation is important because it reflects the return required by shareholders for bearing investment risk.
4. Computation of Cost of Retained Earnings
Cost of Retained Earnings refers to the opportunity cost of profits retained in the business instead of being distributed to equity shareholders as dividends. Retained earnings are an internal source of finance, but they are not completely cost-free. Shareholders could have received these profits as dividends and invested them elsewhere to earn a return. Therefore, the return shareholders sacrifice represents the economic cost of retained earnings.
In a simple approach, the cost of retained earnings is considered equal to the Cost of Equity.
Kr = Ke
Where:
Kr = Cost of Retained Earnings
Ke = Cost of Equity
Example: If the company’s Cost of Equity is 14%, then:
Kr = Ke
Kr = 14%
Therefore, the Cost of Retained Earnings is 14%.
In some approaches, adjustments may be made for personal taxes, brokerage costs, and other factors affecting shareholders’ investment opportunities. However, the simple equality between retained earnings and equity cost is widely used for basic financial calculations.
Retained earnings can reduce dependence on external financing and avoid flotation costs, underwriting expenses, and issue-related expenses. However, management must ensure that retained profits are invested in projects capable of generating adequate returns. If the company earns less than the opportunity cost of retained earnings, shareholders may be worse off. Thus, computation of this specific cost is essential for capital budgeting, dividend decisions, financing decisions, and WACC calculation.
5. Computation of Cost of New Equity Capital
Cost of New Equity Capital represents the cost incurred by a company when it raises additional funds by issuing new equity shares. It is generally higher than the cost of existing equity because the company may incur flotation costs, such as brokerage, underwriting commission, legal expenses, advertising expenses, and other issue costs.
The Dividend Growth Model can be used to calculate the cost of new equity:
Ke = D1 / NP + g
Where:
Ke = Cost of New Equity
D1 = Expected Dividend per Share
NP = Net Proceeds per Share
g = Expected Growth Rate
Net proceeds are calculated as:
NP = Issue Price – Flotation Cost per Share
Example: A company issues new shares at Rs. 100 per share. Flotation expenses are Rs. 5 per share. Expected dividend is Rs. 8 per share and expected growth is 6%.
NP = 100 – 5 = Rs. 95
Ke = 8 / 95 + 0.06
Ke = 0.0842 + 0.06
Ke = 0.1442 or 14.42%
Therefore, the Cost of New Equity is 14.42%.
The inclusion of flotation costs increases the effective cost of raising new equity. Therefore, management should consider the cost of new equity when choosing between retained earnings, debt, preference shares, and new equity financing. It is also an important component in calculating the company’s marginal cost of capital and WACC.
