Capital structure

Cost of debt

Tax is deductible expenses. The cost of capital is equivalent to debt burden on organization has to bear in terms of interest, tax or dividend etc. the formula for calculation is as below:

I (1-t) + (F-P/N)

Kd=       (P+F)/2

Kd – cost of debt, I- interest, t- taxation rate, F- face value of debenture, P- net amount realized, N- period of maturity.

Cost of preference capital

Cost of dividend + cost of actual additional liability in terms of tax+dividend payment expenses will result in cost of capital. The effective rate of interest which organization needs to bear is more than face value if tax and additional amounting expenses are high. The formula for the same is as below:

   PD+ (F-P)/N

Kp=        (F+P)/2

Kp- cost of preference shares, PD- preference dividend, F-repayable value, P- net amount realised, and N- maturity period

Cost of long term loan:

Long term loan is one of the sources for capital. When loan is repaid additional burden of interest to with of principle is to be bared by the firm as cost of capital. In this formula tax is value additional factor considered in calculating cost of capital. Formula for the same is as below:

Kd= interest (1- Tax Rate)

Cost of equity capital:

Different approaches towards cost of capital are as below:

Cost of equity capital

 

Dividend /Price     Dividend, Price          EPS to Price            Cost of Retained Earnings       Realised Yield

Approach                 and Growth                 Approach                      Approach                          Approach   

                                 Approach                                        

EPS to Price approach:

Comparison of price of share with earning per share is done as there is difference between face value and market value of share so in place of dividend importance is given to earnings per share. The formula for the same is as below:

Ke = EPS/P

EPS- earnings per share, P -price of share

Cost of retained earnings approach:

Cost of retained earnings is a kind of opportunity cost for investors. When company retains higher amount of earnings then it is indication of future gain in terms of value addition to price and asset charge of company. The formula for the same is as below:

Kr = cost of equity capital X (1-tp/ 1-tg)

Kr – cost of retained earnings, tp – ordinary personal income tax rate, tg – personal long term capital gains

Dividend /Price     :

In this approach dividend and market price of the shares is compared to analyse the cost of capital. This approach can also be termed as EPS approach based on market price of the share. Ion this approach what is current price and earnings for the same price in terms of dividend are measured and then the amount of cost of capital is calculated .formula for the same is as below:

Ke = D/MP

D- Dividend per share, MP- market price of share

Dividend, Price and Growth Approach:

In this approach with amount of dividend expected rate of growth of organization is also considered. The formula to calculate cost of capital for the same is as below

Ke = D/ MP+ G (growth)