Untitled-29

Cost of Capital^73

Determining individual costs of capital

a) Cost of Debt: As we discussed in the last chapter the before-tax cost of debt is
found by trial-and-error by solving for kd in

PV = ( ) ( )n

d

n

t d t

t

k

incipal

k

Interest

PV

+

+

+

=


=^1

Pr

(^011)
where PV = the market price of the debt, less flotation costs,
Interestt = the annual interest paid to the investor each year,
Principal = the maturity value of the debt
kd = before-tax cost of the debt (before-tax required rate of
return on debt)
n = the number of years to maturity.
The after-tax cost of debt equals = kd(1 - T).
b) Cost of preference share (required rate of return on preference share), kps,
equals the dividend yield based upon the net price (market price less flotation
costs) or
kps = netprice
dividend
= NPo

D

c) Cost of equity share: There are three measurement techniques to obtain the
required rate of return on equity shares as discussed in the last chapter. The first
is the perpetuity growth model, also known as the dividend growth model. A
variation on the same is to look at the floatation of a new equity share and include
the floatation costs when determining the cost of capital. The second one is the
CAPM model. The third one derives its value from the value of the debt of the
company.

i) Dividend growth model

a. Cost of internally generated common equity, ks

ks = market price

dividend in yea r 1

+ 

in dividends

annual growth

ks =

Po

D 1

+ g

b. Cost of new equity share, kns

kns =

NPo

D 1

+ g