Chapter 4: Cost of Capital
Cost of capital is the minimum rate of return a company must earn on its investments to maintain its market value and attract funds. It serves as the discount rate in capital budgeting and the benchmark for evaluating financial performance. This chapter covers cost of individual sources and the weighted average cost of capital (WACC).
4.1 Concept
Cost of capital represents the opportunity cost of using funds — what investors could earn elsewhere at similar risk. It is the required rate of return that compensates investors for both time value of money and risk.
Cost of Individual Sources
| Source | Formula | Key Notes |
|---|---|---|
| Cost of Debt (Kd) | Kd = I(1-T) / NP or Kd after tax = Kd × (1-T) | Interest is tax-deductible; use after-tax cost |
| Cost of Preference Shares (Kp) | Kp = Dividend / Net Proceeds | Dividend is NOT tax-deductible |
| Cost of Equity (Ke) — DDM | Ke = D1/P0 + g | D1 = expected dividend, P0 = current price, g = growth rate |
| Cost of Equity — CAPM | Ke = Rf + β(Rm - Rf) | Rf = risk-free rate, β = beta, Rm = market return |
| Cost of Retained Earnings (Kr) | Kr = Ke (same as equity) | No flotation costs, but still has opportunity cost |
Worked Examples
Kd: 12% debenture, face value NPR 1,000, net proceeds NPR 950, tax rate 25%
Kd = [120(1-0.25)] / 950 = 90/950 = 9.47%
Ke (DDM): Current price NPR 500, dividend NPR 30, growth 8%
Ke = (30×1.08)/500 + 0.08 = 32.4/500 + 0.08 = 0.0648 + 0.08 = 14.48%
Ke (CAPM): Rf = 6%, β = 1.2, Rm = 14%
Ke = 6% + 1.2(14%-6%) = 6% + 9.6% = 15.6%
4.2 Weighted Average Cost of Capital (WACC)
WACC = Wd×Kd(1-T) + Wp×Kp + We×Ke
Where W = weight (proportion) of each source in capital structure.
WACC Calculation
| Source | Amount (NPR) | Weight | Cost | Weighted Cost |
|---|---|---|---|---|
| Debt | 30,00,000 | 0.30 | 9.47% | 2.84% |
| Preference | 10,00,000 | 0.10 | 11% | 1.10% |
| Equity | 60,00,000 | 0.60 | 15.6% | 9.36% |
| Total | 1,00,00,000 | 1.00 | WACC = 13.30% |
Book Value vs Market Value Weights
| Basis | Book Value | Market Value |
|---|---|---|
| Source | Balance sheet values | Current market prices |
| Advantage | Easy to calculate, stable | Reflects true cost, theoretically correct |
| Preferred | When market data unavailable | Theoretically preferred for WACC |
4.3 Cost of Debt — Advanced Calculations
Cost of Redeemable Debentures
When debentures have a maturity date, cost of debt is the yield to maturity (approximate method):
Kd (before tax) = [I + (RV - NP)/n] / [(RV + NP)/2]
Where: I = Annual interest, RV = Redemption value, NP = Net proceeds, n = years to maturity
Example: 14% debenture, face value NPR 1,000, issued at NPR 950 (after flotation), redeemable at NPR 1,050 after 5 years. Tax rate 25%.
I = 1,000 × 14% = NPR 140
Kd (before tax) = [140 + (1,050-950)/5] / [(1,050+950)/2] = [140 + 20] / 1,000 = 160/1,000 = 16%
Kd (after tax) = 16% × (1-0.25) = 12%
Cost of Term Loan
Example: Bank loan at 12% interest, processing fee 2% of loan amount, tax rate 25%
Effective rate = 12% / (1-0.02) = 12/0.98 = 12.24%
After-tax cost = 12.24% × (1-0.25) = 9.18%
4.4 Cost of Equity — Comprehensive CAPM Application
CAPM for Nepali Companies:
Ke = Rf + β(Rm - Rf)
In Nepal context: Rf = Government bond yield (~8-10%), Rm = NEPSE average return (~15-18%), β varies by sector:
| Sector | Typical β | Ke (if Rf=8%, Rm=16%) | Interpretation |
|---|---|---|---|
| Commercial Banks | 1.0-1.2 | 8 + 1.1(8) = 16.8% | Average market risk |
| Hydropower | 0.8-1.0 | 8 + 0.9(8) = 15.2% | Slightly below market risk |
| Insurance | 0.6-0.8 | 8 + 0.7(8) = 13.6% | Lower risk (defensive) |
| Manufacturing | 1.2-1.5 | 8 + 1.3(8) = 18.4% | Above market risk |
| Hotels/Tourism | 1.5-2.0 | 8 + 1.7(8) = 21.6% | High risk (cyclical, seasonal) |
4.5 Comprehensive WACC Calculation — Nepal Bank Example
Capital Structure of Himalayan Bank:
| Source | Book Value (NPR Cr) | Market Value (NPR Cr) | Weight (MV) | Cost (after tax) | Weighted Cost |
|---|---|---|---|---|---|
| Equity Capital | 500 | 800 | 0.533 | 16.8% (CAPM) | 8.95% |
| Retained Earnings | 200 | 200 | 0.133 | 16.8% (=Ke) | 2.24% |
| Debentures (12%) | 300 | 310 | 0.207 | 9.0% | 1.86% |
| Term Loan (11%) | 190 | 190 | 0.127 | 8.25% | 1.05% |
| Total | 1,190 | 1,500 | 1.000 | WACC = 14.10% |
Interpretation: The bank should accept projects earning more than 14.10%. Any project with IRR > 14.10% or NPV > 0 at 14.10% adds value.
Note: Market value weights give WACC of 14.10% vs book value weights which would give a different (less accurate) result. Market values are preferred because they represent the actual cost of raising new capital today.
4.6 Factors Affecting Cost of Capital
| Factor | Effect on Cost of Capital | Nepal Context |
|---|---|---|
| General Interest Rate Level | Higher rates → higher cost of all sources | NRB's policy rate directly affects base rate for all Nepali companies |
| Market Risk Premium | Higher perceived risk → higher equity cost | NEPSE volatility and political risk increase Nepal's risk premium |
| Tax Rate | Higher tax → lower after-tax cost of debt | Nepal's 25% corporate tax creates meaningful debt tax shield |
| Capital Structure | More debt initially lowers WACC, then increases (bankruptcy risk) | NRB regulates bank leverage (capital adequacy ~11%+) |
| Company Size and Reputation | Larger, reputed firms have lower cost | Top NEPSE companies (Nabil, NIC Asia) borrow cheaper than SMEs |
| Flotation Costs | Higher for equity (5-10%) than debt (1-3%) | SEBON regulations, underwriting fees affect IPO costs in Nepal |
Practice Questions
Short Answer:
1. What is cost of capital? Why is it important?
2. Explain cost of debt. Why is after-tax cost used?
3. How is cost of equity calculated using DDM and CAPM?
4. What is WACC? State the formula.
5. Compare book value and market value weights for WACC.
Long Answer:
6. Company's capital: Debt NPR 20L (10% coupon, NP=NPR 950), Preference NPR 10L (12% dividend, NP=NPR 980), Equity NPR 30L (price NPR 200, div NPR 15, growth 10%). Tax=25%. Calculate cost of each source and WACC. (15 marks)
7. Explain the CAPM model for estimating cost of equity. Calculate Ke if β=1.5, Rf=5%, Rm=15%. (15 marks)
8. "WACC is the appropriate discount rate for capital budgeting." Discuss with assumptions and limitations. (15 marks)
9. How does capital structure affect WACC? Discuss the optimal capital structure concept. (15 marks)
10. Calculate WACC using both book value and market value weights. Why might they differ? (15 marks)
Exam Tips: ✓ WACC calculation with all components is always asked ✓ After-tax cost of debt — don't forget (1-T) ✓ DDM and CAPM for Ke — know both methods ✓ Show clear tabular format for WACC ✓ Remember: Kr = Ke (retained earnings cost = equity cost)