Unit 2: Cost of capital & capital structure
Financial Management notes · PTU syllabus (BBA 403-18)
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Unit summary
Every source of finance has a cost, and the mix of debt and equity affects both risk and value. This unit covers the cost of capital — equity, preference, debt and the weighted average — capital structure theories (NI, NOI, traditional and MM), and operating and financial leverage.
After this unit you can
- Calculate the cost of debt, preference and equity capital
- Calculate the weighted average cost of capital
- Compare the NI, NOI, traditional and MM theories of capital structure
- Calculate operating, financial and combined leverage
PTU syllabus topics
- Meaning and significance of cost of capital
- cost of equity
- preference shares and debt
- weighted average cost of capital
- capital structure theories — NI approach
- NOI approach
- MM approach
- traditional approach
- financial and operating leverage
Cost of debt (after tax)
Kd = I (1 − t) / net proceeds
Cost of preference shares
Kp = preference dividend / net proceeds
Cost of equity (Gordon)
Ke = D1 / P0 + g
WACC
Σ (weight × cost of each source)
Financial leverage
EBIT / EBT
Topic 1
Cost of capital
The cost of capital is the minimum rate of return a firm must earn on its investments to satisfy its investors. It is used as the discount rate in capital budgeting.
Cost of debt (after tax)
Kd = I (1 − t) / NP
Cost of preference shares
Kp = D / NP
Cost of equity (dividend growth)
Ke = D₁ / P₀ + g
Cost of equity (CAPM)
Ke = Rf + β (Rm − Rf)
Cost of retained earnings
Kr = Ke (adjusted for personal tax, if any)
Weighted average cost of capital (WACC) = Σ (weight of each source × its cost).
Example
Equity ₹6 lakh at 15%, debt ₹4 lakh at 8% after tax. WACC = 0.6 × 15% + 0.4 × 8% = 9% + 3.2% = 12.2%.
Topic 2
Capital structure theories
Capital structure is the mix of long-term sources — equity, preference capital and debt.
Net Income (NI)
Yes
More debt lowers WACC, raising value
Net Operating Income (NOI)
No
WACC stays constant whatever the mix
Traditional
Yes, up to a point
An optimal capital structure exists
Modigliani-Miller (no taxes)
No
Arbitrage keeps value independent of capital structure
MM with taxes
Yes
Interest tax shield increases value
Topic 3
Leverage
Leverage is the use of fixed costs (operating or financial) to magnify returns.
Operating leverage
DOL = Contribution / EBIT
Financial leverage
DFL = EBIT / EBT
Combined leverage
DCL = DOL × DFL = Contribution / EBT
Example
Sales ₹10 lakh, variable cost ₹6 lakh, fixed cost ₹2 lakh, interest ₹1 lakh. Contribution = 4 lakh, EBIT = 2 lakh, EBT = 1 lakh. DOL = 2, DFL = 2, DCL = 4 — a 10% rise in sales raises EBT by 40%.
Trading on equity: using debt to increase the return to equity shareholders when the return on investment exceeds the cost of debt.
Key terms
- Cost of capital
- Minimum return required by investors
- WACC
- Weighted average of the costs of all sources
- Capital structure
- The mix of long-term sources of finance
- Financial leverage
- Use of fixed-interest funds to magnify EPS
- Trading on equity
- Using debt to raise returns to shareholders
Quick revision
- Kd after tax = I(1 − t)/NP; Ke = D₁/P₀ + g.
- WACC = Σ weight × cost.
- NI: debt adds value; NOI and MM (no tax): it doesn't; traditional: optimum exists.
- DOL = C/EBIT; DFL = EBIT/EBT; DCL = C/EBT.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Define the cost of capital.
- Q2.Why is the cost of debt calculated after tax?
- Q3.What is WACC?
- Q4.State the MM hypothesis without taxes.
- Q5.Define operating leverage.
Long-answer questions
- Q1.Calculate specific costs of capital and the WACC from given data.
- Q2.Explain the theories of capital structure.
- Q3.Explain operating, financial and combined leverage with calculations.
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