COST OF CAPITAL

Case Objective:
 

To understand the need for optimum mix of own money & loan money.
The capital structure of a company consists of equity and debt. The use of debt is called
financial leverage or gearing. Debt is raised on the basis of equity funds supplied by owners.
Therefore, financial leverage is also called trading on equity.
The basic purpose in using debt is to increase the return of owners (shareholders) of a co. by
employing the debt to earn more than its cost. For example, you have an opportunity of
earning 15 % return on an investment of Rs. 1000 for one year. If you put your own money, you
would earn 15 % . Suppose you are able to borrow Rs. 500 at 10% interest from your friend, and
then you invest Rs. 500 of borrowed funds and Rs. 500 of your own. Your return would be Rs.
15, out of which you will have to pay Rs 5 to your friend as interest. On your investment of Rs.
500, you could earn Rs. 10, which is 20%. It is 5% more than what you would have earned if you
had put entirely your own money. (Remember you still have Rs.500 to invest elsewhere) .How
did your rate of return increase? You earned 15% on your friend’s money, but paid him only
10%. The difference of 5% accrued to you without your having put your money. This analysis
may be applied to a co. also. The co.’s borrowings can be evaluated in terms of its impact on
shareholders’ return. Shareholders’ return can be expressed in various ways. One most popular
measure is earnings per share (EPS). You obtain EPS when a co.’s profit after tax is divided by
the number of common shares outstanding:

EPS= PROFIT AFTER TAX/ No. of shares
 

Alternatively, EPS can be calculated by using the following formula:
EPS= (PBIT-INT) (1-T)/ N where PBIT is profit before interest and tax, INT interest on debt, T tax
 Rate and N the no. of outstanding shares. We can also deduce that (PBIT-INT) (1-T) =PAT (profit after tax)