Calculating Overall Cost of Capital for a Company

Understanding the Calculation

The overall cost of capital, often referred to as the Weighted Average Cost of Capital (WACC), represents the blended cost of all the capital a company uses, including debt and equity. It's a crucial metric for evaluating investment opportunities and company valuation. This calculation helps determine the minimum return a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital. We will calculate it using the company's Earnings Before Interest and Taxes (EBIT), the value of its debt (debentures), and its equity capitalization rate.

Key Information Provided

• Debenture Interest Rate: 10%
• Debenture Amount (Debt, D): 20 lakh = ₹2,000,000
• Earnings Before Interest and Taxes (EBIT): ₹5,00,000
• Equity Capitalisation Rate (k_e): 16% or 0.16

Formula for Overall Cost of Capital

The overall cost of capital ($k_o$) can be calculated using the formula:

$k_o = \frac{\text{EBIT}}{\text{Total Firm Value}}$

To use this formula, we first need to determine the Total Firm Value ($V$). The Total Firm Value is the sum of the Value of Equity ($V_e$) and the Value of Debt ($V_d$).

$V = V_e + V_d$

The Value of Equity ($V_e$) is calculated by capitalising the earnings available to equity shareholders (Net Income) at the equity capitalization rate ($k_e$).

$V_e = \frac{\text{Net Income}}{k_e}$

Since the tax rate is not provided, we will assume no taxes for simplicity. Therefore, Net Income is calculated as EBIT minus Interest Expense.

Net Income = EBIT - Interest Expense

Step-by-Step Calculation

1. Calculate Interest Expense:

   The debentures carry a 10% interest rate. The total interest expense is:

   $ \text{Interest Expense} (I) = 10\% \times ₹2,000,000 = 0.10 \times ₹2,000,000 = ₹200,000 $

2. Calculate Net Income:

   Assuming no taxes, Net Income is EBIT minus the Interest Expense:

   $ \text{Net Income} = EBIT - I = ₹500,000 - ₹200,000 = ₹300,000 $

3. Calculate the Value of Equity ($V_e$):

   Using the equity capitalization rate ($k_e$):

   $ V_e = \frac{\text{Net Income}}{k_e} = \frac{₹300,000}{0.16} = ₹1,875,000 $

4. Identify the Value of Debt ($V_d$):

   The value of debt is given by the face value of the debentures:

   $ V_d = ₹2,000,000 $

5. Calculate the Total Firm Value ($V$):

   Sum the value of equity and the value of debt:

   $ V = V_e + V_d = ₹1,875,000 + ₹2,000,000 = ₹3,875,000 $

6. Calculate the Overall Cost of Capital ($k_o$):

   Now, divide the EBIT by the Total Firm Value:

   $ k_o = \frac{EBIT}{V} = \frac{₹500,000}{₹3,875,000} $

7. Convert to Percentage:

   $ k_o \approx 0.129032 $

   Converting this decimal to a percentage gives:

   $ k_o \approx 12.90\% $

Final Result

The calculated overall cost of capital for the company is approximately 12.90%.