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Chapter 1

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Cost of Debt - Irredeemable Debt ($K_d$)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kd=I(1−t)NPK_{d} = \frac{I(1 - t)}{NP}
Used when debt has no maturity date. II is the annual interest, tt is the tax rate, and NPNP is the Net Proceeds (Issue Price minus flotation costs).

Cost of Debt - Redeemable Debt ($K_d$)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kd=I(1−t)+RV−NPnRV+NP2K_{d} = \frac{I(1 - t) + \frac{RV - NP}{n}}{\frac{RV + NP}{2}}
Used for debt with a fixed maturity. RVRV is the Redemption Value, nn is the number of years to maturity, and NPNP is the Net Proceeds. This uses the approximation method.

Cost of Preference Shares - Irredeemable ($K_p$)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kp=PDNPK_{p} = \frac{PD}{NP}
Used for preference shares that are not repayable. PDPD is the annual Preference Dividend and NPNP is the Net Proceeds.

Cost of Preference Shares - Redeemable ($K_p$)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kp=PD+RV−NPnRV+NP2K_{p} = \frac{PD + \frac{RV - NP}{n}}{\frac{RV + NP}{2}}
Used for preference shares with a fixed redemption period. RVRV is the Redemption Value and nn is the number of years to maturity.

Cost of Equity - Dividend Yield Method

Topic: Cost of Capital ComponentsChapter: Chapter 1
Ke=D1P0+gK_{e} = \frac{D_{1}}{P_{0}} + g
Used when dividends are expected to grow at a constant rate. D1D_{1} is the expected dividend at the end of year 1, P0P_{0} is the current market price, and gg is the growth rate.

Cost of Equity - Earnings Price Ratio Method

Topic: Cost of Capital ComponentsChapter: Chapter 1
Ke=EP0K_{e} = \frac{E}{P_{0}}
Used when the company does not pay dividends or when earnings are used as a proxy. EE is Earnings Per Share (EPS) and P0P_{0} is the market price per share.

Cost of Equity - Capitalization of Earnings Method

Topic: Cost of Capital ComponentsChapter: Chapter 1
Ke=E(1−t)P0K_{e} = \frac{E(1 - t)}{P_{0}}
Used when calculating the cost of equity based on after-tax earnings. EE is Earnings and tt is the tax rate.

Cost of Retained Earnings ($K_{r}$)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kr=Ke(1−tp)K_{r} = K_{e}(1 - t_{p})
Often approximated as the cost of equity, but adjusted for personal taxation if specified. KeK_{e} is the cost of equity and tpt_{p} is the personal tax rate on dividends.

Weighted Average Cost of Capital (WACC)

Topic: Cost of Capital ComponentsChapter: Chapter 1
WACC=∑i=1n(Ki×Wi)WACC = \sum_{i=1}^{n} (K_{i} \times W_{i})
The overall cost of capital calculated by multiplying the specific cost of each component (KiK_{i}) by its respective weight (WiW_{i}) in the capital structure.

Cost of Irredeemable Debt (Before Tax)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kd=INPK_d = \frac{I}{NP}
Calculates the cost of perpetual debt before considering tax benefits. I = Annual Interest Payment, NP = Net Proceeds from issue of debt.

Cost of Irredeemable Debt (After Tax)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kd=I(1−t)NPK_d = \frac{I(1 - t)}{NP}
Calculates the cost of perpetual debt after considering the tax shield on interest. I = Annual Interest Payment, t = Corporate Tax Rate, NP = Net Proceeds from issue of debt.

Cost of Redeemable Debt (Approximation Method - Before Tax)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kd=I+(RV−NP)n(RV+NP)2K_d = \frac{I + \frac{(RV - NP)}{n}}{\frac{(RV + NP)}{2}}
Approximates the cost of redeemable debt before tax. I = Annual Interest Payment, RV = Redemption Value, NP = Net Proceeds from issue of debt, n = Number of years to maturity.

Cost of Redeemable Debt (Approximation Method - After Tax)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kd=I(1−t)+(RV−NP)n(RV+NP)2K_d = \frac{I(1 - t) + \frac{(RV - NP)}{n}}{\frac{(RV + NP)}{2}}
Approximates the cost of redeemable debt after tax. I = Annual Interest Payment, t = Corporate Tax Rate, RV = Redemption Value, NP = Net Proceeds from issue of debt, n = Number of years to maturity.

Cost of Irredeemable Preference Shares

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kp=PDNPK_p = \frac{PD}{NP}
Calculates the cost of perpetual preference shares. PD = Annual Preference Dividend, NP = Net Proceeds from issue of preference shares.

Cost of Redeemable Preference Shares (Approximation Method)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kp=PD+(RV−NP)n(RV+NP)2K_p = \frac{PD + \frac{(RV - NP)}{n}}{\frac{(RV + NP)}{2}}
Approximates the cost of redeemable preference shares. PD = Annual Preference Dividend, RV = Redemption Value, NP = Net Proceeds from issue of preference shares, n = Number of years to maturity.

Cost of Equity (Dividend Yield Method / No Growth Model)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Ke=D1P0K_e = \frac{D_1}{P_0}
Calculates the cost of equity assuming no growth in dividends. D_1 = Expected Dividend per share at the end of year 1, P_0 = Current Market Price per share.

Cost of Equity (Dividend Growth Model / Gordon's Model)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Ke=D1P0+gK_e = \frac{D_1}{P_0} + g
Calculates the cost of equity considering a constant growth rate in dividends. D_1 = Expected Dividend per share at the end of year 1, P_0 = Current Market Price per share, g = Constant Growth Rate of Dividends.

Cost of Equity (Capital Asset Pricing Model - CAPM)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Ke=Rf+β(Rm−Rf)K_e = R_f + \beta (R_m - R_f)
Calculates the cost of equity based on the risk-free rate, market risk premium, and the company's beta. R_f = Risk-free Rate, \beta = Beta Coefficient of the stock, R_m = Expected Return on Market Portfolio.

Cost of Equity (Earnings Yield Method)

Topic: Cost of Capital ComponentsChapter: Chapter 1
Ke=EPSP0K_e = \frac{EPS}{P_0}
Calculates the cost of equity based on earnings per share, often used for companies with stable earnings and high payout ratios. EPS = Earnings Per Share, P_0 = Current Market Price per share.

Cost of Retained Earnings

Topic: Cost of Capital ComponentsChapter: Chapter 1
Kr=KeK_r = K_e
The cost of retained earnings is generally considered equal to the cost of equity, as it represents the opportunity cost for shareholders who forgo current dividends.

Net Present Value (NPV)

Topic: Capital BudgetingChapter: Chapter 1
NPV=∑t=1nCFt(1+k)t−I0NPV = \sum_{t=1}^{n} \frac{CF_t}{(1+k)^t} - I_0
NPV is the difference between the present value of cash inflows and the initial investment. If NPV>0NPV > 0, the project is acceptable. CFtCF_t is cash flow at time tt, kk is the discount rate, and I0I_0 is initial outlay.

Profitability Index (PI)

Topic: Capital BudgetingChapter: Chapter 1
PI=Present Value of Cash InflowsInitial Investment=∑t=1nCFt(1+k)tI0PI = \frac{\text{Present Value of Cash Inflows}}{\text{Initial Investment}} = \frac{\sum_{t=1}^{n} \frac{CF_t}{(1+k)^t}}{I_0}
Also known as the Benefit-Cost Ratio. It measures the relative profitability of a project. A project is viable if PI>1PI > 1.

Internal Rate of Return (IRR)

Topic: Capital BudgetingChapter: Chapter 1
0=∑t=1nCFt(1+IRR)t−I00 = \sum_{t=1}^{n} \frac{CF_t}{(1+IRR)^t} - I_0
IRR is the discount rate that makes the NPV of a project equal to zero. The interpolation formula is used to estimate IRR between a lower rate (L) and a higher rate (H).

Payback Period (PB)

Topic: Capital BudgetingChapter: Chapter 1
PaybackPeriod=Year before full recovery+Unrecovered Cost at start of yearCash Flow during the yearPayback Period = \text{Year before full recovery} + \frac{\text{Unrecovered Cost at start of year}}{\text{Cash Flow during the year}}
The time required to recover the initial investment from the net cash inflows. It ignores the time value of money unless 'Discounted Payback Period' is specified.

Accounting Rate of Return (ARR)

Topic: Capital BudgetingChapter: Chapter 1
ARR=Average Annual Profit after TaxAverage Investment×100ARR = \frac{\text{Average Annual Profit after Tax}}{\text{Average Investment}} \times 100
ARR uses accounting profits rather than cash flows. Average Investment is often calculated as Initial Investment+Salvage Value2\frac{\text{Initial Investment} + \text{Salvage Value}}{2}.

Payback Period (Even Cash Flows)

Topic: Capital BudgetingChapter: Chapter 1
Payback Period=Initial InvestmentAnnual Cash Inflow\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}
Calculates the time required to recover the initial investment when annual cash inflows are constant.

Payback Period (Uneven Cash Flows)

Topic: Capital BudgetingChapter: Chapter 1
Payback Period=Years before full recovery+Unrecovered amount at the beginning of the yearCash flow during that year\text{Payback Period} = \text{Years before full recovery} + \frac{\text{Unrecovered amount at the beginning of the year}}{\text{Cash flow during that year}}
Calculates the time required to recover the initial investment when annual cash inflows are not constant.

Discounted Payback Period

Topic: Capital BudgetingChapter: Chapter 1
Discounted Payback Period=Years before full recovery of PV+Unrecovered PV at the beginning of the yearDiscounted Cash Flow during that year\text{Discounted Payback Period} = \text{Years before full recovery of PV} + \frac{\text{Unrecovered PV at the beginning of the year}}{\text{Discounted Cash Flow during that year}}
Calculates the time required to recover the initial investment in present value terms, considering the time value of money.

Accounting Rate of Return (ARR) / Return on Investment (ROI)

Topic: Capital BudgetingChapter: Chapter 1
ARR=Average Annual Profit After TaxAverage Investment×100\text{ARR} = \frac{\text{Average Annual Profit After Tax}}{\text{Average Investment}} \times 100
Measures the average annual accounting profit generated by a project as a percentage of the average investment. Average Investment = (Initial Investment + Salvage Value) / 2.

Internal Rate of Return (IRR) - Interpolation Method

Topic: Capital BudgetingChapter: Chapter 1
IRR=L+NPVLNPVL−NPVH(H−L)\text{IRR} = L + \frac{\text{NPV}_L}{\text{NPV}_L - \text{NPV}_H} (H - L)
Estimates the discount rate at which the Net Present Value (NPV) of a project becomes zero. LL = Lower discount rate, HH = Higher discount rate, NPVLNPV_L = NPV at lower rate, NPVHNPV_H = NPV at higher rate.

Equivalent Annual Annuity (EAA)

Topic: Capital BudgetingChapter: Chapter 1
EAA=NPVPVIFA(r,n)\text{EAA} = \frac{\text{NPV}}{\text{PVIFA}(r, n)}
Converts the NPV of a project into an equivalent annual cash flow, useful for comparing projects with unequal lives. PVIFA(r, n) is the Present Value Interest Factor of an Annuity for rate 'r' and 'n' periods.
Chapter 1 Formulas — CA Intermediate | Kartavvya