Amity Business School

Presentation Plan
• Introduction

• Significance of cost of capital

• Different types of costs

• Components of cost of capital

• Calculation of WACC

• Calculation of Beta (β )

• Capital Asset Pricing Model

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Introduction
• Cost of Capital – The opportunity cost of capital or
simply the cost of capital is the minimum required
rate of return on funds committed to the project,
which depends on the riskness of its cash flows.

• The firm’s cost of capital is different from that of

the project’s. The project’s cost of capital is
defined by the risk involved in the respective
project, whereas, the firm’s cost of capital is the
required rate of return on the aggregate of
investment projects.
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SIGNIFICANCE OF COST
OF CAPITAL
• Evaluating investment decision

• Designing a firm’s debt policy

• Appraising the financial performance of

top management
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Different types of costs

• Opportunity cost

• Future cost

• Marginal cost

• Historical Cost
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Components of cost of
capital
• Cost of debt
Kd = I (1-T) Kd = I(1-T) + (RV – NIP/ no. of years)
P (RV + NIP/2)

• Cost of equity
Ke = Expected Dividend + Growth Ke = D0(1+g) x g
Price P

• Cost of retained earnings or surplus

Kr = Ke when MP or FV is taken but is different in case
where, FP is taken because in retained earnings,
there is no floatation cost involved
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COMPONENTS CONTD.

• Cost of Preference Capital

Kp = Preference Dividend + Corporate Dividend Tax

Price
Kp = PD + CDT
P
Kp = PD + CDT + (RV – NIP/ no. of years)
(RV + NIP/2)
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CALCULATION OF WACC
• Weighted average cost of capital is the
calculation of a firm's cost of capital in which
each category of capital is proportionately
weighted.

WACC = Σ WX
Total Investment
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RISK & RETURN

RETURN
RISK (σ )

Ex – post Ex – ante
Systematic (β ) Historical data based Anticipation
Unsystematic (ρ im) based

Macro economic Unique to Quantitative Qualitative

firm
factors Objective Subjective

First short listing knowledge of

Can’t be eliminated Can be macroeconomic
eliminated factors
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CALCULATION OF BETA
(β )
Beta = Cov (i, m)
σ ^2 m

= Σ (Ri – R1’)(Rm – Rm’)/ n-1

Σ (Rm – Rm’)^2/Ri =nreturn
-1 on security
Rm = Return on market
n = Number of samples
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CAPITAL ASSET PRICING

MODEL
• High Return
Expected & underpriced
Return (Ri)

• Low return
& Overpriced

Risk (β )
Ri = Rf + β (Rm - Rf)
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