C O S T O F C A P ITA L

D efi
nition
The cost of capital is the minimum

required rate of earning or cut-off

rate of capital expenditure.

M eaning
It represents the minimum rate of

return required or expected by the

investors on their investment which
will maintain the market value of
shares at particular level.

Im portance
Capital decisions
Designing o capital structure
Evaluation of Financial Performance
Knowledge of firms expected income

& risk .

Specifi
c cost ofCapital
Cost of Debt
Cost of Preference capital
Cost of Equity share capital

Cost ofD ebt

Simple to calculate
Rate of interest payable on debt
Debt capital is obtained through

issue of Debentures
Issue of Debentures involves floating
charges for e.g printing of
prospectus, advertisement, etc

Form ula
Kd = I/P
Whereas Kd = Cost of Debt before tax
I = Interest
P = Principal
In case the issue of Debentures is at

discount or at premium ,the net

proceeds should be considered as
the value of P
Kd = I / NP where NP is net proceeds

Contd .
When debt is a source of finance, the

firm saves tax as interest on debt is

deductible for taxation purpose.
After tax cost of Debt = Kd (1-t)
Where t is tax rate.
Debt is redeemable after such
period.
Before tax cost of debt:
K db = I + 1/n (P NP)/ (P + NP )

 Where I = Interest , N = No. of yrs in

which debt is to be redeemed

P = Proceeds at par
NP = Net proceeds
After tax cost of Debt
Kda = Kdb (1-t )

Cost ofPreference capital

Carries dividend at fixed rate
Cost of preference share capital is the

function of dividend expected by the

investors
In case dividends are not paid capacity of
firm to raise funds is affected
Formula = Kp = D/P
Where Kp is cost of preference capital, D
is annual preference dividend, P is
preference share capital (proceeds )

Contd .
When preference shares are issued at

premium or discount
Kp = D/NP *100
In case of redeemable preference shares
Kpr = D + MV NP/n/ (MV + NP) *100
Where Kpr = cost of redeemable
preference shares, D = Annual preference
dividend, MV= Maturity value of
preference shares & NP = Net Proceeds

Cost ofEquity share capital

Rate of dividend is not fixed

therefore some financial experts

draw the conclusion that there is no
cost of equity capital.
Share holders invest money with a

view to earn some return

W eighted average cost of

capital
Is the average cost of various source

of finance
Also known as overall cost of capital
Formula