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Cost of capital of a firm is the minimum rate of return expected by its investors.

The capital used by a firm may be in the form of equity shares, preference shares ,debts and retained earnings. The cost of capital is the weighted average cost of these sources of finance used by a firm. The concept of cost of capital occupies a very important role in financial management because the investment decision based on it. If a firm is not able to achieve its cost of capital the market value of its shares will fall.

Definitions of cost of capital: According to M.J.Gordon,james,The cost of capital is the minimum rate of return which a
firm requires as a condition for undertaking an investment. According to C.Van.Horne,Soloman, The cost of capital is the rate of return a company must earn on an investment to maintain the value of the company.

Significance of the cost of capital: 1) Helpful in designing the capital structure: The concept of cost of capital
plays a vital role in designing the capital structure of a company. Capital structure of a company consists of different sources of capital such as equity capital, retained earnings, preference capital debt capital. These sources differ from each other in terms of their respective costs. Hence, the calculation of cost of capital of different sources of capital is very essential to design an optimum capital structure. 2) Helpful in taking capital budgeting decisions: The concept of cost of capital is very useful in making capital budgeting decisions because the cost of capital is the minimum required rate of return on an investment project. 3) Helpful in comparative analysis of various sources of finance: calculation of cost of capital is helpful in analysis of usefulness of various sources of finance. A particular source of finance may be encouraged or discouraged on the basis of its changed cost. 4) Helpful in taking other financial decisions: The cost of capital concept is also useful in making other financial decisions such as dividend policy, rights issue, working capital decisions and capitalization of profits.

Factors affecting cost of capital: 1) Risk free interest rate: The risk free interest rate is the interest rate on the risk
free and default free securities. Risk free interest rate determined by the demand and supply of such securities in the financial market. When the risk free interest rate rises overall cost of funds increases in the economy and vice - versa. 2) Business risk: The term business risk refers to the variability in the operating profits (Earning before interest and taxes or EBIT) due to change in sales. 3) Financial risk: Financial risk also affects the cost of capital of a firm. If the financial risk increases the investors will be demanding higher rate as compensation for increased financial risk and consequently the overall cost of capital will increases.

4) Requirement of funds: If a firm requires large amount of funds it will have to


bear a high cost of capital as compared to those firms which require lower amount of funds.

CONCEPT OF COST OF CAPITAL


The term cost of capital refers to the maximum rate of return a firm must earn on its investment so that the market value of company's equity shares does not fall. This is a consonance with the overall firm's objective of wealth maximization. This is possible only when the firm earns a return on the projects financed by equity shareholders' funds at a rate which is at least equal to the rate of return expected by them. If a firm fails to earn return at the expected rate, the market value of the shares would fall and thus result in reduction of overall wealth of the shareholders. Thus, a firm's cost of capital may be defined as "the rate of return the firm requires from investment in order to increase the value of the firm in the market place" .There are three basic aspects of concept of cost: (i)It is not a cost as such: A firm's cost of capital is really the rate of return that it requires on the projects available. It is merely a 'hurdle rate'. Of course, such rate may be calculated on the basis of actual cost of different components of capital. (ii)It is the minimum rate of return: A firm's cost of capital represents the minimum rate of return that will result in at least maintaining (if not increasing) the value of its equity shares. (iii) It compromises of three components: A firm's cost of capital comprises of three components

(A).Return at zero risk level: This refers to the expected rate of return when a
project involves no risk whether business of financial.

(B).Premium for business risk: The term business risk refers to the variability in
operating profit (EBIT) due to change in sales. In case a firm selects a project having more than the normal or average risk, the suppliers of funds for the project will expect a higher rate of return than the normal rate. The cost of capital will thus go up. The business risk is generally determined by the capital budgeting decisions. (c)premium for financial risk: The term financial risk refers to the risk on account of pattern of capital structure (or debtequity mix). In general, it may be said that a firm having higher debt content in its capital structure is more risky as compared to affirm which has a comparatively low debt content. This is because in the former case the firm requires higher operating profit to cover periodic interest payment and repayment of principal at the time of maturity as compared to the latter. Thus, the chances of cash insolvency are greater in case of such firms. The suppliers of funds would therefore expect a higher rate of return from such firms as compensation for higher risk. The above three components of cost of capital may be put in the form of the following equation:- k= r0 +b +f Where; K = Cost of capital, r0 = return at zero risk level, b=Premium for business risk; f= Premium for financial risk.

COMPUTATION OF COST OF CAPITAL Computation of cost of cost of capital involves: Computation of cost of each
specific source of finance-termed as computation of specific costs.

Computation of specific costs: Cost of each specific source of finance, viz., debt,
preference capital and equity capital, can be determined as follows:

Cost of debt: Debt may be issued at par, at premium or discount. It may be perpetual or redeemable.
The technique of computation of cost in each case has been explained later.

(a) Debt issued at par: The computation of cost of debt issued at par is comparatively
an easy task. It is the explicit interest rate adjusted further for the tax liability of the company. It may be computed according to the following formula: Kd = (l-T)R Where; Kd = Cost of debt; T = Marginal tax rate; R = Debenture interest rate. (b)Debt issued at premium or discount: In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realized on account of issue of such debentures or bonds. Such cost may further be adjusted keeping in view the tax applicable to the company.

Cost of preference capital: The computation of the cost of preference capita


however poses some conceptual problems. In case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while in case of preference shares, there is no such legal obligation. Hence, some people argue that dividends payable on preference share capital do not constitute cost. However, this is not true. This is because, though it is not legally binding on the company to pay dividends on preference shares, it is generally paid whenever the company makes sufficient profits. The failure to pay dividend may be better of serious concern from the point of view of equity shareholders. They may even lose control of the company because of the preference shareholders getting the legal right to participate in the general meetings of the company with equity shareholders under certain conditions in the event of failure of the company to pay them their dividends. Moreover, the accumulation of arrears of preference dividends may adversely affect the right of equity shareholders to receive dividends. This is because no dividend can be paid to them unless the arrears of preference dividend are cleared. On account of these reasons the cost of preference capital is also computed on the same basis as that of debentures. The method of its computation can be put in the form of the following equation: Kp = Dp/Np Where;Kp = Cost of preference share capital Dp = Fixed preference dividend Np = Net proceeds of preference shares.

Cost of redeemable preference shares:


In case of redeemable preference shares, the cost of capital is the discount rate that equals the net proceeds of sale of preference shares with the present value of future dividends and principal repayments. Such cost can be calculated according to the same formula which has been given in the preceding pages for calculating the cost of redeemable debentures.

Cost of equity capital: The computation of the cost of equity capital is a difficult task.
Some people argue, as observed in case of preference shares, that the equity capital does not involve any cost. The argument put forward by them is that it is not legally binding on the company to pay dividends to the equity shareholders. This does not seem to be a correct approach because the equity shareholders invest money in shares with the expectation of getting dividend from the company. The company also does not issue equity shares without having any intention to pay them dividends. The market price of the equity shares, therefore, depends upon the return expected by the shareholders. Conceptually cost of equity share capital may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment in a project in order to leave unchanged the market price of such shares. In order to determine the cost of equity capital, it may be divided into the following two categories:

1) The external equity or new issue of equity shares:From the preceding


discussion, it is implied that in order to find out the cost of equity capital, one must be in a position to determine what the shareholders as a class expect from their investment in equity shares. This is a difficult proposition because shareholders as a class are difficult to predict or quantify. Different authorities have conveyed different explanations and approaches. The following are some of the appropriate according to which the cost of equity capital can be worked out:

1. Dividend price (D/P) Approach: According to this approach, the investor


arrives at the market price of an equity shares by capitalizing the set of expected dividend payments. Cost of equity capital has therefore been defined as "the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share". Ke=d1/p0 Where, ke =cost of equity capital D1=expected dividend per share P0=net proceeds/current market per share.

2. Dividend price plus growth (D/P+g) approach:


According to this approach, the cost of equity capital is determined on the basis on the expected dividend rate plus the rate of growth in dividend. The rate of growth in dividend is determined on the basis of the amount of dividends paid by the company for the last few years. The computation of cost of capital according to this approach can be done by using the following formula: Ke = (D1/p0) + g Where; Ke = Cost of equity capital; D1 = Expected dividend per share; p0

= Net proceeds of per share; g= Growth in expected dividend It may be noted that in case of existing equity shares, the cost of equity capital can also be determined by using the above formula. However, the market price (MP)should be used in place of net proceeds (P0) of the shares as given above.

3. Earning price (E/P) approach : According to this approach, it is the earning per
share which determines the market price of the shares. This is based on the assumption that the shareholders capitalize a stream of future earnings (as distinguished from dividends) in order to evaluate their share holdings. Hence, the cost of capital should be related to that earnings percentage which could keep the market price of the equity shares constant. This approach, therefore, takes into account both dividends as well as retained earnings. However, the advocates of this approach differ regarding the use of both earnings and the market price figures. Some simply use of current earning rate and the current market price of the share of the company for determining the cost of capital. While others recommend average rate of earnings (based on the earnings of the past few years) and the average market price (calculated on the basis of market price for the last few years) of equity shares. The formula for calculating the cost of capital according to the approach is as follows:- ke = E/M Where; ke =cost of equity capital; E=earning per share; M=market price per share However, in case of existing equity shares, it will be appropriate to use market price (MP) instead of net proceeds (NP) for determining the cost of capital.

4. capital asset pricing model or (CAPM approach):


According to this approach, cost of equity capital has two parts. one is risk less rate of return which is received on investment in government securities and the other being additional risk premium to compensate for the risk arising from the investment in risky security. The risk premium depends upon the return on market portfolio (overall market) and beta (risk) of the security. In this method cost of capital is calculated with the help of the following formula: Ke= Rf+(Rm Rf) Where; Rf=risk free rate of return = beta or risk of the investment Rm=return on market portfolio.

Explain with illustration: Calculate the cost of equity capital of a company where beta factor is 1.5.risk free rate of interest on government securities is 8%. Return on market portfolio is 12%. Solution: ke=Rf+b(Km-Rf) =8%+1.5(12%-8%) =8%+1.5(4%) =14%

Cost of Retained Earnings: The companies do not generally distribute the entire
profits earned by them by way of dividend among their shareholders. Some profits are retained by them for future expansion of the business. Many people feel that such retained earnings are absolutely cost free. This is not the correct approach because the amount retained by company, if it had been distributed among the shareholders by way of dividend, would have given them some earning. The company has deprived the shareholders of these earnings by retaining a part of profit with it. Thus, the cost of retained earnings is the earning forgone by the shareholders. In other words, the opportunity cost of retained earnings may be taken as the cost of the retained earnings. It is equal to the income that the shareholders could have otherwise earned by placing these funds in alternative investments. For example, if the shareholders could have invested the funds in alternative channels, they could have got a return of 10%.This return of 10% has been forgone by them because of the company is not distributing the full profits to them. The cost of retained earnings may, therefore, be taken at 10%. In other words, if earnings were paid as dividends and simultaneously an offer for the right shares was made, the shareholders would have subscribed to the right shares on the expectation of certain return. This expected return can be taken as the cost of retained earnings of the company. The cost of retained earnings is calculated as follows: Kr= Ke (1-T) (1-B) Where; Kr=cost of retained earnings Ke=cost of equity capital T=tax rate of shareholders B=rate of brokerage.

Explain with illustration: Source of fund 40,000 equity shares (fully paid up) 3,000 6% debentures 2,000 6% preference shares Retained earnings Rs. 4,00,000 3,00,000 2,00,000 1,00,000

Earnings per equity share has been Re.1 during the past years and equity share is being sold in the market at par. Assume corporate tax at 35% and shareholders tax liability at 30%. Solution:Cost of equity capital or Ke = D1/MP*100 = 1/10*100=10% Cost of debt : Kda = I/NP*100(1-t) =6/100*100(1-.35) =6%(0.65) =3.9% Calculate of weighted average cost of capital using book values:

Sources of funds Equity Share Capital 6% Debentures 6% Preference share Capital retained Earnings

Book value Proportion Cost % 400000 .4 10 300000 .3 3.9 200000 .2 6 100000 .1 10 ---------------1000000 1.00

Weighted cost 4 1.17 1.2 1 ------7.37