STUDY MATERIAL

SYLLABUS: Financing decision Cost of Capital - Cost of specific sources of capital Equity
-Preferred stock debt reserves - weighted average cost of capital, Operating leverage and
Financial Leverage.
COST OF CAPITAL
The term Cost of Capital refers to the minimum rate of return a firm must earn on its
investments so that the market value of the companys equity shares does not fall. This is possible
only when the firm earns a return on the projects financed by the equity shareholders funds at a
rate at which is 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.
DEFINITION
A firms 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.
IMPORTANCE OF COST OF CAPITAL
The determination of Cost of Capital is important from the point of view of both capital
budgeting as well as capital planning decisions.
(a)CAPITAL BUDGETING DECISIONS:
In Capital budgeting decisions, the cost of capital is often used as a discount rate on the
basis of which the firms future cash flows are discounted to find out their present values. Thus, the
cost of capital is the very basis for financial appraisal of new capital expenditure proposals.
(b)CAPITAL STRUCTURE DECISIONS:
The finance manager must raise capital from different sources in a way that optimises the
risk and cost factors. The sources of funds, which have less cost, involve high. Therefore, It is
necessary that cost of each source of funds is carefully considered and compared with the risk
involved in it.
CLASSIFICATION OF COST OF CAPITAL
1.EXPLICIT COST:
It is the discount rate that equates the present value of the funds received by the firm net of
underwriting costs, with the present value of the expected cash outflows.
2. IMPLICIT COST:
It is the rate of return associated with the best investment opportunity for the firm and its
shareholders that will be foregone if the project presently under consideration by the firm were
accepted.
3.FUTURE COST:
It refers to the expected cost of funds to finance the project.
4. HISTORICAL COST:
It is the cost, which has been already incurred for financing a particular project.
5. SPECIFIC COST:
The cost of each component of capital (i.e., equity shares, Preference shares,

debentures, loans etc.) is known as specific source of capital.

6. COMBINED OR COMPOSITE COST:
It is inclusive of all cost of capital from all sources, i.e., equity shares, preference shares,
debentures and other loans.
7. AVERAGE COST:
It is the weighted average of the costs of each component of funds employed by the firm.
The weights are in proportion of the share of each component of capital in the total capital
structure.
8. MARGINAL COST:
It is the weighted average cost of new funds raised by the firm.
APPROACHES IN DETERMINING THE COST OF CAPITAL
I. TRADITIONAL APPROACH:
According to this approach, a firms cost of capital depends on the level of financing or its
capital structure. A firm can change its overall cost of capital by increasing or decreasing the debtequity mix.
For eg., if a company has 9% debentures, the cost of funds raised from this sources comes only
4.5% ( assuming tax rate 50%). Funds from equity and preference shares also involve cost, but the
raising of finance through debentures is cheaper because of the following reasons:
Interest rates are usually lower than the dividend rates.
Interest is shown as a tax-deductible expense.
The traditional approach argues that the weighted average cost of capital will decrease with
every increase in the debt content in the total capital employed. However, the debt content in the
total capital employed should be maintained at a proper level because cost of debt is a fixed burden
on the profits of the company and may lead to adverse consequences when the company has low
profits.
II. MODIGLIANI AND MILLER APPROACH:
According to this approach, the companys total cost of capital is constant and is
independent of the method and level of financing. In other words, this approach says that the
change in the debt-equity ratio does not affect the total cost of capital. According to the traditional
approach, the cost of capital is the weighted average cost of debt and equity and a change in the
debt-equity ratio will change the cost of capital.
For eg, the capital structure of a company is as follows:
9% debentures
Rs. 1, 00,000
Equity share capital
Rs.1, 00,000
Dividend
12%
The company has at present even debt-equity ratio. In case, the debt-equity ratio changes tp say
60% debt and 40% equity, the following consequences will follow:
1. The debt being cheaper, the overall cost of capital will come down.
2.The expectation of the equity shareholders from present dividend of 12%, will go up because
they will find the company now more risky.

Thus, the overall cost of capital of the company is not affected by the change in the debt-equity
ratio. Modigilani and Miller, therefore argue that within the same risk class, mere change of debtequity ratio does not affect the cost of capital and the following theories has been given by them:
1. The total market value of the firm and its cost of capital are independent of its capital
structure. The total market value of the firm can be computed by capitalising the expected
stream of operating earnings at discount rate considered appropriate for its risk class.
2. The cut-off rate for investment purposes is completely independent of the way in which
investment is financed.

Assumptions under Modigilani-Miller approach:

(i)Perfect capital market:

The securities are traded in perfect capital markets. This implies that:
The investors are free to buy or sell securities.
The investors are completely knowledgeable and rational persons. They know all
information and changes in conditions immediately.
The purchase and sale of securities involve no costs such as brokers commission, transfer,
fees etc.
The investors can borrow against securities without restrictions on the same terms and
conditions as the firms can.

(ii) Firms can be grouped in homogenous risk classes:

All the firms can be categorised according to the return they give and a firm in each class is
having the same degree of financial risk.

(iii) Same expectation:

All investors have the same expectation of firms net operating income (EBIT) Which is
used for evaluation of firm. There is 100% dividend pay-out i.e., the firms distribute all of their net
earnings to the shareholders.
(iv) No corporate Taxes.
CONCLUSION:
In conclusion, it may be said that inspite of the correctness of the basic reasoning of the
Modigilani-Miller, the traditional approach is more realistic on account of the following reasons:
(a)The companies are subject to income-tax and therefore due to tax effect, the cost of debt is lower
than the cost of equity capital.
(b)The basic assumption of Modigilani-Miller approach that capital markets are perfect, is seldom
true.
On account of the above reasons Modigilani-Miller approach has come under several
criticisms and it has been suggested by financial analysts that the companys cost of capital is
independent of its financial structure is not valid.

COMPUTATION OF COST OF CAPITAL

Computation of cost of capital involves:

(i)
Computation of cost of each source of finance (specific cost).
(ii)
Computation of composite cost (weighted average cost).
I. COMPUTATION OF SPECIFIC COSTS:
Cost of each sources of finance, viz, debt, preference capital, equity capital can be determined as
follows:
1. COST OF DEBT:
Debt may be issued at par, at premium or discount. It may be Perpetual or redeemable.
(a)Debt issued at par:
The Computation of cost of debt issued at par is comparatively easy. It is the explicit
interest rate adjusted further for the tax liability of the company and is computed as follows:
Kd = (1-T) R
Where Kd = Cost of debt
T = Tax rate
R = Debenture Interest rate.
The tax is deducted out of the interest payable, because interest is treated as an expense while
computing the firms income tax for tax purposes.
(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 realised on account of issue of such debentures or bonds.
Such cost may further be adjusted with the tax rate applicable to the company.
Cost of debentures are calculated using the following formula:
Kd =

I
(1 T )
NP

Where Kd = cost of debt

I = Annual Interest Payment
NP = Net proceeds of loans or debentures
T = Tax rate.
C) Cost of redeemable debt:
(i)If the debentures are redeemable after the expiry of a fixed period the cost of debt before tax can
be calculated as follows:
Kd =

I ( P Np ) / n
( P NP ) / 2

Where I = annual interest Payment

P = Par value of debentures
NP= Net Proceeds of debentures
n=Number of years to maturity.
(ii) The cost of debt after tax can be calculated as follows:
Kd =

I ( P Np ) / n
(1-T)
( P NP ) / 2

Where T = Tax rate.

In order to keep sufficient earnings available to equity shareholders for maintaining their
present value, the company should see that it earns on the funds provided by raising loans at least

equal to the effective interest rate payable on them. If the company earns less than the effective
interest rate, earnings available for the equity shareholders will decrease and this would adversely
affect the market price of the companys equity shares.
2. COST OF PREFERENCE CAPITAL:
In case of borrowings, there is a legal obligation on the firm to pay fixed interest while in case
of preference shares, there is no such legal obligation. But it cannot be concluded that preference
share capital does not involve cost as the Preference dividend is generally paid whenever the
company earns sufficient profits.
The failure to pay dividend may be serious concern as they have the first preference and
accumulation of arrears of Preference dividend may adversely affect the payment of dividend to the
equity shareholders.
(a) On account of these reasons, the cost of Preference share capital may be computed as
follows:
Kp=

Dp
NP

Where Kp= Cost of preference share capital

Dp=Annual Preference dividend
Np=Net proceeds of Preference shares
(b) 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 as follows:
Kp=

D ( P NP ) / n
( P NP ) / 2

Where D= Preference dividend

P=Par value of Preference shares
NP=Net proceeds of Preference shares
n=Number of years to maturity
The cost of preference share capital is not adjusted for taxes, since dividend on preference capital is
taken as an appropriation of profits and not as a charge against profits. Thus, the cost of preference
capital is higher than the cost of debt.
3. COST OF EQUITY CAPITAL
The Dividends are paid to the equity shareholders only if the company earns profits and so
there is an argument that the Equity share capital does not involve any cost . But this is not correct.
Because, the equity shareholders invest money with the expectation of getting dividends and the
market value of the share depends on the return expected by the shareholders.
Moreover, the company issues Equity shares and pays dividend to increase the market
value of the firm.

Therefore, the Cost of Equity share capital can be defined as the minimum rate of return
that a firm must earn on the equity financed portion of an investment 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:
The external equity or new issue of equity shares.
The retained earnings.
(A) THE EXTERNAL EQUITY OR NEW ISSUE OF EQUITY SHARES:
In order to determine the cost of equity capital, the shareholders expectation from their
investment has to be determined first. The following are some of the approaches for the
computation of cost of equity capital.
(1)Dividend Price (D/P) approach:
According to this approach, the investor arrives at the market price of an equity share by
capitalising the expected dividends payments. Cost of equity capital has therefore defined as the
discount rate that equated the present value of all expected future dividends per share with the net
proceeds of the sale of a share.
In other words, the cost of equity capital will be that rate of expected dividends which will
maintain the present market price of the equity shares.
Ke is computed as follows:
Ke =
Where

D
NP

Ke = Cost of equity capital

D = Dividend per equity share
NP= Net proceeds of an equity share.

Limitation:
This approach ignores the fact that retained earnings also have an impact on the market
price of the equity shares.
In case of existing shares, it will be appropriate to calculate the Ke based on the market
price of the equity shares. It is computed as follows:
Ke =

D
MP

Where Ke = Cost of equity capital

D = Dividend per equity share
MP = Market Price of an equity share.
(2) Dividend Price plus growth (D/P + g) approach.
According to this approach, the cost of equity capital is determined on the basis of 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 equity capital is done as follows:
Ke =

D
g
NP

Where Ke = Cost of equity capital

D = Dividend per equity share

NP=Net Proceeds per share

G= Growth in expected dividend.
In the case of existing equity shares the cost of equity can be calculated as follows:
Ke =

D
g
MP

Where Ke = Cost of equity capital

D = Dividend per equity share
MP = Market Price of an equity share.
G = Growth in expected dividend.
(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 in order to evaluate their shareholdings. Hence, the cost of equity capital should be related
to that earning percentage which would keep the market price of the equity shares constant. This
approach takes into account both the dividends as well as retained earnings.
The formula for calculating the cost of equity capital is as follows:

E
Ke= NP
Where Ke = Cost of equity capital
E = Earnings per share
NP = Net Proceeds of an equity 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 equity capital.
(4) Realised Yield approach
According to this approach, the cost of equity capital should be determined on the basis of
return actually realized by the investors in a company on their equity shares. Thus, according to this
approach, the past records in a given period regarding dividends and the actual capital appreciation
in the value of equity shares held by the shareholders should be taken to compute the cost of equity
capital. This approach gives fairly good results in case of companies with stable dividends and
growth records. In case of such companies, it can be assumed that the past behavior will be
repeated in the future also.
(B) COST OF RETAINED EARNINGS.
The companies do not generally distribute the entire profits earned by them by way of
dividend among their shareholders. They retain some profits for future expansion of the business.
There is an assumption that the retained earnings is absolutely cost free. This is not the correct
approach because the amount retained by the company, if it had been
distributed 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 foregone by the shareholders i.e., the
opportunity cost of retained earnings may be taken as the cost of retained earnings. It is equal to the

income that the shareholders could have otherwise earned by placing these funds in alternative
investments.
For eg., if the shareholders have invested the funds in alternative channels, they could
have got a return(say 10%) and this return has not earned by them as the company has retained the
earnings without distributing them. The cost of retained earnings may, therefore be taken as 10%.
The following adjustments are made for ascertaining the cost of retained earnings:
Income Tax adjustment:
The dividends receivable by the shareholders are subject to income tax. Hence, the
dividends actually received by them are not the gross dividends but the amount of net dividend, i.e.,
gross dividends less income tax.
Brokerage cost adjustment:
Usually the shareholders have to incur some brokerage cost for investing the dividends
received. Thus, the funds available with them for reinvestment will be reduced by this amount.
The opportunity cost of retained earnings to the shareholders is therefore, the rate of return
that they can obtain by investing the net dividends (i.e., after tax and brokerage) in alternative
opportunity of equal quality.
The cost of retained earnings after making adjustment for income tax and brokerage cost
payable by the shareholders can be determined by the following formula:
Kr= Ke (IT) (IB)
Where
Kr = Required rate of return on retained earnings
Ke = Shareholders required rate of return
T = Shareholders marginal tax rate
B = Brokerage cost.
The computation of the cost of retained earnings, after making adjustments for tax
liabilities, is a difficult process because personal income tax will differ from shareholder to
shareholder. So in order to avoid this, External yield criterion has been recommended by some
authorities. According to this approach the opportunity cost of retained earnings is the rate of return
that can be earned by investing the funds in another enterprise by the firm. But this method is not
universally acceptable.
WEIGHTED AVERAGE COST OF CAPITAL
After calculating the cost of each component of capital, the average cost of capital is
generally calculated on the basis of weighted average method. This may also be termed as the
overall cost of capital. The computation of the weighted average cost of capital involves the
following steps:
1.CALCULATION OF THE COST OF SPECIFIC SOURCE OF CAPITAL:
This involves the determination of cost of debt, equity & preference capital. This can be
done either on before tax basis or after tax basis. But it will be appropriate to calculate on the
after tax basis. Because the shareholders get dividends only after the taxes have been paid.
2.ASSIGNING WEIGHTS TO SPECIFIC COSTS:

This involves the determination of the proportion of each source of funds in the total
capital structure of the company and this done in any one of the following methods:
(a) MARGINAL WEIGHTS METHOD:
In this method weights are assigned to each source of funds, in proportion of financing
inputs the firm intends to employ. However, this method is suffering from the following limitations:
The weightage is given only for the new capital and not for the already existing
capital and so the weighted average cost of capital so earned may be different from
the actual cost of capital.
A firm should give due attention to long-term implication while designing the firms
financial strategy. But this method does not consider the longterm implications of
the firms current financing.
(b) HISTORICAL WEIGHTS METHOD:
In this method, the relative proportions of various sources to the existing capital
structure are used to assign weights. This is based on the assumption that the firms present capital
structure is optimum and it should be maintained in the future also. Weights under this method may
be either
Book value or
Market value weights.
The weighted average cost of capital will be different depending upon whether book
value weights are used or market value weights are used.
The use of market value weights has the following advantages and practical difficulties:
Advantages:
(i)
The market values of the securities are closely approximate to the actual amount to be
received from the sale of such securities.
(ii)
The cost of specific source of finance that constitutes the capital structure is calculated
according to the prevailing market price.
Limitations:
(i)
The market value of the securities fluctuates considerably.
(ii)
Market values are not readily available as compared to the book values. The book values
can be taken from he published records of the firm.
(iii)
The analysis of the capital structure of the company, in terms of debtequity ratio, is
based on the book value and not on the market value.
3. ADDING OF THE WEIGHTED COST OF ALL SOURCES OF FUNDS TO GET AN
OVERALL WEIGHTED AVERAGE COST OF CAPITAL

LEVERAGES
MEANING:

The term leverage refers to an increased means for accomplishing some

purpose. It is used to describe the firms ability to use fixed cost assets or funds to
magnify the return to its owners.
James Horne has defined leverage as the employment of an asset or funds for
which the firm pays a fixed cost or fixed return.
TYPES OF LEVERAGES
Leverages are of three types:
(i) Operating leverage,
(ii)Financial leverage,
(iii)Composite leverage.
I. OPERATING LEVERAGE:
Meaning:
The operating leverage may be defined as the tendency of the operating profit to vary
disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of
volume of output or sales. The firm is said to have a high degree of operating leverage if it employs
a greater amount of fixed costs and a lesser amount of variable costs and vice versa. Thus, the
degree of operating leverage depends on the amount of fixed elements in the cost structure.
Operating leverage is a function of three factors:
1. The amount of fixed costs.
2. The contribution margin.
3. The volume of sales.
There will be no operating leverage if there are no fixed costs.
Computation: The Operating leverage can be calculated as follows:
Operating leverage measures the sensitivity of EBIT to changes in Q.
Contribution

Operating leverage= Operatingprofit or

Where
Contribution
Operating Profit

C
OP

= Sales - Variable cost

= Earnings before interest and Tax (EBIT)

Operating leverage may be favourable or unfavourable. In case the contribution exceeds the
fixed cost, it is favourable and in the reverse case, it is unfavourable.
Degree of Operating leverage:
The degree of Operating leverage may be defined as the percentage change in the
profits resulting from a percentage change in the Sales.

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Degree of Operating leverage = Percentage change in profits

Percentage change in sales
Degree of operating leverage =
Change in EBIT
Change in Sales (Q)
Where EBIT = Total revenue - Total Variable cost Fixed cost
=QxP-QxV-F
=Q(P-V)-F
Where Q = Quantity produced and Sold
P = selling price per unit
V = Variable cost per unit
F = Fixed cost
Uses:
The Operating leverage indicates the impact of change in sales on operating income. If
a firm has a high degree of Operating leverage, small changes in sales will have large effect on
operating income i.e., the operating profits (EBIT) of such a firm will increase at a faster rate
than the increase in sales.
Similarly the operating profits of such a firm will suffer a greater loss as compared to
reduction in its sales.
Generally it is not advisable to have a high degree of operating leverages there is risks of
decreasing the profits even for a sight drop in sales.
II.FINANCIAL LEVERAGE
MEANING:
The financial leverage may be defined as the tendency of the net income to very
disproportionately with the operating profit. It indicates the change that takes place in the taxable
income as a result of change in the operating income.
It signifies the existence of fixed interest/dividend bearing securities in the total capital
structure of the company. Thus, the use of debt capital, preference capital along with the owners
equity in the total capital structure of the company is described as the financial leverage. If the
fixed interest/dividend bearing securities are greater as compared to the equity capital, the leverage
is said to be larger. In a reverse case the leverage will be said to be smaller.
FAVOURABLE AND UNFAVOURABLE FINANCIAL LEVERAGE:
The leverage may be considered to be favourable if the firm earns more on the assets
purchased with the funds than the fixed costs of their use. Unfavourable or negative leverage occurs
when the firm does not earn as much as the funds cost.
Trading on Equity and financial leverage:
Financial leverage is also sometimes termed as trading on equity.
COMPUTATION:
It can be computed by the following methods:
(i)Where the capital structure consists of equity shares and debt:
Financial leverage measures the responsiveness of EPS to changes in EBIT.
In this case, the financial leverage an be computed as follows:

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Financial Leverage =

OP
PBT

or

OP

EBT
Where
OP = Operating Profit or Earnings before Interest and Tax (EBIT).
PBT = Profit before tax but after Interest.
Degree of Financial Leverage:
Degree of Financial Leverage may be defined as the percentage change in taxable profit as a result
of percentage change in operating profit. . It can be computed as follows:
Degree of Financial Leverage = Percentage change in the taxable income
Percentage change in the operating income.
(ii)Where the capital structure consists of preference shares and equity shares:
The formula for computing computation of financial leverage can also be applied to a
financial plan having preference shares. The amount of preference dividends will have to be
grossed up (as per the tax rate applicable to the company) and then deducted from the earnings
before interest and tax.
(iii)Where the capital structure consists of equity shares, preference shares and debt:
In this case, the financial leverage can be computed after deducting from operating profit
both interest and preference dividend on a before tax basis.
Alternative definition of financial leverage:
The ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on
the firms Earning per share.
Degree of Financial Leverage = Percentage change in Earning per share (EPS)
Percentage change in the EBIT
Where
EPS = Earning per share =

( EBIT I )(1 T ) Dp
N

Where
EBIT = Earnings before interest and tax
I
= Interest paid on debt
T = Tax rate
Dp = Preference dividend
N
= Number of equity shares
III.COMPOSITE LEVERAGE:

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Operating leverage measures the percentage change in the operating profit due to
percentage change in sales and it explains the degree of operating risk.
Financial leverage measures the percentage change in taxable profit (or EPS) on account of
percentage change in operating profit (EBIT) and it explains the financial risk.
Both these leverages are closely concerned with the firms capacity to meet its fixed costs
(both operating and financial). If both the leverages are combined, the result obtained will disclose
the
effect of change in the sales over change in taxable profit (EPS).

Composite Leverage thus explains the relationship between revenue on

account of sales (i.e., contribution or Sales less Variable cost) and the taxable
income. It helps in finding out the resulting percentage change in taxable income
on account of percentage change in sales.
Computation:
Composite Leverage = Operating Leverage x Financial Leverage.
Composite Leverage =

C
OP
C
x
=
OP PBT
PBT

Where
C = Contribution (i.e., Sales - Variable cost)
OP = Operating profit or Earnings before Interest and Tax (EBIT)
PBT = Profit before tax.

;SIGNIFICANCE OF OPERATING AND FINANCIAL LEVERAGES

The operating leverage and the financial leverage are the two important quantitative tools
used by the financial experts to measure the return to the owners (EPS) and the market price of the
equity shares.
The financial leverage is superior of these two tools as it focuses on the market price of the
shares, which the management always tries to increase by increasing the net worth of the firm.
When there is increase in EBIT, the price of the equity shares also increases. If a firm goes
on increasing the debt capital, the marginal cost of debt also will increase as the lenders will
demand higher rate of interest.
A company should try to have a balance of the two leverages because they have got
tremendous acceleration and deceleration effect on EBIT and EPS. It may be noted that a right
combination of these leverages is a very big challenge to for the management. A proper
combination of both operating and financial leverages is a blessing for a firms growth while an
improper combination may prove to be a curse.
A high degree of operating leverage together with a high degree of financial leverage makes
the position very risky. This is because on the one hand it is employing excessive assets for which it
has to pay fixed costs and at the same time it is also using a large amount of debt capital. The fixed
costs towards using assets and fixed interest charges bring a greater risk, as the company may not
be able to meet in case of declined earnings.

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The existence of operating leverage will result in more than proportionate change even for a
small change in sales. The Presence of high degree of financial leverage causes a more than
proportionate change in EPS even on account of a small change in EBIT.
Thus firms having a high degree of operating leverage and financial leverage has to face the
problems of liquidity or insolvency in one year or the other year. It does not however mean that a
firm should opt for low degree of financial leverage. This may indicate the cautious policy of the
management, but the firm will be losing profit-earning opportunities.
A firm having high operating leverage should not have high financial leverage. Similarly a
firm having a low operating leverage will gain profit by having a low operating leverage provided it
has enough profitable opportunities for the employment of borrowed funds.
Low operating leverage and high financial leverage is considered to be an ideal situation for the
maximization of the profits with minimum risk. A firm should therefore, make all possible efforts to
combine the operating and financial leverage to maximize the risk and minimize the risk.
SUGGESTED QUESTIONS:
Short answer questions:
1.
2.
3.
4.
5.
6.

Define cost of capital.

What is meant by cost of equity capital?
What is meant by cost of debt?
What is meant by cost of Preference capital?
Define operating leverage?
Define financial leverage?

Long answer questions:

1.What is meant by cost of capital? What is meant by explicit cost and real cost of capital?
2.Define the concept of cost of capital and State how you would determine the weighted average
cost of capital of a firm.
3.What is Modigilani - Miller approach to the problem of capital structure? Under what
assumptions do their conclusion hold good?
4. Discuss briefly the different approaches for the calculation of cost of equity capital.
5. Why is that the debt is the cheapest source of finance for a profit making company?
6. Discuss briefly the different approaches for the calculation of cost of debt capital.
7. Discuss briefly the different approaches for the calculation of cost of preference capital.
8. Explain how the cost of retained earnings is determined where such retained earnings are
proposed to distribute as bonus shares to the existing shareholders.
9. Define leverage. Explain its types. Discuss its significance.
10. Explain the concept of operating leverage with suitable examples.
11. Explain the concept of financial leverage with suitable examples.
12. Explain the concept of combined leverage with suitable examples.

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13. Explain the significance of operating and financial leverage.

14. Explain how the various leverages are computed?
15. Explain the Modigilani - Miller approach to the capital structure of a company.
16. Explain the three different types of leverages elaborately.
17. Explain the different sources of capital in detail.
18. Explain the concept of Weighted average cost of capital in detail
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