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COST OF CAPITAL
The cost of capital is the rate of return the firm expects to earn from its investment in order to
increase the value of the firm in the market place. It can be regarded as the rate of return required
by investors on the capital provided by them.

The cost of capital is the discount rate used in NPV calculation and so also the financial
yardstick against which the IRR (Internal rate of Return) is evaluated. Therefore an estimate of
the cost of capital is imperative.

Source of Capital:-

The source of capital employed by the firm is usually in the form:-

i) Equity Share Capital
ii) Preference share Capital
iii) Debts
iv) Retained Earnings.

Components of Cost of Capital

i) Zero Risk Return
ii) Premium for the Business Risk
iii) Premium for the Financial Risk.

i) Zero Risk Return:-

It is the expected rate of return when a project involves no financial and business risks.

ii) Premium for the Business Risk:-

Business risk is determined by the capital budgeting decision that a firm takes for its
investment proposals. So if a firm selects a project that has more than normal risk, then it
is obvious that the capital providers would require or demand a higher rate of return than
the normal rate.
Thus the premium factor plays an important role here as it increases the cost of capital.
But how much premium should be?
It depends on the firm’s goals and objectives and how badly the want the project to
increase their market value.
iii) Premium for the Financial Risk:-

Financial risk is associated with the capital structure pattern of the firm. It depends on the
volume of debts of the firm owes. Higher the debt capital, the more is the risk component
to a firm that has relatively low debts.
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Average Cost of Capital

A firm’s cost of capital is the weighted arithmetic average of the post–tax cost of various
sources of long-term finance used by it. In general, if the firm has n different sources of
finance, its cost of capital will be:-

ka =  wi ki

where
ka = average cost of capital
wi = proportion or weight of the ith source of finance
ki = cost ith source of finance

For calculating the weighted average cost of capital, we multiply the cost of each source of
finance by their respective weights applicable to it. Therefore we need to find the cost of capital
of specific sources of finance and their proportions in the overall capital structure.

I) HOW TO FIND ki ?

ki = (cost of specific sources of finance i.e. Debt capital, Preference Capital, Equity capital
and Retained Earnings).

Cost of specific source of capital is measured as the rate of discount which

equates the Present Value (PV) of expected payments to that source of
finance with the net funds received from that source of finance.

General formula:

P = [ Ct / (1 + k)t ]

where
P = Net funds received from the specific source
Ct = Expected payment to the source at the end of year t
n = Maturity period.

a) Cost of Debt Capital (kd):-

P = [ Ct (1 – T) / (1 + kd)t ] + F / (1 + kd)n

where
P = Net amount release4d on debt issue.
Ct = Annual Interest Payable
T = Tax Rate applicable to the firm
n = Maturity Period of dDebt
F = Redemption Price.
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In order to find the cost of debt capital, solve it for kd.

b) Cost of Preference Capital (kp)

P = [ D / (1 + kp)t ] + F / (1 + kp)n

where
P = Net amount realized per preference share.
D = Preference Dividend per share payable
n = Maturity Period
F = Redemption Price.

In order to find the cost of preference capital, solve it for kp.

c) Rate of Return Required on by Equity Investors

ii) Capital asset Pricing Model (CAPM) Approach:

ki = rf + i (km – rf)

where:

ki = rate of return required on security i.

rf = the risk free rate of return. It may be taken as the rate of return
on bank deposit of long-term nature.

i = beta of security i. Measure of responsiveness of the return on

security i to the return on the market portfolio. The
past beta may be used as the proxy for the future beta.

km = rate of return on market portfolio. For practical purposes we

may regard it as the rate of returned earned on a well
diversified portfolio.

d) Cost of External Equity and Retained Earnings(ke):-

Cost of External equity

i) Dividend Capitalization Approach:

ks = (D1 / P0) + g

If we take Under Pricing and Issue Expenses under consideration,

then
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ke = [D1 / P0( 1- f)] + g

where:
ke = Cost of equity
ks = Rate of Return required by equity investors
f = Under Pricing and Issue Expenses expressed as a
percentage of the current market price.

Cost of Retained Earnings (kr):-

i) Tax-Adjusted Rate of Return Approach

ii) External Yield Approach

kr = kg [(1 – tp) / ((1 – tg)]

where
kr = Cost of Retained Earnings
ks = Rate of Return required by equity investors
tp = Ordinary personal income tax rate
tg = Personal long-term capital gain

II) DETERMINATION OF WEIGHTS:

How to find wi (weights or proportions specific component of overall capital)?

Now we need to determine the weights (wi). These weights or proportions may be based
on:-
i) Book Values
It is based on the values found in the balance sheet. Weight/Proportion is
simply the book value of that source of finance divided by the
book value of the total long-term financing.
ii) Financing Plan
It is based on the proposed sources and size of financing.
iii) Market value
The proportion applied to a source of finance divided by the market value
of all sources of long-term finance employed by the firm.
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WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Given the costs of specific sources of finance and scheme of weighing , the Weighted
Average Cost of Capital (WACC) can be readily calculated by multiplying the specific
cost of each sources of financing by its proportion in the capital structure and adding the
weighted values.

ka = wd kd + wp kp + ws kr

where
ka = Weighted Average Cost of Capital
kd = Cost of long-term debt capital
kp = Cost preference capital
kr = Cost of retained earnings
ke = Cost of external equity
wd = proportion of long-term debt in the capital structure
wp = proportion of preference capital in the capital structure
ws = proportion of equity in the capital structure
a) Sum of weights (wd + wp + ws) = 1

b) The weight equity (ws) is multiplied by either the cost of retained earnings (k r) or
(the cost of external equity (ke). The specific cost used (kr or ke) will
depend on whether the equity is obtained by the way of retained earnings or
external equity issue.
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Illustration:

The costs of specific sources of capital for Bharat Nigam Limited are as follows:-

Cost of debt, kd = 7.5%

Cost of preference capital, kp = 14.0%

Cost of retained earnings, kr = 17.0%

The market value proportions in the company’s target structure are as follows:-

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Source of Capital Market value Proportions

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Debt 0.45

Preference 0.05

Equity 0.50

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Find the overall cost of capital.

Solution:

Weighted Average Cost of Capital (ka):-

ka = wd kd + wp kp + ws ke

= (0.45) (7.5%) + (0.05) (14%) + (0.5) (16%)

= 3.375 + 0.700 + 8.000

= 12.075%