GTU MBA II Sem Financial management

Chapter Objectives
 Cost of Debt
Chapter - 9
 Cost of Preference Capital
The Cost of Capital
 Cost of Equity Capital

 WACC

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Cost of Capital FUND

 Discount rate
 Target rate
 Hurdle rate
 Opportunity cost of capital
 Minimum required rate of return
 Cut-off rate

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Sources of funds
 Equity shareholders
 Preference shareholders  To procure funds, the firm must pay
 Debt holders this return to the investor.

 These investors provide funds to the firm  So, the proposal must earn at least
 They expect a minimum return from the firm. that much, which is sufficient to pay to
 This minimum return depends upon the risk. the investors.

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GTU MBA II Sem Financial management

Introduction
 The project’s cost of capital is the
minimum required rate of return on funds
committed to the project, which depends
on the riskiness of its cash flows.

 The firm’s cost of capital will be the

overall, or average, required rate of
return on the aggregate of investment
projects.

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Explicit and Implicit Cost of Capital

Significance of the Cost of Capital  Explicit COC: Interest or dividend that the firm
has to pay to the suppliers of funds.
It is useful as a standard for:
(Payment by the firm)

 Evaluating investment decisions (NPV, IRR)

 Designing a firm’s debt policy, and
 Appraising the financial performance of top
management.
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 Implicit COC: Retained earnings does not
involve any payment.
The implicit cost of the retained earnings is the
return which could have been earned by the
investors, had the profit been distributed to them
(they could have invested these funds
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The Concept of the Opportunity Cost General Formula for the Opportunity
of Capital Cost of Capital
 The opportunity cost is the rate of return  Opportunity cost of capital is given by the
following formula:
foregone on the next best alternative
investment opportunity of comparable risk. C1 C2 Cn
I0    
(1  k ) (1  k ) 2 (1  k ) n

where Io is the capital supplied by

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investors in period 0 (it represents a net
cash inflow to the firm),
Ct are returns expected by investors
(they represent cash outflows to the firm)
k is the required rate of return or the
cost of capital.
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GTU MBA II Sem Financial management

Cost of Capital Weighted Average Cost of Capital Vs. Specific

Costs of Capital

 The cost of capital of each source of capital

is known as component, or specific, cost
of capital.

 The overall cost is also called the weighted

average cost of capital (WACC).

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Cost of Debt
It is the rate of return required by lenders.

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GTU MBA II Sem Financial management

Example:
Cost of Preference Capital

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Example:
Weighted Average Cost of Capital

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Ko= k1w1 + k2w2 + k3w3 + …….

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GTU MBA II Sem Financial management

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