NAME: FAISAL AHMAD WANI

ROLL NO : 20660333
SECTION : C
SEMESTER : 5TH
TOPIC : BUDGETARY CONTROL.
TEACHER INC: DR. FAROOQ AJAZ SHAH.
What is cost of capital?

Cost of capital is a company's calculation of the

minimum return that would be necessary in order
to justify undertaking a capital budgeting project,
such as building a new factory.

The term cost of capital is used by analysts and

investors, but it is always an evaluation of whether
a projected decision can be justified by its cost.
Investors may also use the term to refer to an
evaluation of an investment's potential return in
relation to its cost and its risks.

The concept of the cost of capital is key

information used to determine a project's hurdle
rate. A company embarking on a major project
must know how much money the project will have
to generate in order to offset the cost of
undertaking it and then continue to generate
profits for the company.
Sources of long-term financing: -
 Equity financing: - This involves raising funds by
issuing shares of common or preferred stock to
investors. Equity financing does not require
repayment, but it results in dilution of ownership and
may involve sharing control of the company with
new shareholders.
 Debt financing: This involves borrowing money from
lenders and repaying it with interest over a specified
period of time. Debt financing may include bank
loans, corporate bonds, or other debt instruments.
 Lease financing: This involves leasing assets such
as equipment, vehicles, or real estate instead of
purchasing them outright. Lease financing may offer
tax benefits and lower initial costs, but it may be
more expensive in the long run.
 Venture capital: This involves raising funds from
professional investors who provide capital in
exchange for a share of ownership and control in
the company. Venture capital is often used by
startups and early-stage companies that have high
growth potential.
 Crowdfunding: This involves raising funds from a
large number of individuals through online
platforms. Crowdfunding may be used for a variety
of purposes, such as product development or
charitable causes.

Methods for calculating cost of equity capital:

Cost of Debt: The cost of debt is the effective interest rate that
a company pays on its debts, such as bonds and loans. The
cost of debt can refer to the before-tax cost of debt, which is
the company’s cost of debt before taking taxes into account, or
the after-tax cost of debt. The key difference in the cost of debt
before and after taxes lies in the fact that interest expenses are
tax-deductible.

The cost of debt is merely the interest rate paid by the company on its
debt.

There are many ways to calculate cost of debt. One common method is
adding your company’s total interest expense for each debt for the year,
then dividing it by the total amount of debt.

Another formula that businesses and investors can use to calculate cost
of debt is:

Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax

Rate)

Here’s a breakdown of this formula’s components:

 Risk-free return: Determined from the return on US government

security
 Credit spread: Difference in yield between US Treasury bonds
and other debt securities
 Tax rate: Percentage at which a corporation is taxed


Cost of Equity:
Equity is the amount of cash available to shareholders as a result of
asset liquidation and paying off outstanding debts, and it’s crucial to a
company’s long-term success.

Cost of equity is the rate of return a company must pay out to equity
investors. It represents the compensation that the market demands in
exchange for owning an asset and bearing the risk associated with
owning it.

This number helps financial leaders assess how attractive investments

are—both internally and externally. It’s difficult to pinpoint cost of equity,
however, because it’s determined by stakeholders and based on a
company’s estimates, historical information, cash flow, and comparisons
to similar firms.

Cost of equity is calculated using the Capital Asset Pricing Model

(CAPM), which considers an investment’s riskiness relative to the
current market.

To calculate CAPM, investors use the following formula:

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of

Return - Risk-Free Rate of Return)

Here’s a breakdown of this formula’s components:

Risk-free return: Determined from the return on US government security

Average rate of return: Estimated by stocks, such as Dow Jones

Return risk: Stock’s beta, which is calculated and published by

investment services for publicly held companies

Companies that offer dividends calculate the cost of equity using the
Dividend Capitalization Model. To determine cost of equity using the
Dividend Capitalization Model, use the following formula:

Cost of Equity = (Dividends per Share / Current Market Value of Stocks)

+ (Dividend Growth Rate)

Here’s a breakdown of this formula’s components:

Dividends: Amount of money a company pays regularly to its

shareholders

Market value stocks: Fractional ownership of equity in an organization

that’s value is determined by financial markets

Dividend growth rate: Annual percentage rate of growth of a dividend

over a period
Question: - Calculate the cost of equity capital of H limited whose risk-free
rate of return equals 10%. The firm’s beta equals 1.75 and the return on
the market portfolio equals to 15%?

Solution: -

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of

Return - Risk-Free Rate of Return)

Ke =10% +1.75 (15% -10%)

Ke = 10% +1.75 (5%)

Ke = 10% +8.75%

Ke = 18.75%

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the most common
method for calculating cost of capital. It equally averages a company’s
debt and equity from all sources.

Companies use this method to determine rate of return, which indicates

the return that shareholders demand to provide capital. It also helps
investors gauge the risk of cash flows and desirability for company
shares, projects, and potential acquisitions. In addition, it establishes the
discount rate for future cash flows to obtain value for a business.

WACC is calculated by multiplying the cost of each capital source (both

equity and debt) by its relevant weight by market value, then adding the
products together to determine the total. The formula is:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Here’s a breakdown of this formula’s components:

 E: Market value of firm’s equity

  D: Market value of firm’s debt
 V: Total value of capital (equity + debt)
 E/V: Percentage of capital that’s equity
 D/V: Percentage of capital that’s debt
 Re: Required rate of return
 Rd: Cost of debt
 T: Tax rate
A high WACC calculation indicates that a company’s stock is volatile or
its debt is too risky, meaning investors will demand greater returns.

Capital Structure concept and determinants of capital

structure: -

Capital structure refers to the mix of debt and equity financing that a
company uses to finance its operations and investments. It represents
the way in which a company raises funds and manages its financial risk,
and it has important implications for the company's cost of capital,
financial flexibility, and shareholder value.

The determinants of capital structure are the factors that influence a

company's choice of financing mix, and they can be grouped into two
broad categories: internal and external factors.

Internal factors are those that are specific to the company's operations
and financial condition, and they include:

1. Profitability: Companies that are more profitable may be able to

take on more debt without increasing their financial risk.
2. Size: Larger companies may have greater access to capital
markets and may be able to issue debt or equity at a lower cost.
3. Asset structure: Companies with a higher proportion of tangible
assets may be able to secure debt financing more easily, as these
assets can serve as collateral.
4. Financial flexibility: Companies that have more cash flow and
lower debt levels may have greater flexibility in choosing their
financing mix.

External factors are those that are outside the control of the company,
and they include:
 1. Market conditions: The availability and cost of debt and equity
financing may vary depending on market conditions, such as
interest rates and investor demand.
2. Taxation: The tax implications of debt and equity financing can
affect a company's choice of financing mix.
3. Regulatory environment: Regulations and legal restrictions may
limit a company's ability to use certain types of financing or impose
costs associated with compliance.
4. Competitive environment: The financing choices of competitors
may influence a company's decision to use debt or equity
financing.

Overall, the determinants of capital structure are complex and

multifaceted, and a company must consider a wide range of factors
when deciding on its financing mix. A well-designed capital structure can
help a company achieve its financial goals and maximize shareholder
value.

The End.