COST OF CAPITAL

SOURCES OF CAPITAL
For a businessperson or entrepreneurs, to find the sources of business finance is the most important aspect when starting a
business or a new venture. It needs the maximum effort and dedication. The sources of business finance are categorized based on
ownership, time, period, and control, etc., evaluate, and used in different situations.

Corporations often need to raise external funding or capital in order to expand their businesses into new markets or locations. It
also allows them to invest in research & development (R&D) or to fend off the competition. And, while companies do aim to use the
profits from ongoing business operations to fund such projects, it is often more favourable to seek external lenders or investors to
do so.

Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset acquirement - new
machinery or the construction of a new building or depot. The development of new products can be enormously costly and here
again capital may be required. Normally, such developments are financed internally, whereas capital for the acquisition of
machinery may come from external sources. In this day and age of tight liquidity, many organisations have to look for short term
capital in the way of overdraft or loans in order to provide a cash flow cushion. Interest rates can vary from organisation to
organisation and also according to purpose.

Despite all the differences among the thousands of companies in the world across various industry sectors, there are only a few
sources of funds available to all firms. Some of the best places to look for funding are retained earnings, debt capital, and equity
capital.

Sources of funds
A company might raise new funds from the following sources:
· Equity capital
· Preference capital
· Debentures
· Retained earnings
· Bank borrowing
· Venture capital

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Equity Capital
A company can raise capital by selling off ownership stakes in the form of shares to investors who become stockholders. This is
known as equity funding. Private corporations can raise capital by offering equity stakes to family and friends or by going public
through an initial public offering (IPO).
Public companies can make secondary offerings if they need to raise more capital. (RIGHTS ISSUE)

Rights issues
A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to
subscribe cash for new shares in proportion to their existing holdings.

Preference capital
Preference shares are a long-term source of finance for a company. They are neither completely similar to equity nor equivalent to
debt. The law treats them as shares but they have elements of both equity shares and debt. For this reason, they are also called
‘hybrid financing instruments. These are also known as preferred stock, preferred shares, or only preferred in a different part of
the world.

Preference shares are an optimal alternative for risk-averse equity investors. They fall between common equity and corporate
bonds on the risk spectrum. Preferred shares can offer a steady flow of dividends similar to an interest payment that is promised to
bondholders. Preferred shareholders also rank higher than common stock for liquidation rights, but they still fall after debentures.

Debentures
Debenture is used to issue the loan by government and companies. The loan is issued at the fixed interest depending upon the
reputation of the companies. When companies need to borrow some money to expand themselves they take the help of debentures.

Features of Debentures
• Debentures are instruments of debt, which means that debenture holders become creditors of the company
• They are a certificate of debt, with the date of redemption and amount of repayment mentioned on it. This
certificate is issued under the company seal and is known as a Debenture Deed
• Debentures have a fixed rate of interest, and such interest amount is payable yearly or half-yearly

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• Debenture holders do not get any voting rights. This is because they are not instruments of equity, so debenture
holders are not owners of the company, only creditors
• The interest payable to these debenture holders is a charge against the profits of the company. So these payments
have to be made even in case of a loss.

Retained earnings
For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-
invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to
finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not
true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an
attractive source of finance because investment projects can be undertaken without involving either the shareholders or any
outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example,
because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than
receive current income, then finance through retained earnings would be preferred to other methods.

A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in
line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company
that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous
salaries to owner-directors.

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Bank borrowing
Bank loans are the most commonly used source of funding for small and medium-sized businesses. Consider the fact that all banks
offer different advantages, whether it's personalized service or customized repayment. It's a good idea to shop around and find the
bank that meets your specific needs.

In general, you should know bankers are looking for companies with a sound track record and that have excellent credit. A good
idea is not enough; it has to be backed up with a solid business plan. Start-up loans will also typically require a personal guarantee
from the entrepreneurs.

Venture capital
Venture capitalists take an equity position in the company to help it carry out a promising but higher risk project. This involves
giving up some ownership or equity in your business to an external party. Venture capitalists also expect a healthy return on their
investment, often generated when the business starts selling shares to the public. Be sure to look for investors who bring relevant
experience and knowledge to your business.

It is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest
venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term
'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a
management buy-out or a major expansion scheme.

The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire
investment, and it might take a long time before any profits and returns materialise. But there is also the prospect of very high
profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments,
to compensate for the high risk.

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COST OF CAPITAL

DEFINITION:
SOLOMAN EZRA, - “ COST OF CAPITAL IS THE MINIMUM REQUIRED RATE OF EARNING OR THE CUT-OFF RATE FOR CAPITAL
EXPENDITURE ”
JOHN J HAMPTON, “ COST OF CAPITAL IS THE RATE OF RETURN A FIRM REQUIRES FROM INVESTMENT IN ORDER TO
INCREASE THE VALUE OF THE FIRM IN THE MARKET ”

MEANING:
Cost of Capital is the minimum rate of return which a company is expected to earn from a proposed project (invested funds),
so as to meet the cost of funds employed by a company.

IMPORTANCE/SIGNIFICANE OF COC
The concept of COC derives its importance from its usefulness in investment mgt. proposals. COC is used in Capital Budgeting
& Capital Structure decisions.

a. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally cost of capital is the
discount rate used in evaluating the desirability of the investment project. In the internal rate of return method, the project will be
accepted if it has a rate of return greater than the cost of capital. In calculating the net present value of the expected future cash
flows from the project, the cost of capital is used as the rate of discounting. Therefore, cost of capital acts as a standard for
allocating the firm’s investible funds in the most optimum manner. For this reason, cost of capital is also referred to as cutoff rate,
target rate, hurdle rate, minimum required rate of return etc.
COC is applied in CBD and is imp for evaluating business proposals.
- It uses the required rate of return for discounting cash flows to determine the NPV of proposal
- It evaluates the proposals to see that the minimum cut off rate is achieved. If minimum cut off rate is achieved, than the
project is accepted otherwise should be rejected.
- It measures the financial utility of the proposals. If the NPV is positive & the IRR is above cut-of rate, the proposal
should be accepted.

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- To maximise the value of firm, the concept of COC is used. The COC should be as low as possible to maximise the wealth
of the firm.
- The COC is also useful in financial appraisal, regarding whether money should be invested or not in a proposal.

b. Capital Structure Decisions:

Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is the proportion of debt and
equity, due importance is given to the overall or weighted average cost of capital of the firm. The objective of the firm should be to
choose such a mix of debt and equity so that the overall cost of capital is minimised.
- To find out optimum risk & cost factors in different sources of capital.
- Combination of debt, equity, & preference of right quantity gives the maximum return
- Like, raising debt in form of loan is good from tax point of view, but is very expensive & involves high financial risks. So
cost of each sources of funds is considered with risk involved in it.
- To take a decision, COC find outs the COC from each sources & then to mix those sources to get maximum returns at
minimum risks.

c. Comparative study of sources of financing:

There are various sources of financing a project. Out of these, which source should be used at a particular point of time is to be
decided by comparing costs of different sources of financing. The source which bears the minimum cost of capital would be
selected. Although cost of capital is an important factor in such decisions, but equally important are the considerations of
retaining control and of avoiding risks.

d. Financing and Dividend Decisions:

The concept of capital can be conveniently employed as a tool in making other important financial decisions. On the basis,
decisions can be taken regarding dividend policy, capitalization of profits and selections of sources of working capital.
Out of the total profit of the firm, a certain portion is paid to shareholders as dividends. The concept of capital can be conveniently
employed as a tool in making other important financial decisions. However, the firm can retain all the profit in the business if it
has the opportunity of investing in such projects which can provide a higher rate of return in comparison to the cost of capital. On
the basis, decisions can be taken regarding dividend policy, capitalization of profits, and selections of sources of working capital.

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On the other hand, all the profits can be distributed as dividends if the firm has no opportunity of investing the profit. Therefore,
the cost of capital plays a key role in formulating the dividend policy.

e. Evaluation of Financial Performance:

The concept of cost of capital can be used to evaluate the financial performance of top management. This can be done by
comparing the actual profitability of the investment project undertaken by the firm with the overall cost of capital. The cost of
capital is the benchmark of evaluating the performance of different departments. It can be used to evaluate the progress of
ongoing projects and investments by matching up the progress of those investments against the cost of capital. The department is
considered the best which can provide the highest positive net present value to the firm. It helps in evaluating the investment
options, by converting the future cash flows of the investment avenues into present value by discounting it. The activities of
different departments are expanded or dropped out on the basis of their performance.

EXPLICIT & IMPLICIT COST

a. Explicit Cost:
-It is the internal rate of return which a company pays for procuring the finance
(Step : cash inflow & for that inflow there is outflow in form of interest to loan lenders & dividends for investors/shareholders)
LOAN - PRINCIPAL + INTEREST
INVESTORS - PRINCIPAL + DIVIDEND
- Explicit cost of capital will be only in the case of interest bearing loan. If loan is interest free then the explicit cost will be
ZERO PERCENT, as no cash outflow of interest will be involved.

b. Implicit Cost:
- The rate of return which can be earned by investing the capital in alternative investment. ( opportunity cost )
- The basic difference between explicit & implicit cost of capital is that, explicit cost arises when capital is raised, where as
implicit cost arises when capital is used

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COMPONENTS:
COC Comprises three important components:
➢ Expected normal rate of return (when there is no risk “ZERO RISK”)
➢ Premium for business risk (business risk refers to the variability in operating profits “EBIT” , due to changes in sales)
➢ Premium for financial risk on account of pattern of capital structure
The above three components of COC may be put in form of an equation, :
K = r0 + b + f ,
WHERE, K = COST OF CAPITAL
r0= NORMAL RATE OF RETURN AT ZERO RISK LEVEL
b = PREMIUM FOR BUSINESS RISK
f = PREMIUM FOR FINANCIAL RISK

COMPUTATION / MEASUREMENT OF COST OF CAPITAL

- A Company raises funds from different sources of funds.
- Thus the first step is to compute or measure each individual or specific sources of funds/ capital, such as debt or
borrowed capital, preference share capital, equity share capital, retained earnings.

1. COMPUTATION OF COST OF DEBT/BORROWED CAPITAL i.e., (Debentures & Bonds)

- -Debt is generally raised through the issue of debentures & bonds, & long-term loans from Financial institutions.
- “The cost of debt capital is the RATE OF INTEREST PAYABLE ON DEBT”
- Here rate of interest has to be calculated after adjusting tax rate.
- Debt may be at par (face value of debt), at premium (face value of debt + premium on issue) or at discount (face value of
debt-discount allowed).
- It may be perpetual (non-redeemable) or redeemable

A). COST OF PERPECTUAL DEBT/DEBENTURES (irredeemable) –

a. ISSUED AT PAR: in this case it is the explicit interest rate adjusted further for the tax liability of the company.
FORMULA: Kd=R "(Before Tax); Kd = R ( 1 – T ) "(After Tax)
WHERE, Kd=cost of debt, R= Debenture interest rate, T= tax rate

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b. ISSUED AT PREMIUM & DISCOUNT:

FORMULA: Kd= I "(Before Tax) ; Kd = I ( 1 – T ) "(After Tax)
NP NP
WHERE, Kd=cost of debt, I = Annual interest payment, T= tax rate, NP= Net proceeds
NOTE: ASSUME TAX RATE @ 50%, IF ITS NOT GIVEN IN THE PROBLEM.

B). COST OF REDEEMABLE DEBT (DEBENTURES) -

FORMULA: I+(F-P)
Kd= n . X 100 " (Before Tax);
(F+P)
2
Cost of Redeemable debt = Kd( 1 – T ) " (After Tax)

WHERE, Kd=cost of debt, I = Annual interest payment, F= Face Value of Debentures, P= Issue Price of Debentures, n =
number of years to maturity

2). COMPUTATION OF COST OF PREFERENCE SHARE CAPITAL –

- For preference shares, the dividend rate can be considered as its cost, since it is this amount which the company wants to
pay against the preference shares.
- Preference shareholders must receive their stated dividends prior to the distribution of any earnings to the equity
shareholders.
- In this respect preference shares are very much like bonds or debentures with fixed interest payment.
- The issue expenses or the discount/premium on issue/redemption are also to be taken into account.

A). COST OF IRREDEEMABLE PREFERENCE CAPITAL

FORMULA: Kp= DP x100

NP
WHERE, Kp=cost of preference share , NP= Net proceeds of Preference capital, DP= Fixed preference dividend

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B). COST OF REDEEMABLE PREFERENCE CAPITAL

FORMULA: DP +(F-P)
Kp= n . X 100
(F+P)
2
WHERE, Kp=cost of preference share , P= Net proceeds of Preference capital, DP= Fixed preference dividend, , F= Face
Value of Debentures, n = number of years to maturity.

3). COMPUTATION OF COST OF EQUITY CAPITAL:

- The cost of equity share is calculated on the basis of the market price of the share as the market price depend upon the
return expected by the shareholders.
- Hence Cost of Equity is defined as the minimum rate of return on equity investment.

In order to determine cost of equity capital, it may be divided into following categories-
THE EXTERNAL EQUITY/NEW ISSUE OF EQUITY SHARE -
a) DIVIDEND PRICE APPROACH (Dividend/Price ratio method; D/P Ratio method; Dividend Yield method)
- According to this method, cost of equity share capital is equal to the expected normal rate of return of the equity
shareholders.
- i.e., the investor arrive at the market price of a equity share by capitalising the set off expected dividend
payments.
- This approach rightly emphasis the importance of dividends, but it ignores the fact that the retained earnings
have also an impact on the market price of equity share.
- Hence this approach does not seam to be very logical.
FORMULA:
Ke = D X 100
P
Where, Ke= cost of equity share capital, D= current dividend per equity share, P= current market price per equity share

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b) EARNING PRICE APPROACH (Earning/Price Ratio method; E/P Ratio method; Earning Yield method)
- This method establishes a relationship between earnings & market price of equity shares.
- According to this approach, it is the earning per share that determine the market price of share.
- Since this method emphasis the earning capacity of equity share capital rather than simple dividend rate, this method
seems to be more logical.
FORMULA:
Ke = EPS X 100
MP
Where, Ke= cost of equity share capital, EPS= Earning per equity share, MP= current market price per equity share

4). COMPUTATION OF COST OF RETAINED EARNINGS-

- Retained earnings are the profits which have not been distributed by a company to its shareholders as dividend, but
have been retained by the company for the future expansion.
- Retained earnings are used so that a firm has sufficient funds in the future for making reinvestment, which are
profitable in future.
- Hence the cost of retained earnings is the opportunity cost of dividend foregone by the shareholders.
FORMULA:
Kr = Ke ( 1-t ) X ( 1-b )
Where, Kr= cost of retained earnings , Ke= rate of return available for shareholders , t= share holder tax rate, b= brokerage for
investment.
Personal tax rate: the dividends receivable by the shareholders are subject to income tax.
Floatation/Brokerage cost: usually the shareholders have to incur some brokerage cost for investing the dividend received.
Thus, the funds available with them for reinvestment will be reduced by this amount.

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MEASUREMENT OF WEIGHTED AVERAGE COST OF CAPITAL

- It is the overall cost of capital by giving due weightage to the cost of different components of capital (like Equity capital, preference
capital, debt capital), on the basis of the proportion of each type of capital in the total investments of the firm
- It is the average cost of the specific costs of various sources of capital
FORMULA: WACC= TOTAL COST X 100
TOTAL AMOUNT OF CAPITAL

STEPS IN THE CALCULATION OF WEIGHTED AVERAGE COST OF CAPITAL

1. CALCULATION OF COST OF EACH SPECIFIC SOURCES OF FUNDS
This involves determination of cost of debt, equity capital & preference capital. It will be more appropriate to measure the cost of
capital on after tax basis.

2. ASSIGNING WEIGHTS TO SPECIFIC COSTS.

This involves determination of proportion of share of each source of capital in the total capital structure of the company.
This will be done in any one of the following method-
a. Historical weights/Book value weights:
- The basis of assigning weights is the proportion of funds already employed by the company.
- This method is based on the assumption that the company’s present capital structure is optimum and it will raise
additional funds in future if required in the same proportion.

b. Market value weights:

- The basis of assigning weights is the proportion of the market value employed by the company.
- This method is based on the assumption that the company’s present capital structure is optimum and it will raise
additional funds in future if required in the same proportion.

c. Marginal weights:
- This method is used when new capital or additional capital is introduced at different proportions/different cost of
capital than the existing proportion/cost of capital.
- Thus, Marginal weights is the weightage given to the additional investment. i.e., weightage marginal cost of capital is
the overall cost of capital of the additional capital introduced.

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Note:
- When both the proportions of various sources of funds & cost of each component in the additional capital are same, as to the
existing one, then, WEIGHTED MARGINAL COST OF CAPITAL WILL BE EQUAL TO WEIGHTED AVERAGE COST OF CAPITAL
- When the cost of new investment components are different than the existing cost/proportions of each component, then,
WEIGHTED MARGINAL COST OF CAPITAL WILL BE CALCULATED & ALSO THE WEIGHTED AVERAGE COST OF CAPITAL IS
DETERMINED

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