FINANCIAL MANAGEMENT

WEEK-7

QUESTION:
Explain with illustration on calculating cost of capital for each source of finance.

The cost of capital is the minimum rate of return that a company must earn before generating
value
It is the cost that a business incurs to finance its operations, and it measures the cost of
borrowing money from creditors or raising it from investors
The cost of capital is important because it helps a company determine the minimum return it
needs to generate from its investments to satisfy the expectations of its investors and lenders

To calculate the cost of capital for each source of finance, companies must consider the
following factors:
Cost of debt: The cost of debt is the interest rate that a company pays on its existing debt
It is calculated by dividing the interest expense by the market value of debt
The cost of debt is influenced by factors such as interest rates, inflation, credit ratings, and
financial leverage

Cost of equity: The cost of equity is the expected rate of return that investors require for
investing in a company's stock
It is calculated using the dividend discount model or the capital asset pricing model (CAPM)
The cost of equity is influenced by factors such as the company's financial risk, market risk,
and dividend policy

Weighted average cost of capital (WACC): WACC is the average cost of all capital sources,
including debt and equity, weighted by their proportion in the company's capital structure
It is calculated by multiplying the cost of debt by the weight of debt, adding it to the cost of
equity multiplied by the weight of equity, and adjusting for the corporate tax rate

Illustration:
Suppose a company has the following capital structure:
Debt: Rs. 50,00,000
Equity: Rs. 1,00,00,000
The cost of debt is 10%, and the cost of equity is 15%. The corporate tax rate is 30%.
To calculate the WACC, we need to find the weight of debt and equity:
Weight of debt = Debt / (Debt + Equity) = 50,00,000 / (50,00,000 + 1,00,00,000) = 0.333
Weight of equity = Equity / (Debt + Equity) = 1,00,00,000 / (50,00,000 + 1,00,00,000) =
0.667
Now we can calculate the WACC:
WACC = (Weight of debt x Cost of debt x (1 - Corporate tax rate)) + (Weight of equity x
Cost of equity)
= (0.333 x 0.1 x (1 - 0.3)) + (0.667 x 0.15)
= 0.126 or 12.6%
Therefore, the WACC for this company is 12.6%.
In conclusion, calculating the cost of capital for each source of finance is crucial for
companies to determine their capital structure and make informed investment decisions. The
cost of debt, cost of equity, and WACC are the key factors to consider when calculating the
cost of capital.