You are on page 1of 19

Cost of Capital

Cost of Capital-concept
Cost of capital is central concept of financial
2 schools of thought:-
MM argue that firms cost of capital is
constant and it is independent of the method
and the level of financing.
Traditionalist argue that cost of capital is

Cost of Capital-concept
3 viewpoints:-
1) From investors point of view:
Measurement of sacrifice made by him in
capital formation
Eg: A invested in equity amount Rs 10000 not
in bank, so he had scarified 7 percent for not
having invested in bank.
2)Firms point: It is minimum required rate of
return needed to justify the use of capital.
Eg:- a firm raised Rs 50 lakhs through issue of
debenture at 10percent then minimum rate of
return should be at least 10 percent.
3)Capital expenditure point of view: The
capital expenditure is the minimum required
rate of return, the hurdle or target or cut off
rate or any discounting rate used to value cash
Meaning and Definition

Cost of capital is minimum rate of earning or
the cut off rate of capital expenditure.
Meaning and Definition
3 Basic aspect:-

1) Rate of return Cost of capital is not a cost
as such, it is rate of return that a firm requires
to earn from its investment project.
2)Minimum rate of return-Cost of capital is
that minimum rate of return that will at least
maintain the market value of shares.

3) Cost of capital comprises of 3 components :
A) The risk less cost of particular type of
financing( )
B) The business risk premium (b)
C) The financial risk premium (f)

Hence, cost of capital K = + b + f
Cost of equity
Firms obtain capital in 2 ways:-
1) retained earnings
2)issue of additional equity shares

Cost of retained earning:-

D= dividend
NP= market price per share
Ti = tax rate
Tb = broker rate

A company paid dividend of Rs 2 , market
price per share is Rs 20, tax rate is 60% and
broker rate is 2 %. Calculate cost of retained

Ans : 4.1 %

Cost of debt
Pre tax cost:-

Post tax cost:-

Company decide to float debenture at 12% of
Rs 100 each. Calculate cost of debenture

Ans : pre tax : 12%
Post tax: 6%
Source of fund Rs After tax cost
Debt 30,00,000 4
Preference share 10,00,000 8.5
equity 20,00,000 11.5
Retained earning 40,00,000 10
Source of fund weight After tax cost Weighted cost
Debt 0.30 0.04 0.012
Preference share 0.10 0.08 0.008
equity 0.20 0.11 0.022
Retained earning 0.40 0.10 0.040
1 0.082
Overall cost = 0.082 x 100 = 8.2 percent

Cost of weight = debt capital / total capital
= 30,00,000/100,00,000