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Meaning

The term cost of capital means


the rate of acquiring the total
amount of all the funds used
with in a firm. The main object of
cost of capital of a firm is the
minimum rate of return expected
by the investors.

Defination
According to Soloman
Ezracost of capital is the
minimum required rate of
earnings or the cut-off rate
of capital expenditure.

Importance /
significance of the
cost capital
(1)Optimum capital structure decision.
(2)Helpful in taking decision.
(3)For evaluating the financial

performance.
(4)For deciding about the method of
financing.
(5)For taking financial decision.

Classification of cost
Marginal cost-

Marginal cost is the


change in the total cost that arises when the
quantity produced changes by one unit.

Average cost- Average cost is equal to


total cost divided by the number of goods
produce.

*Explicit cost- An explicit cost is a business expenses


accounted cost that can be easily identified such as
wage , rent and materials .Explicit cost gives clear
cash outflows from business.

*Implicit cost- An implicit cost results if the person


who at first foregoes the satisfaction in the search of
an activity and is not rewarded by money or another
from of payment. Goodwill is a good example of
implicit cost. Its also known as opportunity cost.

*Historical cost- Historical costs are the book cost


which are related to the past . the book cost has its
origin in the accounting system in which the book
value as maintained by the books of account are
readily available

*Future cost-

future cost are estimated cost


for the future. In financial decision future cost are
move relevant than the historical costs.

*Specific cost-

specific costs refers to the cost


of a specific source of capital . It is also known as
component cost of capital.

*Opportunity cost-

The opportunity cost is


the rate of return the shareholder forgoes by not
putting the funds elsewhere. Keeping in mind the
shareholders interest , this cost is used while
making the investment decision to determine the
cut-off point of the project

regarding the
cost of capital
(a) Traditional ApproachAccording to this approach , a
companys cost of capital depends
upon the method and level of
financing or its capital structure .
It means that a company can
change its overall cost of capital
by changing its capital structure.

(b) Modigliani and miller


approach- According to this
approach, a change in capital
structure does not affect the
cost of capital . In other
words, the method and level
of financing will not affect
the cost of capital, this will
remain constant

Measurement of
cost of capital

(1)Debt (borrowed) capital


(2)Preference share

capital
(3)Equity share capital

(1) Cost of debt


Such capital is generally obtained
through the issue of debenture. The
issue of debenture may involve a
number of floatation charge such as
printing of prospectus , advertising ,
underwriting ,brokerage etc. Debenture
may be issued at par or at a discount.
Debt capital may be of two types viz.
(a)Perpetual or Irredeemable.
(b)Redeemable debt

Perpetual or
irredeemable debt
Perpetual or irredeemable debt provides
permanent funds to the firm, because the funds
will remain in the firm till liquidation. For
calculating the cost of perpetual or
irredeemable debt, amount of interest payable
on it is dividend by the net proceeds from its
issue. It can be calculate in two ways viz.
* Cost of irredeemable debt before tax.
* Cost of irredeemable debt after tax.

Cost of
irredeemable debt
before tax
Kdp = I np 100
I =interest
NP=net proceed
Net proceeds which will be as under.
1.When debenture are issued at par
NP= par value floatation charges

2. When debenture are issued at discount.


NP=par value- discount-floatation

3.When debenture are issued at premium.


NP=par value + premium-floatation

COST OF REDEEMABLE DEBENTURE


When debenture are redeemable during the lifetime of the
company, the principal amount is returned back to the holders
either at par or premium or even discount.
When debenture are issued at par and redeemable at par.

Kd= I+f/n NP+RV/2


i= interest
f=floatation
n= years
NP= net proceeds
RV= redeemable value

2.When debenture are issued at premium


or at discount but redeemable at par with
floatation cost
Kd=I + f/n + d/n - pi/n NP+RV/2 100
D= discount
pi= premium

3. Case b as above plus redemption


at premium.
Kd= I + f/n + d/n pi/n +

pr/n 100

Pr = premium on redemption on
debenture

Cost of preference share


The cost of preference share capital
may be defined as the dividend
expected by preference shareholders.
Preference shareholders have a
priority in dividend payment over the
equity shareholders. It can be divide
into two categories. (a) irredeemable
(b) redeemable

Cost of Irredeemable preference


share capital
(Before tax)

Kpt = Pd 100 NP
pd = dividend payment
* When preference share are issued at par.
NP = Par value floatation charge
* When preference share are issued at discount.
NP = par value discount floatation cost
*When preference share are issued at premium.
NP = Par value floatation + premium.
(After tax)
= kpt ( 1- t )

Cost of redeemable
preference share
NOTE Cost of
redeemable preference
share are calculate as
same as redeemable
debenture

Cost of equity share Capital


MEANING
Equity shares are treated as variable dividend
securities and there is no legal obligation to
pay dividend on them as well as rate of
dividend is not predetermined.
*There are 3 approaches for calculating the cost
of equity share capital.
*Earning yield method
*Dividend yield method
*Dividend yield plus growing dividend method

Earning yield method


It is also called earning price ratio method . According to
this method , it is the earning per share which means
determines the market price of per share.It is also
assume that the invested capital in a business is equal to
the market price of shares.

Ke = E 100 P
Ke = cost of equity share capital
E = earning per share
P = market price per share

Dividend yield method


It is also called dividend price ratio
method. According to this method ,
the cost of capital is equal to the
expected normal rate of return on
the equity shareholders. The
formula is
Ke = D 100 P
D = dividend

Dividend yield plus growing


dividend method
This is popularly known as ( D/P + G ) method.
According to this method , the yearly growth rate
in dividend is added to the cost of equity capital
ascertained in accordance with D/P method.
Ke = D 100 p + G
G = growth rate

Example of growth rate


The average rate of dividend is paid by the Y ltd;
for the last five years is 25%.The company have
recorded a growth rate of 4% of p. a. year.

Cost of retained
earnings
Based on a sound policy , a successful company does
not distribute the entire profit earned by it ; a
portion of earned profit is retained in the business
for future expansion of the business. This is known
as retained earnings . Thus the formula is
Kr = AD/RE 100
AD = earning from alternatives investment
* When brokerage & tax on dividend are taken into
account
Kr = (1-Td) (1-B) / RE 100
When brokerage , dividend tax and capital gains
tax are taken into account.

Kr = (1-Td) (1-B)AD / ( 1- Tc)RE 100