COST OF CAPITAL

INTRODUCTION
Each source incurs some cost. No source is
free
of cost.
COC is a major standard of comparison used in
any financial decision.
Acceptance or rejection of an investment
project depends on COC (whether the
company
uses NPV or IRR method).
 WHAT IS COST OF CAPITAL?

It is the Rate of Return that the

company must pay to the suppliers of
capital.

It is the minimum rate of return that a

project must yield in order to keep the
existing value of the firm intact.

In operational terms, COC refers to the

Discounting Rate.
 DEFINITON OF COC
Economists define COC in 2
senses:
COC in terms of cost of generating
funds to finance a project.
COC in terms of opportunity cost of
the fund to the firm.
In the first category, it refers to
borrowing rate Combined Cost of
Capital.(i.e., Explicit Cost)
In the second category, it refers to the rate
of return which the company would have
earned in other investment opportunities.
(Implicit Cost)
Cost of Capital, in whatever sense it is
used, refers to the rate of return prevailing
in the market and anyone seeking capital
must be prepared to pay this rate to the
suppliers or anyone investing funds will
receive return at this rate.
COC is not set by the Management nor by
negotiation between management and suppliers
of capital.

Rather, it is set impersonally in the market by

collective actions of investors and lender
competing against each other.

COC is always represented in terms of

percentage (%). Necessary allowances is made
for tax factor.
 IMPORTANCE OF COST OF CAPITAL

Plays a crucial role in Capital Budgeting decision.

Has an important bearing on the acceptance or

rejection of an investment project.

Serves as a Screening Tool.

Provides useful guidelines in determining

optimum Capital Structure of a company by
adjusting the Financial Plan.
 IMPORTANCE OF COST OF CAPITAL (Contd)

Investors feelings about the

expected income of company and
risks inherent in it are reflected in the
COC of a company.

Leasing Decisions, Dividend

Decisions, Working Capital Policies,
Bond Redemption are some other
fields where COC plays its role.
 CALCULATION OF COST OF
CAPITAL
As you know, each source involves some cost. So, cost of
each capital component must be ascertained and then the
combined cost of capital must be worked out.

STEPS IN CALCULATING COST OF CAPITAL

1. Determine the type of funds to be raised and

their share in their total capitalization.

2. Determine the cost of each type of funds.

3. Calculate the combined Cost of Capital of the

company by assigning weights to each type of
funds in terms of its proportion to total funds.
 CALCULATION OF INDIVIDUAL
COST OF FUNDS
Cost has to be worked out for,
Short-Term Debt
Long Term Debt
Irredeemable Debt
Redeemable Debt
Preference Shares
Equity Shares
Retained Earnings
 COST OF SHORT-TERM
DEBT
Cost of ST Debt may be expressed as
the explicit interest rate on such
Debt/ Loan subject to adjustment for
Tax (interest is tax deductible).

FORMULA:
Kd = R(1-T) Where Kd = Cost of
Debt
R=
Rate of Interest
T=
Tax Rate
 COST OF LONG-TERM
DEBT
Cost of Long-Term Debt is the minimum rate of
return that must be earned on the debt financed
investment.
This rate is the contractual rate of interest.
Relatively easy to calculate as the rate of interest
is known.
Its calculation depends on type & nature of debt
i.e., Irredeemable or Redeemable.
FORMULA:
Kd = R/SP (1-T) Where R= Rate of
Interest
SP=
Sale Proceeds of Debt
T= Tax Rate
COST OF IRREDEEMABLE DEBT

Such debt will never be redeemable

before maturity.
It is like permanent capital.
Such debt enables the company to
plan well.
Repayment arises only on maturity.
Unless otherwise stated, calculation
of cost of LT Debt is relating to
irredeemable debt only.
 COST OF REDEEMABLE DEBT

Definite date of maturity

Repaid in one lump sum or in installments.
If repaid in one lump sum, cost of such debt
is calculated as follows:
R+(RV-SP)/N Where. R= Annual Interest

Payment in Rs.

Kd= ----------------- (1-T) RV= Redeemable Value

(RV+SP)/2 SP= Sale Proceeds from

issue of Debt
N= Term of Debt
 COST OF PREFERENCE

SHARES
Analogous to LT Debt
Cost of Pref. shares may be defined as the
minimum rate of return that must be earned on
the preference share financed investment.
This rate is obtained by dividing the DPS by
the current market price per share.
FORMULA:
DPS Where. DPS= Dividend
Per Share.
Kp= ------ x 100 MPS= Market Price
Per Share
MPS
 COST OF EQUITY
SHARES
Most difficult to compute.
No fixed dividend distributed
There are two approaches for
calculation:
Dividend Approach
Earnings Approach
I. DIVIDEND APPROACH:
All that the Shareholders get is only
dividends and so Cost of Equity shares
is equal to current dividend compared
 COST OF EQUITY SHARES
(Contd)
FORMULA:
DPS
Ke = -------- X 100
MPS Where,
DPS =
Dividend Per Share
MPS =
Market Price Per Share

But,there is always an expectation on the

part of the shareholders a higher dividend
on account of Growth of the firm. So,
 COST OF EQUITY SHARES
(Contd)
DPS
Ke = ------------ + g
MPS (1-F)
Where,
DPS = Dividend Per Share
MPS =
Market Price Per Share
g = Growth Rate
F
= Floatation Cost
 COST OF EQUITY SHARES
(Contd)
II. EARNINGS APPROACH:
In this approach, total earnings and not
total dividends that are taken into account.
This approach is useful in two ways:
Even undistributed profits belong to
equity shareholders
Market Price is influenced more by
earnings & not by dividend alone
 COST OF RETAINED
EARNINGS
Retained Earnings also incurs some
cost, i.e., Opportunity Cost.
The minimum cost of Retained
Earnings should be equal to Ke.
Suitable adjustments must be made
for individual tax and Brokerage
charges.
FORMULA:
K Re = Ke (1-T) (1-B)
 CALCULATION OF COMPOSITE
COST OF CAPITAL
Once the cost of individual capital
components are calculated, then
combined COC can be calculated
following
1
the 3 steps
2
discussed
3
earlier.
4
SOURCES OF PROPORTION AFTER WEIGHTED
FUNDS OF TOTAL TAX COST (2x3/100)
(%) COC (%) (%)
Debentures 40 04.00 1.60
Equity Shares 40 14.00 5.60
Preference Shares 10 10.00 1.00
Retained Earnings 10 10.00 1.00
100 9.20 (WACOC)