CORPORATE FINANCE/

FINANCIAL MANAGEMENT

Cost of Capital

- Dr. Sandeep Goel

 COST OF CAPITAL
• Cost of raising the funds for investment purposes.

• It is often referred to as cut-off rate, target rate of return,

hurdle rate.
• Cost of Capital and (WACC) are used interchangeably

Importance
(i) Capital Budgeting decisions
- A yard stick to accept/reject a project.

(ii) Capital Structure Decision

 “Risk-Return Relationship”

Equity Share
Rate of Return/Cost of Capital

Preference
Share
Debentures

Government
Bonds
Risk-free
security

Risk
 CLASSIFICATION
Explicit Costs
- Cost that the firm pays to procure a source of finance
 Debt

 Preference Shares

Implicit Costs
- No ‘assured cost’ attached to a source of finance
 Equity Shares

 Retained Earnings
COMPUTATION OF COST OF CAPITAL
• Compute Specific Costs (Cost of each source of fund)
 Cost of Debt
 Cost of Preference Shares
 Cost of Equity
 Cost of Retained Earnings

• Assign Weights to specific costs (to each source of fund)

• Multiply (1) by (2) to get cost of capital (WACC)

 ko = kdwd + kpwp + kewe+ krwr
I COMPUTATION OF SPECIFIC COSTS
Cost of Debt
 Explicit Cost

 Tax Shield
o Interest paid is tax deductible
 Tax shield on Interest
25% tax rate
A (Zero debt) B (Rs. 2,000 debt@10%)
EBIT 1,000 1,000
Less: Interest - 200
EBT 1,000 800
Less: Tax 250 200
PAT 750 600

Effective interest rate 7.5%

Effective rate = I (1-T) = 10 (1-0.25) = 7.5%

 CAPITAL ASSET PRICING MODEL (CAPM)
o This approach to calculate cost of equity describes the ‘risk-
return’ trade-off for securities

o It is based on certain assumptions:

(a) the efficiency of the security markets
(b) investors’ preferences
-contd.-

Categories of beta
1. Aggressive beta Shares with a beta 1 More risky

2. Average / Neutral beta Shares with a beta = 1

3. Defensive beta Shares with a beta 1 Less risky

-contd.-

CAPM Equation

ke = Rf + b (km - Rf )

Here, ke = Cost of equity capital

Rf = the risk free rate of return
km = Expected market return, i.e. return expected
on the market portfolio of shares

km - Rf = risk premium (difference between expected

market return and risk free rate of return)

b = beta of the firm’s share (systematic risk of

an equity share in relation to the market)
-contd.-

Calculation of Beta

βj = Covariance j m Co-movements of individual stock and market

Variance m Index volatility

Covar j, m
j =
σ 2m
σ j σ m Cor j, m σj
= =  Cor j, m
σm  σm σm