Cost of capital

INTRODUCTION:
 The cost of capital is the cost of a company’s funds
{both debt and equity} or , and investor’s point of view
“the expected return on a portfolio of all the company’s
existing securities”.
 It is used to evaluate new projects of a company as it
is the minimum return that investors expect for
providing capital to the company , thus setting a
benchmark that a new project has to meet.
 DEFINITION
“The cost of capital is the minimum required
rate of earnings or the cut off rate of
expenditure”
- SOLOMON EZRA
“The cost of capital represents a cut off rate
for the allocation of capital to investment of
projects.it is the rate of return on a project
that will leave unchanged the market price
of the stock.” - JAMES C. VAN
HORNE
SIGNIFICANCE OF THE COST OF CAPITAL
HELPFUL IN DESIGNING THE CAPITAL STRUCTURE
HELPFULIN TAKING CAPITAL BUDGETING
DECISIONS
HELPFUL IN EVALUATION OF FINANCIAL
EFFICIENCY OF TOP MANAGEMENT
HELPFUL IN MAKING OTHER FINANCIAL DECISION
SUCH AS-
 DIVIDEND POLICY
 RIGHT ISSUE
 WORKING CAPITAL DECISIONS
 THE CONCEPT OF
OPPORTUNITY COST OF
CAPITAL

The opportunity cost of capital is the incremental

return on investment that a business foregoes when it
elects to use funds for an internal project , rather
then investing cash in a marketable security. Thus ,if
the projected return on internal project is less than
the expected rate of return on a marketable security,
one would not invest in the internal project, assuming
that this is the only basis for the decision.the
opportunity cost of capital is the difference between
the return on the two projects.
 General formula for the
opportunity cost of capital
 Cost of debt
A company may raise debt in a variety of
ways. It may borrow funds from financial
institutions or public either in the form of
public deposits or debentures for a specified
period of time at a certain rate of interest. A
debenture or bond may be issued at par and
at a discount or premium as compared to its
face value.
 COST OF DEBT
DEBT ISSUED AT PAR
DEBT ISSUED AT DISCOUNT OR PREMIUM
TAX ADJUSTMENT
COST OF THE EXISTING debt
 Cost of preference capital
o The cost of preference capital is a function of the dividend
expected by investors.
o Preference capital is never issued with an intention not to
pay dividends.
o Although it is not legally binding upon the firm to pay
dividends on preference capital.
o Yet it is generally paid when the firm makes sufficient
profits.
o Cost of preference capital is apparently the dividend which
is committed and paid by the company.
 Valuation of preference
share
 IRREDEEMABLE PREFERENCE SHARES:

This type of preference share may

be treated as a perpectual security if it have no
redemption period so the investor can get their investment
value at the time of winding up of a company.

 REDEEMABLE PREFERENCE SHARE :

This type of preference share may

have an predetermined redemption period &redemption value
so investor can get their investment value after an particular
period.
Cost of equity capital
Cost of equity and the capital asset pricing
model(CAPM)
 THE WEIGHTED AVERAGE COST OF
CAPITAL
 The WACC is the rate that a company is expected to
pay on average to all its security holders to finance
its assets.

 The WACC is the minimum return that a company

must earn on an existing asset base to satisfy its
creditors, owners, and trhe other providers of
capital, or they will invest elsewhere.
THANK YOU