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Cost of capital
By Dr. Viqar-U-Nissa
Asst Professor (Dept of Mgmt Studies, NC)
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Concept:
 The items on the financing side of the balance sheet are called capital
components. The major capital components are equity, preference and
debt. Capital as any other factor of production has a cost.

 Cost is the amount that a person is willing to pay or bound to pay for
the usage of a particular product or service.

 The company’s cost of capital is the average cost of various capital

components employed by it. It can also be viewed as the average rate
of return required by the investors who provide capital to the
company.
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 Cost of capital determines capital structure.

 For the evaluation of investment proposals, if:

 Rate of return= cost of capital – project accepted
 Rate of return> cost of capital – project accepted
 Rate of return< cost of capital – project rejected

 Cost of capital is the minimum rate that is to be earned so that there is

no change or deterioration in the market value of the share. It
involves specific cost of capital and weighted average cost of capital
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 Specific cost of capital: Cost of each of the sources of
finance i.e. cost of equity, cost of preference capital or
cost of debt.

 Weighted average cost of capital: It is the combined

cost of all the sources of finance. The proportion of each
component is multiplied by the respective cost and then
aggregated.
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Cost of debt:
 The rate of interest payable on debt. Debt can be raised in a variety of
ways i.e. from financial institutions, debentures and bonds.

 Debenture/ Bonds: It is the acknowledgement of debt given in writing

and agreeing to repay after certain time along with interest at a
particular rate.

 The rate of interest mentioned on a bond or a debenture is called

coupon rate.
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 Debenture/ Bond can be issued at:
 Par – issued at face value
 Premium – issued at more than face value
 Discount – issued at less than face value

 Whether the debenture is issued at par, premium or discount, the

owner is only entitled to the face value.

 The cost incurred for floating the debentures in the market is called
floatation cost. It involves publication cost etc.

 Debt can be irredeemable and redeemable debt.