COST OF CAPITAL

by
S.Surendar
 MEANING
For financing, its operations can raise long term funds
through a combination of

Debt
Preference share capital
 Equity share capital
 DEFINITION
1. MILTON H.SPENCER: The Cost of capital is
a minimum rate of return which a firm requires
as a condition for undertaking an investment.
2. SOLOMON EZRA: The Cost of capital is the
minimum rate of return or cutoff rate for capital
expenditures.
COMPONENTS OF COC
The COC of a firm consists of following
three components:

Return at zero risk

Premium for business risk
Premium for financial risk

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IMPORTANCE OF COC
 Capital budgeting decision

 Designing the capital structure

 Deciding about the method of financing

 Performance of top management

 Other areas of decisions making

 FACTORS DETERMINING THE COC
 General economic conditions

 Market conditions

 Operating and financing decisions

 Amount of financing
 COMPUTATION OF COST OF CAPITAL
1. COST OF DEBT
2. COST OF PREFERENCE SHARE CAPITAL
3. COST OF EQUITY CAPITAL
4. COST OF RETAINED EARNINGS
5. WEIGTHED AVERAGE COST OF CAPITAL
(WACC)
6. MARGINAL COST OF CAPITAL
 I. COST OF DEBT
1.COST OF IRREDEEMABLE DEBT :

A. Cost of debt before tax (Kdp) = Interest

Net proceeds(NP)

B Cost of debt After tax (K da )= Interest – tax savings

Net proceeds

2. COST OF REDEEMABLE DEBT :

A . Cost of debt before tax (K db ) = Annual cost before tax

Average value of debt

B. Cost of debt after tax (K da )= Annual cost - Tax savings

Average value of debt

 II. COST OF PREFERENCE
SHARE CAPITAL

A. COST OF IRREDEEMABLE PREFERENCE SHARE CAPITAL

Cost of preference share capital(kp) = Annual preference dividend

Net proceeds(NP)

B. COST OF REDEEMABLE PREFERENCE SHARE CAPITAL

Cost of Redeemable preference share capital= Annual cost

Average Value of RPS
III. COST OF EQUITY CAPITAL
A. DIVEDEND YIELD :
Cost of equity (ke) = d1
Np
B. DIVIDEND PRICE PLUS GROWTH (D/P+G)
METHOD :
1 .In case of new issue of shares
Cost of equity ( Ke) = d1
Np
2. In case of existing shares
Cost of Equity (ke)= D1 +g
Mp
III. Earnings/ price (E/P) Method
A. In case of new issue of shares :
cost of equity (Ke ) = EPS
NP
B. In case of existing shares
Cost of equity (Ke) = EPS
M
IV. Realised yield method
(a) The share holders expect the realised yield of the past in
future as well ,
(b) The firm remains in the same risk class,
(c)The market Price of shares dose not change significantly.
V. Cost of equity under CAPM
Ke =Rf + ß(Rm-Rf)

4. COST OF RETAINED EARNINGS

Cost of retained earnings (Kr )= ke (1-t)(1-b)

5. WEIGHTED AVERAGE COST OF CAPITAL ( WACC)

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