Cost of Capital

SOURCES OF FINANCE
Sources of finance means various sources from where funds
can be procured for starting as also for running a business.
The major sources of finance may be
Shares
Equity Shares
Preference Shares
Debenture
Loan from Banks
Loan from other financial institutions
Public Deposits
Retained Earning
Sources of Finance
 Capital Structure
• The capital structure of a company refers to a
combination of the long-term finances used
by the firm.

• Capital structure is the proportion of equity –

debt components in the capital of the
company.
 Example of Capital Structure
ABC Company capital is 7,00,000
Equity Share Capital (20,000 equity shares @ Rs 10 Each) Rs 2,00,000
Preference Share Capital (1,500 preference shares @ Rs 100 Each) Rs 1,50,000
Debenture (2,500 Debentures @ Rs 100 Each) Rs 2,50,000
Loan from Bank Rs 1,00,000
Total Rs 7,00,000
 Cost of Capital
• Cost of capital is the minimum rate of return that the company must
earn on its investments.

• Cost of capital is the minimum rate of return expected by its

investors

• According to Khan and Jain, cost of capital means “the minimum

rate of return that a firm must earn on its investment for the
market value of the firm to remain unchanged”.

• Not a cost as such: In fact the cost of capital is not a cost as such, it
is the rate of return that a firm requires to earn from its projects.
Cost of capital depends upon:

(a) Demand and supply of capital

(b) Expected rate of inflation
(c) Various risk involved
(d) Debt-equity ratio of the firm
 The significance or importance of cost of
capital
1. Maximization of the Value of the Firm
2. Capital Budgeting Decisions
3. Decisions Regarding Leasing
4. Management of Working Capital
5. Dividend Decisions
6. Determination of Capital Structure
7. Evaluation of Financial Performance:
The significance or importance of cost of capital

1. Maximization of the Value of the Firm

For the purpose of maximization of value of the

firm, a firm tries to minimize the average cost of
capital.

There should be judicious mix of debt and equity

in the capital structure of a firm so that the
business does not to bear undue financial risk.
2. Capital Budgeting Decisions
Proper estimate of cost of capital is important
for a firm in taking capital budgeting decisions.
Generally cost of capital is the discount rate
used in evaluating the desirability of the
investment project. In the internal rate of
return method, the project will be accepted if it
has a rate of return greater than the cost of
capital.
3. Decisions Regarding Leasing:
Estimation of cost of capital is necessary in
taking leasing decisions of business concern.
4. Management of Working Capital:
In management of working capital the cost of capital
may be used to calculate the cost of carrying
investment in receivables and to evaluate alternative
policies regarding receivables. It is also used in
inventory management also.
5. Dividend Decisions:
Cost of capital is significant factor in taking dividend
decisions. The dividend policy of a firm should be
formulated according to the nature of the firm—
whether it is a growth firm, normal firm or declining
firm.
However, the nature of the firm is determined by
comparing the internal rate of return (r) and the cost of
capital (k) i.e., r > k, r = k, or r < k which indicate growth
firm, normal firm and decline firm, respectively.
6. Determination of Capital Structure:
Cost of capital influences the capital structure
of a firm. In designing optimum capital
structure that is the proportion of debt and
equity, due importance is given to the overall or
weighted average cost of capital of the firm.
The objective of the firm should be to choose
such a mix of debt and equity so that the
overall cost of capital is minimised.
7. Evaluation of Financial Performance:
The concept of cost of capital can be used to
evaluate the financial performance of top
management. This can be done by comparing
the actual profitability of the investment
project undertaken by the firm with the
overall cost of capital.
Measurement of Cost of Capital/ Computation of Cost of Capital

Cost of capital is measured for different sources of

capital structure of a firm.
Components of Cost of Capital
1. Cost of Debt 
2. Cost of Preference share capital
3. Cost of Equity share capital
4. Cost of Retained Earnings
5. Combined cost / Computation of weighted average
cost of capital
 A. Cost of Debt
• The cost of debt is the return that a company provides to its
debt holders and creditors.
• The cost of debt is the rate of interest payable on debt.
• Cost of debt capital is much cheaper than the cost of capital
raised from other sources, because interest paid on debt
capital is tax deductible.
where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of
debenture.
• Example 1:
• (a) A company issues Rs. 1,00,000, 15% Debentures of Rs. 100
each. The company is in 40% tax bracket. You are required to
compute the cost of debt after tax, if debentures are issued at
(i) Par, (ii) 10% discount, and (iii) 10% premium.
• (b) If brokerage is paid at 5%, what will be the cost of
debentures if issue is at par?
B. Cost of Preference Share Capital
• Cost of preference share capital is that part of cost of capital 
which is payable to preference shareholders in the form of
dividend with fixed rate.

• The cost of preference shares (KP) = DP / NP

• Where, DP = Preference dividend per share
• NP = Net proceeds from the issue of preference shares.
• A company issues 10% Preference shares of the face value of
Rs. 100 each. Floatation costs are estimated at 5% of the
expected sale price.
• What will be the cost of preference share capital (KP), if
preference shares are issued (i) at par, (ii) at 10% premium
and (iii) at 5% discount? Ignore dividend tax.
• cost of preference share capital (KP) = DP/P
 C. Cost of Equity
• Cost of equity is the return that a firm pays to
its equity investors i.e., shareholders
where D = Dividend per share
P = Current Market Price

When there will be an annual growth in dividend

XY Company’s share is currently quoted in market at
Rs. 60. It pays a dividend of Rs. 3 per share and
investors expect a growth rate of 10% per year.
You are required to calculate company’s cost of
equity capital.
XY Company’s share is currently quoted in market at Rs. 60. It pays a
dividend of Rs. 3 per share and investors expect a growth rate of 10% per
year.
You are required to calculate: (i) The company’s cost of equity capital.
(ii) The indicated market price per share, if anticipated growth rate is 12%.
(iii) The market price, if the company’s cost of equity capital is 12%,
anticipated growth rate is 10% p.a., and dividend of Rs. 3 per share is to be
maintained.
 D. Cost of Retained Earnings:
• The portion of net profit distributed to shareholders
are known as dividend.
• The remaining portion is known as Retained
Earnings. It is also called undistributed profit.

• Cost of retained earnings is equal to Cost of equity.

The cost of retained earnings is the earnings
foregone by the shareholders.
• ****Flotation cost
• Flotation cost is the total cost incurred by a company in
offering its securities to the public. They arise from expenses
such as underwriting fees, legal fees and registration fees.
• It is given that the cost of equity of a company is 20%,
marginal tax rate of the shareholders is 30% and the Broker’s
Commission is 2% of the investment in share. The company
proposes to utilise its retained earnings to the extent of Rs.
6,00,000.
• Find out the cost of retained earnings
E. Weighted Average Cost of Capital (WACC)

• WACC is the average cost of the costs of various

sources of financing
• WACC is the calculation of cost of capital for all the
components in the capital structure such as debt,
equity, preference share, retained earnings etc.
• WACC is also known as overall cost of capital,
composite cost of capital etc.
• Over all Cost of Capital or WACC
• = Weight of Deb x Cost of Debt + Weight of
Preference Share x Cost of Preference Share + Weight
of Equity x Cost of Equity + Weight of Retained
Earnings x Cost of Retained Earnings
 COMPUTATION OF COST OF CAPITAL :
• STEP 1 Computation of cost of specific sources of a capital,
viz., debt, preference capital, equity and retained earnings,
and
• STEP 2 Computation of weighted average cost of capital.
  
Calculation of Overall Cost of Capital

Step #1 – Find the Weightage of Debt

Step #2 – Find the Cost of debt
Step #3 – Find the Weight of the Preference share
Step #4 – Find the Cost of Preferred Stock
Step #5 – Determine the Weightage of Equity
Step #6 – Find the Cost of Equity