Cost Of Capital

Content
★ Cost OF Capital
★ Use of Cost Of Capital in Financial Decisions
❖ Investment Decision
❖ Capital Structure Decision
❖ Dividend Policy Decision
★ Component of Cost of Capital
● Cost of debt
● Cost of equity
★ Discounted cash flow (DCF) approach
★ Capital Asset Pricing Model (CAPM)
★ Bond Yield Plus Risk Premium Approach
★ Weighted average cost of capital
★ Factor affecting cost of capital
★ conclusion
Cost Of Capital
The rate of return that must be earned on the firm’s investment in order to
satisfy all the investors required rate of return.
Use of Cost of Capital in Financial
Decisions
Investment decision
Net Present Value (NPV): A method of evaluating capital investment
proposed by computing PV of net cash flows discounted at the firm’s cost of
capital.

Internal Rate Of Return (IRR): The discounting rate at which NPV of the
project equals to zero.
Capital Structure Decision

Optimal capital structure: Composition of long term sources of financing

that minimizes WACC or maximizes value of the firm.

Dividend Policy Decision

Cost of equity capital and reinvestment rate of return is compared and

appropriate dividend payout ratio is determined.
Component of Cost of Capital
Cost of Debt:

- A company may borrow funds from financial institution or may

issue bonds or debentures.
- Cost of debt to a firm is the rate of return required by the firm’s
creditors.
Cost of Perpetual Debt:
The debt which does not have any specific maturity period. It is permanent borrowed capital
also called irredeemable debt.

● Where i = Coupon interest in rupees

● NP= Net proceeds
● NP = Selling Price - Flotation Cost

Net proceed is the amount that is actually received from the sale of debt instrument i.e.
bond or debenture or long term loan.

After tax cost of debt = Before tax cost of debt - Tax Saving

=Kd (1- T)

Where T = firm's marginal tax rate

Cost of redeemable debt

Debt with specified maturity period. Redeemable debt requires the firm to pay fixed
amount of interest at the end of each period and principal at the maturity.
Bond Valuation Method:

- Used to determine the actual cost of debt

Cost of equity

- Cost of equity refers to a shareholders required rate of return on an equity

investment. It is the rate of return that could have been earned by putting
the same money into a different investment with equal risk.

- Equity capital can be raised internally through retained earning and

externally through the sales of new common stock.
Cost of Preferred Stock (Kps):

It is the rate of return that must be earned on the preferred stockholders investment to satisfy
their required rate of return.

Cost of preferred stock = Dividend per Share/ Net proceed

Cost of Internal Equity/ Retained Earning (Ks)

- Rate of return stockholders require on retained earning.

- Opportunity cost in terms of dividend forgone by common shareholders.

Three approaches to measure the cost of retained earning:

➢ Discounted cash flow (DCF) approach

➢ Capital Asset Pricing Model (CAPM)
➢ Bond Yield Plus Risk Premium Approach
Discounted cash flow (DCF) approach

The value of a firm’s common stock is equal to the present value of all its
future dividends.

Where Po = value of a share of common stock

D1 = expected year end dividend per share

Ks = investor’s required rate of return or cost of equity capital

g = constant growth rate in dividends

Capital Asset Pricing Model (CAPM)

A model based on the proposition that any stock’s required rate of return is
risk free rate plus a risk premium.

Cost of equity (Ks) = Rf+[ E(Rm)-Rf ]β

Where,

Rf = risk free rate of return

E(Rm) = market rate of return

β = beta, a relative measure of systematic or non- diversifiable risk

Bond Yield Plus Risk Premium Approach

Cost of equity can be determined by simply adding a risk premium of three to

five percentage point to the cost of firm’s own long term debt.
Cost of external equity/ Common stock (Ke)

It is determined by computing the cost of common stock after

considering both the amount of under pricing and the flotation costs
associated with the new issue of common stock.
Weighted average cost of capital
By weighting the cost of each component of capital by its proportion in the
capital structure.
Factor affecting cost of capital

● General economic condition

It determine the demand for and supply of capital within the economy as well as the level of
expected inflation. According to the law of demand, as demand for money in the economy
increases without an equivalent increase in supply, investor increase their required rate of
return. As a result cost of capital increases.

● Marketability of the security

If security is not readily marketable when the investors want to sell and price varies
significantly, an investors will require a relatively high rate of return.
● Amount of finance

WACC increases as the financing requirement of a firm for a given period increases. Flotation
cost, discount, under pricing of security reduce the net proceed and increase the percentage
cost of capital.

● Operating and financing decisions

Risk also results from decisions made within the company.

Business risk is the variability in returns on assets, which is affected by the company’s
investment decision.

Financial risk is the increase variability in returns to common stockholders as a result of

financing with the fixed charge gering source of financing.
Conclusion

● Higher tax rate reduces the cost of debt which ultimately reduces the cost
of capital.
● Higher dividend payout ratio increases amount of external equity
financing and WACC.
Reference
Fundamentals of financial management

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