Module-2

Cost of Capital:
Significance of cost of capital concept,
Opportunity cost of capital,
Components of cost of capital,
Cost of debt,
Cost of preference capital,
Cost of term loans,
Cost of equity capital (only dividend discounting),
Cost of retained earnings,
Determination of weighted average cost of capital.(Theory and
Problems)
Significance of cost of capital concept
 The concept of cost of capital is
indispensable in financial management.
 It is very important in the context of capital

budgeting to calculate the discount rate.

 It plays a dominant role in developing the

firms capital structure.

 It also forms the basis for evaluating the

performance of the top management.

Significance of cost of capital concept

 The computation of cost of capital assumes

great importance as different sources of
capital are found in the capital structure.
Opportunity cost of capital

 Opportunity cost of capital is the opportunity

cost of making a specific investment is the
rate of return that could have been earned by
putting the same money into a different
investment with equal risk.
Components of Cost of capital,

 Components of cost of capital includes:

A. The sources which carry fixed cost and the

B. Those which carry variable cost.
Components of Cost of capital

A. Sources which carry fixed cost:

 Preference shares,
 Debentures and
 loans from banks & financial institutions are

the sources of capital which carry fixed cost.

Components of Cost of capital
 B. Sources which carry variable cost:

 Equity share is a source of capital which carry

variable cost.
 Here variable cost is the variable dividends

which the firm declares to equity share

holders every year depending upon its
profits.
Cost of Debt/ Term loans
 It is the cost of borrowings from debentures
and loans.
 It is the interest rate mentioned in the

instrument (Debenture/loan agreement)

subject to the tax adjustments.
Cost of Preference Share
 It is the cost of borrowings from preference
shares.
 It is the dividend rate mentioned in the

instrument subject to other adjustments.

 Dividends to preference shares are paid after

paying the tax as a result preference share is

costlier than the debenture debt.
Cost of equity capital
 Computation of cost of equity shares is not as easy as
calculating the cost of debt capital or preference
capital.
 Both the debt and preference capital carry a fixed
cost
 Equity capital carry variable cost.
 The equity share holders have expectations as to the
rate of equity dividends.
 There are different methods by which cost of equity
share is calculated. Dividend Yield Method, Dividend
Yield Plus growth method, Earning Price Method,
Realized Yield Method
Cost of retained earnings
 Retained earnings is the amount of profits which is
undistributed as dividends to equity share holders
but retained in the business itself.
 The cost of retained earnings is the rate that the
shareholders would have earned if the retained
earnings were distributed as dividends.
 However, it must be remembered that the equity
share holders cannot invest the whole dividends as
dividends are subjected to tax. Some brokerage has
to be paid to invest in securities.
 Therefore, tax and brokerage has to be deducted
while computing the cost of retained earnings.
Weighted Average Cost of Capital:
 The components of capital namely the Debt
capital, Preference capital, Equity capital and
retained earnings carry different cost.
 Business is actually concerned with weighted

average cost of capital to fix the cut-off point

for evaluating various investment proposals.
 It is in this context that the concept of

weighted average cost of capital is helpful.