Cost of Capital

Concept of Cost of Capital

 Learning Outcomes
1. To find the meaning of cost of capital
2. To find the advantages of cost of capital
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 Topic: Cost of Capital
Outcome of the lecture:
1.To understand how the companies get money
from various sources(Financing).
2.To understand the meaning of components of
cost.
3.To understand the meaning of cost of capital
which is different for every component of cost.
 Cost of Capital
Definition: As it is evident from the name, cost
of capital refers to the weighted average cost of
various capital components, i.e. sources of
finance, employed by the firm such as equity,
preference or debt.
 Cost of Capital

In finer terms, it is the rate of return, that must

be received by the firm on its investment
projects, to attract investors for investing capital
in the firm and to maintain its market value.
 Cost of Capital
• The factors which determine the cost of capital
are:
• Source of finance
• Corresponding payment for using finance.
 Cost of Capital
On raising funds from the market, from various
sources, the firm has to pay some additional
amount(Like Interest, dividend etc.) apart from
the principal itself.
The additional amount is nothing but the cost of
using the capital, i.e. cost of capital which is
either paid in lump sum or at periodic intervals.
Components of Cost of Capital
 Classification of Cost of Capital

• Explicit cost of capital:

It is the cost of capital in which firm’s cash
outflow is oriented towards utilization of capital
which is evident, such as payment of interest to
the loan givers (debenture holders), etc.
 Classification of Cost of Capital

• Implicit cost of capital:

It does not involve any cash outflow, but it
denotes the opportunity foregone while opting
for another alternative opportunity.
Example: Dividend or Retention for Equity
Shareholders.
 Why Cost of Capital?

1.It helps in assessing firm’s new projects.

Hence, it establishes a benchmark, which must
be met out by the project.
 Importance of Cost of Capital

• Evaluating the investment options:

By converting the future cash flows of the
investment avenues into present value by
discounting it various projects are evaluated.
 Importance of Cost of Capital

• Capital budgeting decisions:

Long term investment decisions are called
capital budgeting decisions.Cost of capital helps
in taking such investment decisions.
Example: The promoters of a paper mill
definitely make analysis of cost and incomes
involved in the project.
 Importance of Cost of Capital

 Designing the optimal capital structure

Cost of capital is vital to help a firm to maximize
its value.
Firm’s value is maximum WHERE the cost of
capital is minimum.
 Importance of Cost of Capital

• It can also be used to appraise the

performance of specific projects by
comparing the performance against the cost of
capital.
 Importance of Cost of Capital

• It is useful in framing optimum credit policy,

i.e. at the time of deciding credit period to be
allowed to the customers or debtors, it should
be compared with the cost of allowing credit
period.
 MCQ
Equity has---------cost of capital.
1.Explicit
2.Implicit
 MCQ
Equity has---------cost of capital.
1.Explicit
2.Implicit
Example: There is never seen an Equity Share
with explicit rate viz. 15%Equity Share of
Rs.100 each.]
 MCQ
Debenture has-----cost of capital.
1. Explicit
2. Implicit
 MCQ
Debenture has-----cost of capital.
1. Explicit
2. Implicit

[12%; 5Years Redeemable Debenture of Rs.1000 ]

 MCQ
Cost of capital is the -------return expected from
a unit of money.
1. Minimum
2. Maximum
3. Average
4. None of the above.
 MCQ
Cost of capital is the -------return expected from
a unit of money.
1. Minimum
2. Maximum
3. Average
4. None of the above.
 MCQ
When a company uses different components for
financing then the hurdle rate to be used as cost
of capital is---------?
1.Individual cost of each component
2. Weighted average cost of capital
3. Both 1 and 2
4. None of the above.
 MCQ
When a company uses different components for
financing then the hurdle rate to be used as cost
of capital is---------?
1.Individual cost of each component
2. Weighted average cost of capital
3. Both 1 and 2
4. None of the above.