Cost of capital

Dibin K K
What Is 'Cost of Capital?

 Cost of capital is the required return necessary to make a capital budgeting project, such as
building a new factory, worthwhile. When analysts and investors discuss the cost of
capital, they typically mean the weighted average of a firm's cost of debt and cost of equity
blended together.
 The cost of capital metric is used by companies internally to judge whether a 
capital project is worth the expenditure of resources, and by investors who use it to
determine whether an investment is worth the risk compared to the return. The cost of
capital depends on the mode of financing used. It refers to the cost of equity if the business
is financed solely through equity, or to the cost of debt if it is financed solely through debt.
Contd..

 Many companies use a combination of debt and equity to finance their businesses and, for
such companies, the overall cost of capital is derived from the weighted average cost of all
capital sources, widely known as the weighted average cost of capital (WACC).
Cost of Capital :Components

 Cost of Debt(Kd)
 Cost of Equity (Ke)
 Cost of preference Shares(Kp)
 Retained Earnings
Cost of Debt(Kd)

 The cost of debt is the minimum rate of return that debt holder will accept for the risk
taken. Cost of debt is the effective interest rate that company pays on its current liabilities
to the creditor and debt holders. Generally, it is referred to after-tax cost of debt. The
difference between before-tax cost of debt and after tax cost of debt is depended on the fact
that interest expenses are deductible. It is an integral part of WACC i.e. weight average
cost of capital. Cost of capital of the company is the sum of the cost of debt plus cost of
equity. And Cost of debt is 1 minus tax rate into interest expense.
Cost of debt: Types

 Redeemable
 Irredeemable
Cost of debt(irredeemable)

 Kd=I(1-t)
B0
Formula(redeemable)

 I(1-t)+Rv-B0
n

Rv+B0
2
Formula Explanation

 Refer written note

Cost of Preference Shares(Kp)

 The cost incurred by the company against issuance of preference shares.

 Cost incurred is in the form of preference dividend.
 Two types-redeemable and irredeemable
Cost of Preference shares(irredeemable)

 Kp= PD
P0
Formula(redeemable)

 PD+Pn-P0
n

Pn+P0
2
Reference

 Investopedia