Financial Management

Cost Of Capital

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 What Is Cost Of Capital?
Definition:
 From firm’s viewpoint cost of capital is the price
paid to the investor for the capital provided by
him
 From investor’s viewpoint cost of capital is the
measurement of the sacrifice made by him in
order to invest with a view to get a fair return
in future on his investments as a reward for the
postponement of his present needs
 In other words, the cost of raising funds is the
firm’s cost of capital.

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Utilities Of Cost Of Capital
Designing a firm’s capital structure

Evaluation of investment alternative

Assessment of financial performance

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 How can the firm raise capital?

Bonds
Preferred Stock
Common Stock
Each of these offers a rate of return to
investors.
This return is a cost to the firm.
“Cost of capital” actually refers to the
weighted cost of capital - a weighted
average cost of financing sources. 4
 Factors Affecting Cost of
Capital
General Economic Conditions
 Demand for and supply of capital
 Level of expected inflation
 These are reflected in the riskless rate of return
Market Conditions
 When the economy is doing well, most companies
do well. This reduces the risk that the company
will fail.
 When the economy is doing poorly, many companies
will also do poorly. This increases the risk that a
company will fail.
 Marketability of securities when seller wants to
sell.
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Operating and Financing Decisions

 Affect business risk- Business risk is the

variability in returns on assets that is affected by the
company’s investment decisions
 Affect financial risk-Financial risk is the increased
variability of returns to common stockholders as a
result of using debt and preferred stock
Amount of Financing
Cost of capital increases as the financing
requirements become larger because:
-As increasingly larger security issues are floated in
the market, additional floatation costs
-Investors’ required rates of return increase as the
firm seeks more and more capital without evidence of
the firm to absorb this capital
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Components Of Cost Of
Capital
Cost of Debt

Cost of Equity Share Capital

Cost of Retained Earnings

Cost of Preference Share Capital

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 Cost of Debt Capital
Debt may be in the form of debentures,
bonds, term loans from financial institutions
and banks
The debt carries a fixed rate of interest
payable by the firm to the debenture holders
whether the company makes profit or not.

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 Concept of Net Proceeds
When debt capital is raised, certain expenses
like issue , advertisement, , printing,
underwriting, brokerage expenses occur (also
known as floatation cost or FC)
These expenses reduce the actual amount of
debt capital received by a firm
Net proceeds is the actual debt capital received
by a firm after incurring floatation cost.

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 Calculation of Net Proceeds
Net Proceeds (or NP) is important to be
determined as it is used in calculation of cost
of debt capital.
NP when debentures are issued at par = Par
value - FC
NP when debentures are issued at premium=
Par value + Premium - FC
NP when debentures are issued discount = Par
value – Discount - FC

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 WACC
The Weighted Average Cost of Capital is the weighted
average cost of various sources of finance.

WACC tells us the return that both stakeholders -

equity owners and lenders - can expect. WACC, in other
words, represents the investors' opportunity cost of
taking on the risk of putting money into a company.

Investors use WACC as a tool to decide whether or not

to invest. The WACC represents the minimum rate of
return at which a company produces value for its
investors.

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 Steps
i. Calculate the cost of each specific
source of fund.
ii. Assign weights to specific costs based
on its proportion in the capital structure.
iii. Multiply cost of each source by its
proportion in the capital structure.
iv. Add the weighted component costs to
get the firm’s WACC
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Computing WACC-using New Common Shares
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%)1,000
Common Stock(16.25%)5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%
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+ .50 x 16.25% = 11.72%
 Assumptions
Future proposals do not vary

Balanced Debt and Equity

Analysis based on current costs

Existing capital structure is optimal

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 Summary

Cost of Capital is the rate of return which

the company must earn to satisfy the
investor who have provided long term
finance.

WACC is the weighted average cost of

various sources of finance.

WACC is an important tool in determining

an optimal capital structure.
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Cost of Capital can be calculated using book
values as weights

The Cost of Capital helps in the goal

maximization of shareholder’s wealth by
designing a capital structure which
minimizes the overall cost of capital.

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Thank You!!

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