Chapter 7: Cost of Capital

• The minimum rate of return that a firm must earn

on its investment for the market value of the firm
to remain unchanged. (cut-off rate/target
rate/hurdle rate/minimum required rate of return/
standard rate/weighted average cost of
capital/composite cost of capital/combined cost
of capital)
Assumptions
Assumptions:
•There will be no change in the business risk
complexion of the firm as a result of acceptance of
new investment proposal.
•The firm’s financial structure is assumed to remain
fixed.
Steps of Computation:
•Specific costs of capital
•Overall cost of capital
1. Cost of Debt:
---Cost of Perpetual Debt
---Cost of Redeemable Debt
2. Cost of Preference Shares
---Cost of Perpetual Preference Shares
---Cost of Redeemable Preference Shares
3. Cost of Equity Shares
---Dividend Approach
---Capital Asset Pricing Model (CAPM)
4. Cost of Retained Earnings