Cost of Capital

Definition
• Cost of capital of a firm refers to the cost that is incurred in retaining the funds
obtained from various sources and employed in business.

• Utility of Cost of capital :

1. Designing a firms capital structure
2. Evaluation of investment alternative
3. Assessment of financial performance

• Cost of capital is the rate of return which the company must earn to satisfy the
investor who have provided long term finance.
• Coat of Capital is the rate of return , a firm must earn in order to attract the
suppliers of the funds to make available the funds to the firms.
Components of cost of capital

• Cost of Debt
• Cost of Equity share capital
• Cost of Retained Earnings
• Cost of Preference share capital

• Cost of capital can be calculated using any of the two approaches :

a. Overall cost of capital or WACC
b. Marginal Cost of Capital
Leverages

• Leverage refers to the ability of a firm in employing long term funds

having fixed cost to enhance returns to the owners .

• There are three types of leverage :

a. Operating Leverage
b. Financial Leverage
c. Combined Leverage
1. Operating Leverage : refers to the sales and profit variations. To
determine the relationship between sales revenue and earnings
before interest and tax.
Degree of OL = contribution/EBIT
2. Financial Leverage : This indicates the effect on earnings due to rise
of fixed cost funds. FL represents the relationship between firms
earnings before interest and taxes and the earnings available for equity
shareholders.
Degree of FL = EBIT / EBT
3. Combined Leverage : combination of OL and FL
Degree of CL = Contribution / EBT