COST OF CAPITAL

MEMBERS:

• Beatingo, Elsa
• Berhay, Ruben
• Sienes, Judith
• Suhaili, Sedimar
 TS:
T EN 1.O Meaning of Cost Capital

ON
C 2.0 Classifications of Cost of
Capital

3.0 Importance of Cost of

Capital

4.0 Measurement of Cost of

Capital
MEANING The factors which determine the cost
of capital are:
OF • Source of finance
COST OF CAPITAL • Corresponding payment for using finance.

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.

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.
CLASSIFICATIONS
OF 2. Specific Costs and Composite Cost

COST OF CAPITAL -Specific costs refer to the cost of a specific

source of capital such as equity shares,
1. Historical Cost and Future Cost Preference shares, debentures, retained
earnings etc. -Composite cost of capital refers
– Historical Cost represents the cost which to the combined cost of various sources of
has already been incurred for financing a finance.
project. Future cost refers to the expected
cost of funds to be raised for financing a
project. Historical costs help in predicting
the future costs and provide an evaluation
of the past performance when compared
with standard costs.
3. Average Cost and Marginal Cost 4. Explicit Cost and Implicit Cost

- Average cost of capital refers to the - Explicit cost refers to the discount rate
weighted average cost of capital calculated which equates the present value of cash
on the basis of cost of each source of capital outflows or value of investment.
and weights are assigned to the ratio of their
share to total capital funds. - On the other hand, the implicit cost
represents the rate of return which can be
- Marginal cost of capital may be
earned by investing the funds in the
defined as the ‘Cost of obtaining another alternative investments.
dollar of new capital.’ When a firm raises
additional capital from only one sources
(not different sources), than marginal cost is
the specific or explicit cost.
COMPONENTS OF 3. FINAL RISK PREMIUM
COST OF CAPITAL
Financial Risk relates to the pattern of
1. RETURN AT ZERO RISK LEVEL capital structure of the firm. A firm which has
It relates to the expected rate of higher debt content in its capital structure
return when a project involves no should have more risk than a firm which has
financial or business risk. comparatively low debt content.

2. BUSINESS RISK PREMIUM

Generally, Business risk premium is
determined by the capital budgeting
decisions for investments proposals. If the
firm selects a project which has more
than the normal risk, the suppliers of the
funds for the project will naturally expect
a higher rate of return than the normal
rate. Thus, the cost of capital increases.
IMPORTANCE The 7 significances of cost of capital:

OF 1. Maximiszation of the Value of the

Firm:
COST OF CAPITAL
•A firm tries to minimize the average cost of
The concept of cost of capital plays a capital. There should be a judicious mix of
vital role in decision-making process of debt and equity in the capital structure of a
firm so that the business does not bear
financial management. The financial
undue financial risk.
leverage, capital structure, dividend policy,
working capital management, financial
decision, appraisal of financial performance
of top management etc.
2. Capital Budgeting Decisions: 4. Management of Working Capital:

•Proper estimate of cost of capital is •In management of working capital, the cost
important for a firm in taking capital of capital may be used to calculate the cost
budgeting decisions. Generally, cost of of carrying investment in receivables and to
capital is the discount rate used in evaluating evaluate alternative policies regarding
the desirability of the investment project. receivables.

3. Decisions Regarding Leasing: 5. Dividend Decisions:

•Estimation of cost of capital is necessary in •Cost of capital is significant factor in taking

taking leasing decisions of business concern. dividend decisions. The dividend policy of a
firm should be formulated according to the
nature of the firm— whether it is a growth
firm, normal firm or declining firm.
6. Determination of Capital Structure:

•Cost of capital influences the capital

structure of a firm. In designing optimum
capital structure that is the proportion of
debt and equity, due importance is given to
the overall or weighted average cost of
capital of the firm.

7. Evaluation of Financial Performance:

•The concept of cost of capital can be used

to evaluate the financial performance of top
management. This can be done by
comparing the actual profitability of the
investment project undertaken by the firm
with the overall cost of capital.
 A. Cost of Debentures:
MEASUREMENT OF The capital structure of a firm normally
COST OF CAPITAL includes the debt capital. Debt may be
in the form of debentures bonds, term
loans from financial institutions and
Cost of capital is measured for banks etc. The amount of interest
different sources of capital structure of a payable for issuing debenture is
firm. It includes cost of debenture, cost of considered to be the cost of debenture
loan capital, cost of equity share capital, or debt capital (Kd). Cost of debt capital
cost of preference share capital, cost of
is much cheaper than the cost of capital
retained earnings etc.
raised from other sources, because
interest paid on debt capital is tax
deductible.
The cost of debenture is calculated in the (iii) When the debentures are redeemable at a
following ways: premium or discount and are redeemable after
(i) When the debentures are issued and ‘n’ period: Kd = I(1-t)+1/N(RV– NP) / ½ (RV – NP)
redeemable at par: Kd = r (1 – t) where
Kd = Cost of debenture.
where:
I = Annual interest payment
Kd = Cost of debenture t = Tax rate
r = Fixed interest rate NP = Net proceeds from the issue of debentures
t = Tax rate RV = Redeemable value of debenture at the time
(ii) When the debentures are issued at a of maturity.
Example:
premium or discount but redeemable at (a) A company issues Rs. 1,00,000, 15%
par Kd = I/NP (1 – t) Debentures of Rs. 100 each. The company is in
Where: 40% tax bracket. You are required to compute
Kd = Cost of debenture the cost of debt after tax, if debentures are
issued at (i) Par, (ii) 10% discount, and (iii) 10%
I = Annual interest payment premium.
t = Tax rate
Np = Net proceeds from the issue of (b) If brokerage is paid at 5%, what will be the
debenture. cost of debentures if issue is at par?
B. Cost of Preference Share Capital:
For preference shares, the dividend rate
can be considered as its cost, since it is Where:
this amount which the company wants NP = Net proceeds from the issue of
to pay against the preference shares. preference shares
Like debentures, the issue expenses or RV = Net amount required for
the discount/premium on
redemption of preference shares
issue/redemption are also to be taken
DP = Annual dividend amount.
into account.
(i) The cost of preference shares Example:
(KP) = DP / NP A company issues 10% Preference
Where, shares of the face value of Rs. 100 each.
DP = Preference dividend per share Floatation costs are estimated at 5% of
NP = Net proceeds from the issue of the expected sale price. What will be
preference shares. the cost of preference share capital (KP),
(ii) If the preference shares are if preference shares are issued (i) at par,
redeemable after a period of ‘n’, the (ii) at 10% premium and (iii) at 5%
cost of preference shares (KP) will be: discount? Ignore dividend tax.
Solution:
We know, cost of preference share capital
(KP) = DP/P
C. Cost of Equity or Ordinary Shares: (i) Dividend/Price Ratio Method:
The funds required for a project may be An investor buys equity shares of a
raised by the issue of equity shares particular company as he expects a
which are of permanent nature. These certain return (i.e. dividend). The
funds need not be repayable during the expected rate of dividend per share on
lifetime of the organization. Calculation the current market price per share is the
of the cost of equity shares is cost of equity share capital. Thus the cost
complicated because, unlike debt and of equity share capital is computed on
preference shares, there is no fixed rate the basis of the present value of the
of interest or dividend payment. expected future stream of dividends.

Cost of equity share is calculated by

considering the earnings of the
company, market value of the shares,
dividend per share and the growth rate
of dividend or earnings.
Thus, the cost of equity shares capital
(Ke) is measured by: Ke = D/P
Where: You are required to calculate:
D = Dividend per share
P = Current market price per share. (i) The company’s cost of equity capital.
If dividends are expected to grow at a
constant rate of ‘g’ then cost of equity (ii) The indicated market price per share,
share capital (Ke) will be Ke = D/P + g. if anticipated growth rate is 12%.

Example: (iii) The market price, if the company’s

XY Company’s share is currently quoted cost of equity capital is 12%, anticipated
in market at Rs. 60. It pays a dividend of growth rate is 10% p.a., and dividend of
Rs. 3 per share and investors expect a Rs. 3 per share is to be maintained.
growth rate of 10% per year.
(ii) Earnings/Price Ratio Method: Thus, the cost of equity capital (Ke) is
This method takes into consideration measured by: Ke = E/P
the earnings per share (EPS) and the where
market price of share. Thus, the cost of E = Current earnings per share
equity share capital will be based upon P = Market price per share.
the expected rate of earnings of a
company. The argument is that each If the future earnings per share will grow
investor expects a certain amount of at a constant rate ‘g’ then cost of equity
earnings whether distributed or not, share capital (Ke) will be Ke = E/P+ g.
from the company in whose shares he
This method is similar to dividend/price
invests.
method. But it ignores the factor of
If the earnings are not distributed as
capital appreciation or depreciation in
dividends, it is kept in the retained
the market value of shares. Adjustment
earnings and it causes future growth in
of Floatation Cost There are costs of
the earnings of the company as well as
floating shares in market and include
the increase in market price of the
brokerage, underwriting commission etc.
share.
paid to brokers, underwriters etc.
These costs are to be adjusted with the
current market price of the share at the
time of computing cost of equity share Example:
capital since the full market value per
share cannot be realised. So the market The share capital of a company is
price per share will be adjusted by (1 – f) represented by 10,000 Equity Shares of
where ‘f’ stands for the rate of floatation Rs. 10 each, fully paid. The current
cost. market price of the share is Rs. 40.
Earnings available to the equity
Thus, using the Earnings growth model shareholders amount to Rs. 60,000 at
the cost of equity share capital will be: the end of a period.
Ke = E / P (1 – f) + g
Calculate the cost of equity share
capital using Earning/Price ratio.
D. Cost of Retained Earnings:
The profits retained by a company for If earnings are not retained they are
using in the expansion of the business passed on to the equity shareholders
also entail cost. When earnings are who, in turn, invest the same in new
retained in the business, shareholders equity shares and earn a return on it. In
are forced to forego dividends. The such a case, the cost of retained
dividends forgone by the equity earnings (Kr) would be adjusted by the
shareholders are, in fact, an opportunity personal tax rate and applicable
cost. Thus retained earnings involve brokerage, commission etc. if any.
opportunity cost.
Many accountants consider the cost of Example:
retained earnings as the same as that of It is given that the cost of equity of a
the cost of equity share capital. company is 20%, marginal tax rate of
However, if the cost of equity shares the shareholders is 30% and the
capital i9 computed on the basis of Broker’s Commission is 2% of the
dividend growth model (i.e., D/P + g), a investment in share. The company
separate cost of retained earnings need proposes to utilise its retained earnings
not be computed since the cost of to the extent of Rs. 6,00,000.
retained earnings is automatically
Find out the cost of retained earnings.
included in the cost of equity share
capital.

Therefore, Kr = Ke = D/P + g.
E. Overall or Weighted Average Cost of
The weighted average cost of capital is
Capital (WACC):
used by an enterprise because of the
A firm may procure long-term funds from
following reasons:
various sources like equity share capital,
(i) It is useful in taking capital
preference share capital, debentures,
budgeting/investment decisions.
term loans, retained earnings etc. at
(ii) It recognises the various sources of
different costs depending on the risk
finance from which the investment
perceived by the investors.
proposal derives its life-blood (i.e.,
finance).
When all these costs of different forms of
(iii) It indicates an optimum combination
long-term funds are weighted by their
of various sources of finance for the
relative proportions to get overall cost of
enhancement of the market value of the
capital it is termed as weighted average
firm.
cost of capital. It is also known as
(iv) It provides a basis for comparison
composite cost of capital. While taking
among projects as a standard or cut-off
financial decisions, the weighted or
rate.
composite cost of capital is considered.
 Generally, the-following weights are
F. Computation of Weighted Average
assigned:
Cost of Capital (WACC):
(a) Book values of various sources of
Computation of Weighted Average cost
funds
of capital is made in the following ways:
(b) Market values of various sources of
capital
(i) The specific cost of each source of
(c) Marginal book values of various
funds (i.e., cost of equity, preference
sources of capital.
shares, debts, retained earnings etc.) is to
be calculated.
Book values of weights are based on the
values reflected by the balance sheet of a
(ii) Weights (i.e., proportion of each,
concern, prepared under historical basis
source of fund in the capital structure)
and ignoring price level changes. Most of
are to be computed and assigned to each
the financial analysts prefer to use
type of funds. This implies multiplication
market value as the weights to calculate
of each source of capital by appropriate
the weighted average cost of capital as it
weights.
reflects the current cost of capital.
But the determination of market value Example:
involves some difficulties for which the Jamuna Ltd has the following capital
measurement of cost of capital becomes structure and, after tax, costs for the
very difficult. different sources of fund used:
(iii) Add all the weighted component
costs to obtain the firm’s weighted
average cost of capital.

Therefore, weighted average cost of

capital (Ko) is to be calculated by using
the following formula:

Ko = K1w1 + K2w2 + …………

where K1, K2 ……….. are component costs

and W1, W2 ………….. are weights.
THANK YOU ! !