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The Cost of Capital is the minimum rate of return, that a company

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requires from its investments in order to ensure that the market value
of its shares either increase or remain at the same level. We don't spam. We Educate.

It simply refers to the minimum profit a firm requires from its investment in
order to increase its market valve.

According to James Van Horne, Cost of Capital is “A cut-off rate for the
allocation of capital to investments of project. It is the rate of return on a
project that will leave unchanged the market price of stock”

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Assumptions/Characteristics of Cost of Capital

Cost of capital is the indication of expectations of shareholders regarding

returns from their investments and may not necessarily be in form of cash
cost every time.
It is the minimum rate of return required from investments to maintain
market value of a firm`s equity shares.
Computation of cost of capital requires consideration of the number and
degree of risks associated with the project/business and is directly
proportional to it i.e. cost of capital is high if the risks associated with the
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project/business are high and vice versa.

Cost of capital (Ke) = Risk free rate (Rf) + Risk Premium (Rp) Advertising Management (20)
Articles (240)
  Banking and Insurance (10)
Blog (28)
Business & Entrepreneurship (6)
Importance of Cost of Capital
Business Communication (15)
It is essential to compute cost of capital in order to determine an optimal Business Environment (21)

capital structure of the business concern and take good Capital Budgeting Business Ethics (2)
Business Law (1)
Decisions.
Business Statistics (49)
Cost of capital affects the capital structure and capital budgeting decisions
Company Law (14)
which in turn affect the value of the firm. Therefore it also helps to
Computer Applications (9)
evaluate the financial performance of a business
Consumer Behaviour (22)
It helps to evaluate various sources of finance and select the most Cost Accounting (3)
profitable one. E-commerce (8)

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It helps to formulate an optimum mix of debt and equity capital. Entrepreneurship (11)

It helps to take major financial decisions such as market value of share, Financial Accounting (2)

working capital requirements, earning capacity of securities, distribution of Financial Management (23)
Financial Services (19)
dividends etc.
Human Resource Management (18)
  Income Tax (2)
International Business (13)

  Investment Analysis & Portfolio Management

(10)
IT & Technical Skills (5)
Computation of Cost of Capital
Macro-Economics (9)
Computation of cost of capital consists of two important parts: Management Accounting (5)
Management Information System (4)
Managerial Economics (2)
(I) Measurement of specific costs
Marketing & Advertising (7)
Marketing Management (18)
(II) Measurement of overall cost of capital or WACC
Marketing of Services (6)
Micro-Economics (2)
 
Operations Management (2)
Organizational Behaviour (7)
(I) Measurement of Speci c Cost of Capital Personal Finance (2)
Principles of Management (9)
It refers to the computation of cost related to each specific source of finance
Project Management (11)
like:
Projects and Presentations (32)
Public Finance (11)
Cost of equity capital (Ke)
Research Methodology (9)
Cost of debt/debenture capital (Kd) Rural Marketing (1)
Cost of preference share capital (Kp) Strategic Management (14)
Cost of retained earnings (Kr)

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Valuation of Cost of Equity (Ke) – It is the minimum rate of return required

from equity financing investments to ensure growth of market value of a
company. The various methods of computing cost of equity are as under –

Dividend Yield Method Ke = D/NP x 100 OR D/MP x 100

Dividend Yield + Growth Ke = (D/NP) x 100 + g

Earning Yield Method Ke = E/NP x 100 OR EPS/MP x 100

Earning Growth Method Ke = (E/NP) x 100 + g OR EPS/MP x 100

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NP = Net Proceeds per share = Face value + Premium – Discount – Cost of

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Issue (if any)
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D = Expected dividend per share

MP = Market Price per Share 

Inventory, Inventory Control – Theory Notes

g = Growth rate of dividends/earnings January 13, 2018

E/EPS – Earnings per share Organization Design – Types of Organization

Structure
January 2, 2018
Wt = Wealth for the year t
Marketing Information System – Components,
Dt = Dividend per share at the end of year t  Importance
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Pt = Price per share at the end of year 1 Budget, Budgeting, Budgetary Control
December 20, 2017
Pt-1 = Price per share at the beginning of the year
Resistance to change – Levels, Overcoming
Rf = Risk Free Return Km = Market Return b = beta coefficient Resistance
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Valuation of Cost of Debt (Kd) – Cost of Debt/Debentures refers to the rate

of interest payable by a company on its issued debt instruments.
Debentures issues by a company may be Redeemable or Irredeemable and
may be computed before or after tax has been deducted. They may be
issues at par, at premium or at a discount.

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Here,

NP = Net proceeds

When Shares are issued:

At Par – NP = Face value – Cost of Issue

At Premium – NP = Face value + Premium – Cost of Issue

At Discount – NP = Face value – Discount – Cost of Issue

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I = Fixed Annual Interest Payable t = Tax rate

r = Interest Rate Payable n = Number of Years

P = Par/Face/Redeemable Value of debentures 

Valuation of Cost of Preference Shares (Kp) – It refers to the cost

associated with the payment of dividend to preference shareholders
according to their expectations. It can be simply defined as the minimum
rate of return expected out investments made my preference shareholders
in order to maintain and attract funds. Preference shares may be
redeemable or Irredeemable.

Here,

D = Annual Preference Dividend N = Number of Years

P = Par/Face/Redeemable Value of Preference shares 

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Valuation of Cost of Retained Earnings (Kr) – Generally the cost of

retained earnings is equal to the cost of equity share capital as both sources
of funds belong to the owners of the company and they expect the same
rate of return out of investments made from each source.

Cost of Retained Earnings may be simply defined as opportunity cost of

additional dividends that shareholders would have received, if the retained
earnings were distributed as dividends and not retained. 

Kr = (D/NP + g) x (1-t) x (1-b)                    OR

Kr = Ke x (1-t) x (1-b)

Here,

D = Expected dividend g = Growth Rate

NP = Net Proceeds of Equity shares t = Tax rate 

b = Cost of purchasing securities or brokerage cost Ke = Cost of Equity capital

(II) Measurement of Overall Cost of Capital or Weighted Average cost of capital

(WACC)

Weighted average cost of capital is the weighted average cost of equity and
debt capital, where weights are the amount of capital raised from each
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source.

The computation of the overall cost of capital (Ko) involves the

following steps.

(a) Assigning weights to specific costs

(b) Multiplying the cost of each of the sources by the appropriate weights

(c) Dividing the total weighted cost by the total weights.

(d) The overall cost of capital is calculated with the following formula –

WACC or Ko = (Kd x Wd) + (Kp x Wp) + (Ke x We) + (Kr x Wr)

Here,

Ko = Overall cost of capital Kd = Cost of debt

Kp = Cost of preference share Ke = Cost of equity

Kr = Cost of retained earnings

Wd= Percentage of debt in the total capital 

Wp = Percentage of preference share of the total capital

We = Percentage of equity shares of the total capital

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Wr = Percentage of retained earnings of the total capital

Format for Calculation of WACC

Note: The term ‘Opportunity cost’, ‘Minimum required rate of return’, ‘Cost
of capital’, ‘Discount rate’ and ‘Interest rate’ are all synonymous in financial
management.

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