Cost of capital

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Mr. Karthik Reddy S
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M.Com, UGC-KSET, MBA, MPhil.

Asst. Professor, Dept. of MBA, SVCE

Bengaluru Ka
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COST OF CAPITAL

Firm's cost of capital can be defined as the rate

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of return that could be earned in the capital
market on securities of equivalent risk.
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h i k
In general, the higher the riskiness of the firm's
activities, the higher is its cost of capital, since
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investors typically require compensation for
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greater risk. For a firm financed by debt and
f.
equity, the cost of capital will be a weighted
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average of its cost of capital from both sources.
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In short it refers to Minimum Rate of Return
expected by providers of capital. 2
TYPES OF COST

Marginal Cost: A marginal cost is the additional cost

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incurred for producing one more unit. It refers to the
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change in the total cost, resulting from the change in
production per unit of output. It is also called as
incremental or differential cost R e
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Marginal cost is the newth
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the firm incurs if it were
or the incremental cost that
to raise capital now, or in the
near future.
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SpecificPor Component Cost: It is the combined
cost of capital or an average costs of different sources
of funds. 3
 Explicit cost:
An explicit cost is the discount rate which
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equates the present value of cash inflowsS
with the present value of the cash d d
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outflows. It is the internal rate of return on
cash flows.
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Implicit cost: rt
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It is opportunity cost which is given up in
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order to pursue a particular action.
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 COST OF DEBT CAPITAL

Cost of Debenture
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debenture to the lenders of a company.d
The required rate of return on investment in

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Debenture is an acknowledgment of debt. A
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debenture could be redeemable or irredeemable.
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Redeemable Debenture is one which has to be
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repaid during the life time of co.,
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Irredeemable Debenture is one which will be
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repaid during liquidation of co.,
Debenture carries a fixed rate of Interest and it
is tax deductible expenses.
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Cost of Perpetual / Irredeemable Debt

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Cost of Redeemable Debenture

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 DEBENTURE COST OF CAPITAL :

capital in the following situations:

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Assuming the corporate tax rate of 35%, compute the after tax cost of

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(i)Perpetual 15% Debentures of Rs.1, 000, sold at a premium of 10% with
no flotation costs.
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(ii) 10-year 14% Debentures of Rs. 2,000, redeemable at par, with 5%
flotation costs.
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 Cost of Preferential Capital
The required rate of return on investment
in preference shares to the preference
shareholders of the company.
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Preference shares are those which have
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preferential right over equity in terms of
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dividend payment and claim on asset.
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A preference shares may be redeemable
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or irredeemable. Preference shares carry
a fixed rate of dividend and are not tax
deductible. 10
Cost of Irredeemable/ Perpetual Preference
Share

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Cost of Redeemable Preference Share

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 Cost of Equity Capital

The required rate of return on the y S

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investment in the equity shares to the
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equity shareholders of the co. e
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It is also known as equity capitalization
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rate. The following are the methods of
computing cost of equity.
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 Cost of Equity Capital : methods

1.Dividend Method (No growth model) y S

2.Constant growth model (Gordone d d
model)

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3.Earnings Model
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4.Capital Asset Pricing Model.

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 y S
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The shares of a company are selling at Rs 40 per share and it had paid a
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dividend of Rs. 4 per share last year. The investor’s market expects a

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growth rate of 5 percent per year.
1.Compute the company’s equity cost of capital.
2.If the anticipated growth rate is 7 percent per annum, calculate the indicated
market price per share.
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 y S
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Well do company ltd, is currently earning 15 percent operating profit
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on its share capital of Rs 20 Lakh [FV of Rs 200 per share]. It is
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interested to go for expansion for which the company requires an

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additional share capital of Rs 10 lakh. Company is raising this amount
by the issue of equity shares at 10 percent premium and the expected
floatation cost is 5%. Calculate the cost of equity

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CAPITAL ASSET PRICING MODEL (CAPM)
CAPM is the model that provides a frame work to
determine the required rate of return on an asset
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and indicates the relationship between the return
and risk of an asset. d d
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The required rate of return specified by CAPM
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helps in valuing an asset.
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CAPM envisages the relationship between risk and
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the expected return on the risky securities. It
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provides a frame work to price individual securities
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and determine the required rate of return for
individual securities.
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 y S
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Where,
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Rf = Risk Free rate. Ie yield on government securities as risk free rate

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Rm-Rf = Market Risk premium. Ie the difference between the market return
and the risk free rate
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Bj = Beta of the firms share. Ie Beta is the systematic risk of an ordinary
share in relation to the market
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Beta is the measure of a security’s future risk. But investors do not have
future Data to estimate beta, hence historical data is used to estimate the
value of beta.
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 The Capital Asset Pricing Model
(CAPM)
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• As per the CAPM, the required rate of return on
y
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equity is given by the following relationship:
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• Equation requires the following three
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parameters to estimate a firm’s cost of equity:
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– The risk-free rate (R
– The market risk K
fa)

– The beta of f
. premium (R – R )
m f

r o the firm’s share (β)

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 COST OF RETAINED EARNINGS:

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It is the internal generation of funds, it represents the
investment of existing shareholders and may be used
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for further investments. The cost of retained may be
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calculated in the same way as that of equity capital.

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 WACC

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Weighted Average cost of Capital refers
to the average cost of various sources of
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finance including equity, preference and
debenture or debt capital. It is also know
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as overall cost of capital.
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f
The overall . cost of capital is a weighted
averagero of the individual required rates of
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return ( costs)
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The Weighted Average Cost of Capital

• The following steps are involved for y S

calculating the firm’s WACC: d d
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– Calculate the cost of specific sources of funds
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– Multiply the cost of each source by its proportion
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in the capital structure.
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– Add the weighted component costs to get the
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WACC.
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BOOK VALUE / MARKET VALUE WEIGHTS

Managers prefer the book value weights y S

for calculating WACC: d d
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– Firms in practice set their target capital structure
in terms of book values.
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– The book value information can be easily derived
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from the published sources.
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– The book value debt—equity ratios are analysed
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by investors to evaluate the risk of the firms in
practice.

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• The use of the book-value weights can be
seriously questioned on theoretical
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grounds:
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– First, the component costs are opportunity rates
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and are determined in the capital markets. The
weights should also be market-determined.
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– Second, the book-value weights are based on
arbitrary accounting policies that are used to
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calculate retained earnings and value of assets.
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Thus, they do not reflect economic values.
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• Market-value weights are theoretically superior
to book-value weights:
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– They reflect economic values and are not influenced by
accounting policies.
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component costs.
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– They are also consistent with the market-determined

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• The difficulty in using market-value weights:
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– The market prices of securities fluctuate widely and
frequently.
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– A market value baseda target capital structure means that
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the amounts of. debt and equity are continuously adjusted

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as the value of the firm changes.
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Thank You,
Karthik Reddy S