COST OF CAPITAL

Learning Objectives
What are the different forms of business organizations? What is a company? What are the different type of companies? What are the different source of finances available to a company? What are the cost of these sources of finance?

Forms of Business Organizations

Proprietorship Partnership Limited Liability Partnership (LLP) Company

Advantage of a company?

What is a company?

Company is a voluntary association of person formed for the purpose of doing some business. A company has its own name. A company has a separate legal entity, distinct from its members who constitute it. The company can sue and it can be sued. A company has its own property. The members can not claim the property of the company as their own property.

Types of companies
Private Company Public Company Government Company Foreign Company Company limited by Guarantee

Sources of Finance

The Capital Markets a) New Issue b) Right Issue Public deposits Debt a) Debentures b) Bonds Bank borrowings Retained Earnings Government Sources Are these sources free or they attract any cost ?

Cost of Sources of Finance

Each source has a cost to the company. Collectively all the sources which are used by the company to finance its projects is called as capital.

Cost of capital
For Investors: The rate of return on a security is a benefit of investing. For Company: That same rate of return is a cost of raising funds that are needed to operate the company. In other words, the cost of raising funds is the companys cost of capital

Cost of each source

Cost of debt is denoted by Kd. Cost of equity is denoted by Ke. Cost of preference shares is denoted by Kp. Cost of retained earnings is denoted by Kr.

Collectively cost of capital is denoted as Ko. It is also called as weighted average cost of capital.

Cost of Debt
Debt is in the form of Bonds and Debentures. They are redeemable or Irredeemable. For the issuing company, the cost of debt is: the return required by investors, adjusted for flotation cost (any costs associated with issuing new bonds), and adjusted for taxes. taxes. Incase of Irredeemable debt: Kd= I/B Here I is the interest amount and B is the market value of a bond/debenture

Cost of Debt

In case of redeemable debt: Kd= I(1-t) + (RV-NP)/N (RV+NP)/2 Here I is the interest amount t= Tax rate N=Maturity period RV=Redemption value NP= Net Proceeds after adjustment of flotation cost and discount if any.

Cost of Preference shares

Preference shares are also issued in two forms: Redeemable and Irredeemable Cost of Irredeemable Preference shares is: Kp= Dp/P0 Dp = dividend on preference shares P0=Current market price of a preference share.

Cost of Preference shares

Cost of redeemable Preference shares is: Kp= Dp + (RV-NP)/n (RV+NP)/2 Dp = dividend on preference shares N=Maturity period RV=Redemption value NP= Net Proceeds after adjustment of flotation cost and discount if any.

Cost of Equity shares

There are 2 sources of Equity:

1) Internal equity (retained earnings), 2) External equity (new equity issue) Do these two sources a have the same cost ?

Cost of Internal Equity

Since the shareholders own the firms retained earnings, the cost is simply the shareholders required rate of return.
Kr=Ke

Cost of External Equity

Dividend Growth Model Ke= D1/P0 +g D1= Dividend at the end of 1st Year P0=Current Market Price of a share G=Growth

Cost of External Equity

Capital Asset Pricing Model (CAPM) ke = krf + B ( km - krf )

Krf= Risf free rate B= Beta Km= Market rate

Weighted Cost of Capital

The weighted cost of capital is just the weighted average cost of all of the financing sources.

Any Questions