Cost of Capital

Cost of capital refers to the payment that a firm has to make to the suppliers of capital.
This include dividend payment to equity or preference and interest payment to debentures.
The term cost of capital is generally used in the sense of the overall cost of capital
Ko=kew1+krw2+kpw3+kdw4
Ko=Overall cost of capital
ke = Cost of equity
Kr =cost of retained earning
kp = cost of preference shares
Kd =after tax cost of debt
W1= proportion equity to total capital
W2 = proportion of retained earnings to total capital
Relevance of cost of capital
• It is important criterion in many decision making areas.
• In investment decisions to decide about profitability of the proposal
• Leveraging that is equity and debt mix to reduce the average cost of
capital
• In working capital management
• In performance evaluation
Specific or explicit cost
• An explicit cost is a cost that occurs, is easily identified, and is
accounted for in business documents or financial statements. It
represents clear, obvious cash outflows that reduce a business's
bottom-line profitability. Examples of explicit costs would be items
such as wage expenses, rent, or lease costs; it is easy to identify the
sources of those cash outflows and the business activities to which
the expenses are attributed.
•
• Implicit costs can also be called imputed, implied or notional
costs. Businesses don’t necessarily record implicit costs for
accounting purposes because money does not change hands. These
costs represent loss of potential income and not of profits. A
company may choose to include these costs as the cost of doing
business since they represent possible sources of income.
• Difference Between Implicit and Explicit Costs
• Implicit costs are technically not incurred and therefore cannot be
measured accurately for accounting purposes. There are no cash
exchanges in the realization of implicit costs. However, they are
important costs to ascertain because they help managers make
effective decisions on behalf of the company.
Cost of equity share capital
• Earnings/price model
• Dividend growth model
• Earnings growth model
• Capital asset pricing model
Earnings/price model

•Ke=E/P
• E= earning per share
• P= current market price per share
Dividend growth model

•Ke =(D/P)+g
• D= dividend per share at the end of a period
• P= current market price
• G=growth rate in dividend
Earnings growth Model

•Ke= (E/P)+g
• E= earnings per share
• P= Current market price of shares
• G= Growth rate in earnings
Floatation costs
• These are costs of floating shares in the market and includes
brokerage underwriting etc. There fore cost of new equity will be

•Ke =(D/P(1-f))+g
•F= floating charges
Capital asset pricing model

• On this basis, the most commonly accepted method for calculating cost of
equity comes from the Nobel Prize-winning capital asset pricing
model (CAPM): The cost of equity is expressed formulaically below:
Re = rf + (rm – rf) * β
Where:
Re = the required rate of return on equity
• rf = the risk free rate
• Rm = Expected return on the market as a whole
• rm – rf = the market risk premium
• β = beta coefficient = systematic risk or unavoidable risk
• Rf – Risk-free rate - This is the amount obtained from investing in
securities considered free from credit risk, such as government bonds
from developed countries.
• ß – Beta - This measures how much a company's share price reacts
against the market as a whole. A beta of one, for instance, indicates
that the company moves in line with the market. If the beta is in
excess of one, the share is exaggerating the market's movements; less
than one means the share is more stable. Occasionally, a company
may have a negative beta (e.g. a gold-mining company), which means
the share price moves in the opposite direction to the broader
market.
• (Rm – Rf) = Equity Market Risk Premium (EMRP) - The equity market
risk premium (EMRP) represents the returns investors expect to
compensate them for taking extra risk by investing in the stock
market over and above the risk-free rate. In other words, it is the
difference between the risk-free rate and the market rate. It is a
highly contentious figure. Many commentators argue that it has gone
up due to the notion that holding shares has become more risky.
• The EMRP frequently cited is based on the historical average
annual excess return obtained from investing in the stock market
above the risk-free rate. The average may either be calculated using
an arithmetic mean or a geometric mean. The geometric mean
provides an annually compounded rate of excess return and will in
most cases be lower than the arithmetic mean. Both methods are
popular, but the arithmetic average has gained widespread
acceptance.
• Once the cost of equity is calculated, adjustments can be made to
take account of risk factors specific to the company, which may
increase or decrease a company's risk profile. Such factors include the
size of the company, pending lawsuits, concentration of customer
base and dependence on key employees. Adjustments are entirely a
matter of investor judgment, and they vary from company to
company.
Cost of Retained Earnings
• Opportunity cost involved.
• Dividend foregone by the shareholders
• Two methods for measuring this cost
• Reinvestment assumption
• External yield criterion
Reinvestment assumption

•Kr=Ke(1-t)(1-C)
•Kr= cost of retained earnings
• Ke = cost of equity share capital
•C= Commission,brokerage
•t= Marginal tax rate
External yield criterion

•Kr = Ke =(D/P)+g

•Kr = Ke= (E/P)+g

Cost of preference share
When preference shares are issued at par or at a
premium or discount
•Kp =D/I
•D= Annual dividend
•I = Net proceeds of the preference shares
issued
•Preference shares are paid after tax so no
need for adjustment of tax
• When preference shares are issued at a premium or discount and are
redeemable after the expiry of a given perion(n) the following
formula is used:

•kp =D+(1/n(P-I))½(P+I)
• D= Annual dividend payable
• P= Face value of preference shares
• I= Issue price of shares
Tax on dividends
• A domestic company is required to pay tax at 10% on the amount of
dividend paid to its sharholders(both equity and
preference).Accordingly in computing the cost of equity and cost of
preference, ‘D’ should be adjusted by the factor(1+t) where t
represents the rate of dividend tax

•Ke =(D(1+t)/P)+g
Cost of Debt
• Debt issued at par

• Kd = r(1-t)
• r= Interest rate payable
• t= Marginal tax rate of the firm
Redeemable debt issued at a discount or
premium
•Kd = (C+(1/n)(P-I))(1-t)/(1/2)(P+1)
c= Fixed interest charges per annum
•P=Face value of the debenture
•I= Price at which the debenture or bond is
sold
•t=Marginal tax rate
Perpetual debt
• Debts may be issued for a perpetuity.or calculating the explicit cost of
debt, the formula for a perpetuity would be as follows:
• Kd = (C/I)(1-t)

• C =Fixed annual interest payable

• I= Net proceeds of the issue
• t= applicable tax rate.
Overall cost of capital
• Computation of overall cost of capital
• Compute specific cost of each of the sources of capital
• Select appropriate weights
• Multiply the cost of each of the sources by the appropriate weights
• Divide the total coast by total weights
Selection of Weights
• Book value weights:It is relative proportions of various sources of
capital to the capital structure of the firm
• Market value weights:Proportions of market values of various sources
of capital may be assigned as weights in computing the overall cost of
capital.
Rationale for weighted Average cost
• The rationale for using weighted average cost of capital for capital
budgeting decisions is that by accepting projects that will give more
than the cost of capital, the firm is able to increase its share's market
price because the accepted projects are expected to return more on
their equity financed portion than on the cost of equity capital. Once
theses expectations are apparent to the market place , the market
price of shares will tend to increase, all other factors remaining
constant. This is consistent with the value maximization objective of
the firm.
• The weighted average cost of capital can be calculated on the before-
tax or after tax basis. However, the measurement of the overall cost
of capital on an after tax basis is more appropriate.
Marginal cost of capital
• The cost of obtaining another rupee of new capital. As in practice, a
firm raises some fixed amount of capital at a point of time to finance
an investment proposal, the marginal cost of capital generally signifies
the cost of additional amount of capital that may be raised by a firm.