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Introduction The cost of capital is the cost of a companys funds (both debt and equity)or,from an investors point of view "the expected return on a portfolio of all the companys existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
Definition “The cost of capital is the minimum required rate of earnings or the cut-off rate of expenditure” -Solomon Ezra “The cost of capital represents a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.” -James C. Van Horne
What does cost of capital mean? The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. Costof capital includes the cost of debt and the cost of
Importance of Cost of CapitalThe concept of cost of capital is crucial in financial management. Like any other source of finance has a cost and cannot, therefore, be used in the most effective manner unless that cost can be
TYPES OF COST OF CAPITAL1)COST OF EQUITY (Ke)2)COST OF DEBT (Kd)3)COST OF PREFRENCE SHARES(Kp)4)COST OF RETAINED EARNINGS
Cost of Equity The annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of equity. It is denoted by Ke. Formula- Ke = D X 100 P
Cost of DebtCost of debt capital is associated with the amount of interest that is paid on currently outstanding debts. It is denoted by Kd.Formula-Cost of Debt = I (1 - TAX) I = Interest
Cost of Preference shares The preference share capital is different from equity share capital on account of two basic features : 1)the preference shares are entitled to receive dividends at a fixed rate in priority over equity shares. 2)in case of liquidation of the company ,the preference shareholders will get the capital repayment in priority over the distribution among the equity share holders.
Cost of Retained EarningsInaccounting, retainedearnings refers to theportion of net incomewhich is retained by thecorporation rather thandistributed to its ownersas dividends.
Weighted Average Cost of CapitalA calculation of a firms cost of capital in which each category of capital is proportionately weighted.Formula- WACC = TOTAL WEIGHTED COST X 100 TOTAL CAPITAL
Capital StructureCapital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firms capital structure is then the
Debt financing Debtfinancing is basically money that you borrow to run your business.Types- Long term debt financing . Short term debt financing.
Capital Budgeting Capitalbudgeting is the planning process used to determine whether a firms long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are
Pay back period Thelength of time required to recover the cost of an investment. Formula-
Return On New Invested CapitalA calculationused, either by a firmor investors, todetermine the amount ofreturn that a firmcould earn on additional
RiskThe chance that aninvestments actualreturn willbe different thanexpected. This includesthe possibility of losing
Weighted Average Cost of Equity• A wayto calculate thecost of a companysequity that givesdifferent weight todifferent aspects ofthe equities.