Cost of capital
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  • 1. Cost of Capital
  • 2. “ The cost of raising funds that are needed to operate the firm is the cost of capital.”
  • 3. Sources of Capital
    • Equity
    • Preference Shares
    • Debentures
    • Retained Earnings
  • 4. Cost of Debt
  • 5. Cost of Debt “ The firm has to pay as the contractual amount to the debenture holders.”
  • 6. Formula C d = C d -> Cost of Debt i -> interest NP -> Net Proceed (Par Value) Perpetual / Redeemable Debt NP i x 100 C d = (1 – t) NP i x x 100 (After Tax)
  • 7. Redeemable Debt C d = MV-NP n MV+NP 2 i + { } C d -> Cost of Debt i -> interest NP -> Net Proceed (Par Value) MV-> Maturity Value (After Tax) C d = MV-NP n MV+NP 2 i + (1-t) x 100
  • 8. Cost of Preference Share
  • 9. “ It is payable to preference shareholders in the form of dividend with fixed rate.”
  • 10. Formula Irredeemable Preference Share C p = C p -> Cost of Preference Share PD -> Preference Share Per Share NP -> Net Proceed (Par Value) NP PD x 100 (After Tax) After Tax 1-Tax Rate C p = (Before Tax)
  • 11. Cost of Shares
  • 12. “ It is that part of cost of capital which is payable to equity shareholder.”
  • 13. Formula C e -> Cost of Equity Share CDPS -> Cash Dividend per Share MP -> Market Price EPS -> Earning per Share Dividend Yield method C e = CDPS MP x 100 (After Tax) Earning Yield method C e = EPS MP x 100 After Tax 1-Tax Rate (Before Tax) C e =
  • 14. Cost of Retained Earnings
  • 15. “ The residual of an firm's earnings over expenditures, including taxes and dividends, that are reinvested in its business. The cost of these funds is always lower than the cost of new equity capital, due to taxes and transactions costs.”
  • 16. C e = DPS ( 1 – Ti ) ( 1 – B ) MP ( 1 – Te ) x 100 Formula C r -> Cost of Retained Earnings DPS -> Dividend per Share Ti -> Marginal Tax Rate Applicable to Individual Shareholder B -> Brokerage Cost MP -> Present Market Price per Share Tc -> Capital Gain Tax
  • 17. Weighted Average Cost of Capital
  • 18. “ Weighted Average Cost of Capital is the composite or overall cost of capital from the different sources of financing.”
  • 19. Book Value Weighted Method Sources Amount Specific Cost Long Term Debt 1500000 4% Preference Share 1000000 12% Equity Share 2000000 15% Retained Earnings 500000 15% Total 5000000
  • 20. Book Value of Weights Weighted Cost Percentage Proportion (x) Specific Cost = Weighted cost 30% .3 1.2 20% .2 2.4 40% .4 6 10% .1 1.5 11.10%
  • 21. Market Value Weights Sources Amount Specific Cost Long Term Debt 1500000 4% Preference Share 1000000 12% Equity Share 2000000 15% Retained Earnings 500000 15% Total 5000000
  • 22. Sources Market Value Market Value Weights Specific Cost Weighted Cost Percentage Proportion Long Term Debt 1500000 21.45 .214 4% .856 Preference Share 1500000 21.4 .214 12% 2.568 Equity Share 3200000 45.7 .457 15% 6.855 Retained Earnings 800000 11.5 .115 15% 1.725 8000000 12.004% or 12%
  • 23. By: