Cost of capital


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Cost of capital

  1. 1. Meaning Of Cost of Capital Minimum required Rate Of Return Which A Project MUST earn. a) The Minimum Earning by a firm b) In order to satisfy c) The Expectations of Those Persons d) Who have invested their funds in the firm. DEFINITION
  2. 2. Cost Of Capital also known as: TARGET RATE HURDLE RATE CUT-OFF RATE
  3. 3. What If a firm fails to earn returns at expected rate….. M.V. of shares REDUCE Overall Wealth of Shareholders REDUCE Value of The Firm REDUCE No. of Prospective Investors REDUCE Moreover, Acceptance Or Rejection Of an Investment depends on The Cost Of Capital ADDITIONAL POINT :-
  4. 4. Importance of Cost Of Capital For Capital Budgeting Decisions For Capital Structure Decisions For Working Capital Policy Decisions For Comparative Analysis of various sources of Finance For Evaluation of Fin. Efficiency of TOP MGMT.
  5. 5. Equity share Holders Pref. share Holders Debenture Holders INVESTMENT in the Company EARNINGS If Fulfills the Expectations of The Investors If doesn’t Fulfills the Expectations of The Investors Value of Firm DecreaseValue of Firm Increase ADVERSE CONDITION FAVOURABLE CONDITION
  6. 6. Cost of RETAINED EARNINGS The earnings FORGONE by the ShareholdersThe earnings FORGONE by the Shareholders Part of Profits, Retained for Future Expansion of BusinessPart of Profits, Retained for Future Expansion of Business NOT FREE of COST i.e. Involve Cost As Part of the Shareholders’ Funds which is blocked as Reserves If it is Invested Anywhere else, It will produce some Extra Earnings Opportunity Cost FORMULA- KRE = D1 / MP + g Or D / MP Equity Share Holders Investment in The Company Blocked in Two Ways SHARE CAPITAL RETAINED EARNINGS
  7. 7. Weighted Avg. Cost of Capital Also Known As :- Combined Cost of Capital Composite Cost of Capital Overall Cost of Capital Combination of Component Costs i.e. Kd, Kp, Ke, Kre According to the Weights of each Component Capital Meaning:- Weights are Assigned As per The Proportion of each Component capital In the Capital Structure Any Fin. Decision Should be taken with reference to ‘WACC’ & Not with reference to Cost of Component Capital Main Objective :-
  8. 8. Formula of W.A.C.C. (D / T.F. * Kd) + (P / T.F. * Kp) + (E / T.F. * Ke) Kp Ke Composition according to the respective weights WACC Kd
  9. 9. Explicit Cost The Discount Rate which Equates The PV of Cash Inflows & The PV of Cash Outflows It Arises When The Funds Are Raised Implicit Cost The Rate of Return Which will be Forgone If the project presently Under consideration Is accepted It Arises When The Funds Are Used Also Known as Opportunity Cost
  10. 10. Assignment of Weights Book Value Weights Simple Computations Wrong Estimates No Fluctuations Operationally convenient Readily Available Market Value Weights Difficult To Compute Good Estimates Fluctuate Widely Theoretically consistent Difficult to calculate
  11. 11. Which Weights Should be used in the calculation of WACC ? Market Value weights Should ALWAYS Be given Preference As these provide A Good Estimate of Cost of Capital In Case, M.V. Weights Are not readily avlbl. Then, Book Value Weights Can be Used.
  12. 12. Economic Value Added (EVA) Profits Over And Above the Cost of Capital ROCE > Ko A Test of Profit Adequacy A Measure of Corporate Growth Formula Actual Earnings – Earnings at Ko
  13. 13. Marginal Cost of Capital Cost of Raising ADDITIONAL Funds Marginal Weights are used i.e. The Proportion of Funds, The firm intends to Employ The Problem of choosing b/w. B.V. and M.V. Doesn’t arise in The case of WMACC, Why ? Because WMACC uses Marginal Weights Which represents the Proportion of funds, The firm intends to employ.
  14. 14. Why should a firm periodically re-examine its Cost of Capital before determining Annual Capital Budget ? REASONS :- Firm’s Internal Structure Capital Market Conditions Supply and Demand for Funds Subtle change in Capital Structure