cost of capital ppt

1. COST OF CAPITAL

2. • The primary function of every financial manager is to arrange
adequate capital for the firm.
• There are various sources of the capital where finance can be
arranged:

3. • It is necessary for the firm to pay a minimum return to each source of
capital.
• Therefore, each project must earn so much of the income that a
Minimum Return can be paid to these sources of capital.
Minimum
Return

4. The concept used to determine this minimum return is called ‘Cost of
Capital’.
Cost of Capital for Equity & Preference Shares
Cost of Capital for Bonds & Debenture

5. The concept used to determine this minimum return is called ‘Cost of
Capital’.
Cost of Capital for Equity & Preference Shares
Cost of Capital for Bonds & Debenture

6. Cost of capital is the measurement of
the sacrifice made by him in order to
invest with a view to getting a fair
return in the future on his
investments as a reward for the
postponement of his present needs
cost of capital is the price paid to
the investor for the use of capital
provided by him.
Thus the cost of capital is the reward for the use of capital

7. Cost of
Capital
Hurdle Rate
Minimum
Return
Reward for
Risk
Features of Cost of Capital

8. Historical cost and future cost
Specific cost and composite cost
Average cost and marginal cost
Explicit cost and implicit cost

9. Historical cost and future cost
• Historical costs are those costs which have already been incurred in order to
finance a particular project. They are useful while projecting future costs. In short,
historical costs are very important by the amount they keep in predicting the future
costs. Because, they supply an evaluation of performance in comparison with
standard and/or predetermined costs.
• Future Costs refer to the expected cost of funds to be raised for financing a project.

10. Specific cost and composite cost
• Specific cost refers to the cost of a specific source of capital such an equity shares,
preference shares, debentures, etc.
• This is particularly useful where the profitability of the project is evaluated on the
basis of the specific source of funds taken for financing the said project. For instance,
if the estimated cost of equity capital of a firm becomes 12%, that project which are
financed by the equity shareholders’ fund, will be accepted provided the same will
yield at least a return of 12%.
• Composite cost refers to the combined cost of various sources of finance.

11. Average cost and marginal cost
• Average cost can be defined as the production cost per unit. It is the total cost that is
incurred on producing one unit of output. It takes into consideration both, fixed costs,
as well as variable costs. The formula for calculating average cost is given below:
Average Cost = Total cost / Total output.
• Alternatively, the average cost can be calculated by adding fixed cost per unit,
and variable cost per unit. The formula for calculating Fixed Cost per Unit, and
Variable Cost per Unit, respectively are as follows:
Fixed cost per unit = Total fixed cost / Total output
Variable cost per unit = Total variable cost / Total output

12. • Marginal cost of capital is the cost of obtaining another rupee of new capital. When a
firm raises additional capital from only one source then marginal cost is specific cost.
Marginal cost tends to increase proportionately as the amount of debt increase.
Marginal Cost = Change in Total Cost / Change in Quantity

13. EXPLICT AND IMPLICIT COST
• An explicit cost is the clearly stated costs that a business incurs. For example,
employee wages, inputs, utility bills, and rent, among others. These are the costs
which are stated on the businesses balance sheet.
• By contrast, implicit costs are those which occur, but are not seen. In other words,
these are the costs that are not directly linked to an expenditure. For example, a
factory may close down for the day in order for its machines to be serviced. The
explicit cost to repair the machines is Rs.10,000. However, the factory has lost a
whole days output which has cost it Rs. 50,000 in lost production. This indirect cost is
known as the implicit cost.
• Explicit costs are those which are clearly stated on the firm’s balance sheet, while
implicit costs are not. Instead, it is the indirect cost of choosing a specific course.
When combined together, explicit and implicit costs make up what is known to be the
total economic cost. This is because the cost of choosing option A has an explicit cost
as well as an implicit cost of what could have been achieved otherwise.

14. EXAMPLES: EXPLICIT COST
• An explicit cost is one that is a clear and obvious monetary amount made by the firm.
It has a clear monetary amount which can be seen in the firm’s financial balance
sheet. Such examples include:
• Advertising and marketing costs.
• Employee wages, bonuses, commissions, and any other compensation to
employees.
• Employee benefits that are not paid directly to the employee, I.e. healthcare, staff
restaurant, or staff gym.

15. EXAMPLES: IMPLICIT COST
While explicit costs have a specific value, implicit costs are not always so clear cut. For
example, spending 5 hours playing video games means those 5 hours cannot be used
for studying. The implicit cost is the hours that could have been used for studying
instead. The value by which is not necessarily monetarily quantifiable, but is still
considered as a cost.
• Training a new employee presents an implicit cost in the fact that those seven hours
could have been used doing other work.
• Maintenance means the firm has to stop production for a time which can lead to a
lower level of output or dissatisfied customers.
•

17. • Another example of an implicit cost is that of going to college. The explicit cost may
be Rs. 30,000 per year. However, there is also an implicit cost.
• A student going to college could be working instead. Even in a minimum wage job,
that would be approximately Rs.1,20,000 per year – which is the implicit cost. They
could be earning Rs.12,0,000 a year if they didn’t go to college. So the total economic
cost is the explicit cost of tuition at Rs. 30,000 and the implicit cost of not working
which is over Rs. 1,20,000.

18. COMPUTATION OF SPECIFIC COSTS

19. • A firm can raise funds from different sources such as loan, equity shares,
preference shares, retained earnings etc. all these sources are called
components of capital.
• The cost of capital of these different sources is called overall cost of capital.
• The procedure of calculating specific costs are as follows:

20. 1. COST OF SHORT TERM DEBT
• Every business firm obtains short term loan either form banks or on bills payables that too
has a cost. Generally the interest charged by bank is the cost of loan, but in real cost to the
firm can be computed after establishing relationship of the amount of interest with the net
amount of loan received by the firm because some expenses have to be incurred while taking
loan from the bank or sometimes banks pays loan after deducting interest in advance. In such
case, the net amount received is always less than the loan sanctioned.
• For example: if a company takes a loan of 50,000 @ 8% interest from the bank for one year
on which the company has to occur 250 as expense. In such a case, the company has to pay
interest of 4,000 not on 50,000 but on 49,750, hence the real cost of loan will be:
• Cost of loan= Interest/ Net proceeds* 100
• Cost of loan= 4,000/ 49,750*100= 8.04% (before tax)

21. If tax rate is assumed 50% than the real cost of loan will be 4.02%
After tax coast of loan= before tax cost (1-t)
= 8.04 (1-0.50)= 4.02%

22. 2. COST OF LONG TERM DEBT
• Generally long term debt may be in the form of debenture, bonds, long term loans from
financial institutions and banks etc. this debt carried fixed rate of interest payable to them
irrespective of the profitability of the company.
• The cost of debt defined, in terms of the required rate of return that the debt financed
investment must yield to prevent damage to the shareholders position. i.e., keep the
unchanged the earnings available to equity shareholders.

32. 3. COST OF PREFERENCE SHARE CAPITAL

35. BASIS FOR COMPARISON EQUITY SHARES PREFERENCE SHARES
Meaning Equity shares are the ordinary shares
of the company representing the part
ownership of the shareholder in the
company.
Preference shares are the shares that
carry preferential rights on the
matters of payment of dividend and
repayment of capital.
Payment of dividend The dividend is paid after the
payment of all liabilities.
Priority in payment of dividend over
equity shareholders.
Repayment of capital In the event of winding up of the
company, equity shares are repaid at
the end.
In the event of winding up of the
company, preference shares are
repaid before equity shares.
Rate of dividend Fluctuating Fixed
Redemption No Yes
Voting rights Equity shares carry voting rights. Normally, preference shares do not
carry voting rights. However, in
special circumstances, they get
voting rights.
Arrears of Dividend Equity shareholders have no rights to
get arrears of the dividend for the
previous years.
Preference shareholders generally
get the arrears of dividend along with
the present year's dividend, if not
paid in the last previous year,

36. 4. COST OF EQUIYT SHARES
• Some financial experts hold the opinion that the equity share capital does not carry any cost
because rate of dividend is not pre determined neither payment of dividend is legally
binding. But that is not true.
• When additional equity shares are issued, the new equity shareholders get proportionate
share in the future dividends and undistributed profit of the company.
• It reduces the EPS of the existing shareholders resulting in a fall in the market price of shares.
• So at the time if issue of new equity share, it is the duty of the management to see that the
company must earn at least so much income that the market price of its existing share
remain unchanged.
• This accepted minimum rate of return is the cost of equity share capital.
• The cost of equity can be calculated by following methods:

37. a. DIVIDEND YIELD METHOD
• Also known as dividend/ price ratio. It is based on the assumption that each shareholder,
while investing his savings in the company, expects to receive dividend at the current rate of
return and the future dividend per equity share is expected to remain constant.
• As per this method the cost of capital is defined, the discount rate that equates the present
value of all expected future dividends per share with the net proceeds by the sale or the
current market price of a share.

41. c. COST OF NEWLY ISSUED EQUITY SHARES

42. d. Capital asset pricing model (CAPM)
• This model recognizes that an investor required rate of return is the compensation for
time value of money and risk. It assumes that the investor holds a diversified portfolio
i.e. a mix of securities and investments.
• The return on theses investment are not uniform.
• Therefore the only risk left to be compensated is the risk of the entire market price
fluctuations as a whole i.e. market risk. As investors are generally risk averse they
require a premium for taking risk.
• Hence:
Cost of equity share= Compensation for the time value of money + compensation for
market risk

43. Here,
• Compensation for the time value of money can be represented by: risk free rate of
interest Kf (risk free rate of interest is the rate that is earned by an asset with no risk.
Generally in India on government securities.)
• The market risk premium is the difference between the expected return on the market
(Km) and the expected risk free rates (Kf) i.e. (Km-Kf)
• If the share has a risk different from the market risk, we need to adjust its premium to
reflect this difference. The adjustment factor is represented by Beta.
• Compensation of market risk= ndf ( (Km-Kf)
• Now, the cost of equity share= Ke= Kf + kjjjj ( (Km+Kf)

44. • Ke=cost of equity capital
• Kf= cost of risk free assets
• Km= cost of market portfolio
• Km Kf = risk premium for bearing the risk of market portfolio
• Beta Measure of the sensitivity of the return of a particular
security or a group of securities to changes in the retunes of the
market risk

45. • An equity share with a greater than 1.0 has more risk than the
average security in the market.
• A share with a rgr less than 1.0 has less risk than the average security.
• The CAPM is based on two sensible ideas:
1. Investors are risk averse
2. They hold diversified portfolios

47. 7. WEIGHTED AVERGAE COST OF CAPITAL

55. It Helps in Capital Budgeting
• Cost of capital helps the organization for different alternatives in respect of the
purchase of major fixed assets, i.e., investment decisions. The organization will
choose the project which gives a satisfactory return on investment, while preparing
capital budgeting the various alternatives are available, out of them cost of capital is
the key factor in deciding the project out of various proposals pending before
management.
• The cost of capital has an important bearing on decisions to be taken with respect to
the rejection or acceptance of a particular capital expenditure budget.
• According to the Net Present Value method (NPV) of capital budgeting, if the present
value of expected returns from investment is greater than or equal to the cost of
investment, such project may be accepted.
• If the expected returns from investment is less than investment in such a case project
may be rejected.
• The Net present value of expected return is calculated by discounting the expected
cash inflows at cut-off rate. Therefore cost of capital is useful in capital budgeting
decisions.

56. It Helps in Designing the Capital Structure Decisions
• The cost of capital is an important factor in designing the firm’s capital structure. The
cost of capital is influenced by the changes in the capital structure.
• While designing the capital structure, the main objective is to maximize the value of
the firm.

57. It Helps in Selecting the Sources of Finance (i.e.,
Method of Financing):
Financial executive must have the knowledge of fluctuations in the capital market.
So a financial executive analyses the rate of interest of loans and normal dividend
rates in the market from time to time, whenever a company requires additional
finance he may have a better choice of the sources of finance which bears the
minimum cost of capital.

58. It Helps to Evaluate the Financial Performance of the Top
Management:
Evaluation of the financial performance will involve a comparison of actual
profitabilities of the project undertaken with the projected overall cost of capital.
Similarly the actual cost of raising the funds can be analyzed with the estimated
figures and an appraisal of the actual costs incurred in raising the required funds.

59. ASSUMPTIONS OF COST OF CAPITAL
While computing cost of capital following assumptions are there:
1. The cost can either be explicit or implicit.
2. The financial and business risks are not affected by investing in new investment proposals.
3. The firm’s capital structure remains unchanged.
4. Cost of each source of capital is determined on an after tax basis.
5. Costs of previously obtained capital are not relevant for computing the cost of capital to be
raised from a specific source