3. DEFINATION
• According to I.M. Pandey “It is simply the rate
of return the funds should produce to justify
their use within the firm in light of the wealth
maximization objective”.
• According to Solomon & Pringle “It is the
rate of return required by those who
supply the capital”.
4. COMPUTATION OF COST OF CAPITAL
• Cost of capital is the combined cost of
equity, preference, debt and retained
earnings.
• To calculate cost of capital we need to
calculate cost of different sources of finance.
5. COST OF DEBT
• A company’s debt capital may be of short term
or long term nature.
• For the calculation of cost of debt, the interest
on the debt can be considered, but in reality it
is not the real cost of debt.
• cost of debt is much lower than the rate of
interest the company has to pay.
• while computing the cost of debts adjustments
are to be made for considering tax.
6. TYPES OF COST OF DEBT
• Debt issued at par which are Irredeemable
• Debt issued at premium or discount when the
debt is perpetual or irredeemable.
• Cost of redeemable debt.
7. 1. Debt issued at par which are
Irredeemable
Kd = I (1 –T) X100
•Where, Kd = Cost of capital
•T = Tax rate
•I = Interest Rate
8. 2. Debt issued at premium or discount
when the debt is perpetual or
irredeemable
Kd = (I/ S.V.) X (1 –T) X100
Where :
I = Annual Interest payment
S.V.= Sales Value
T = tax rate
9. 3. Cost of redeemable debt
• Kd = I + [(RV-SV)/n] x (1-t) x 100
(RV+SV)/2
- where,
I = Annual Interest
RV = Redemption Value
SV = Selling Value
n = Number of Years to Maturity
t = Tax Rate
10. Floating Cost
• All the expenditures that company needs to
make for issuing its shares or debentures.
• Examples are underwriter's fee, promotion
cost, advertisement cost etc.
• Flotation cost is always deducted form sale
value.
11. Cost of Term Loan
It is given by the formula :
Kt = I (1-t)
• Where, I = Interest rate on term loans
• t = tax rate
12. Cost of preference shares :
redeemable
• The cost of preference
shares is calculated by
considering the
proceeds received from
the preference shares and
dividend paid.
• Since the amount of
divided payable on
preference shares is not
tax deductable
expenditure, no need to
adjust for tax benefits.
• Kp = D + [(Rv – Sv)/n]
(Rv + Sv)/2
• Where, Kp= cost of
preference shares
• D = Annual Preference
dividend
• Rv= Redemption Price
• Sv = Face valve
• n = Maturity Period.
13. Cost of Irredeemable preference
share Capital
• Kp = (D /P) x 100
• Where, Kp = Cost of
preference capital
• D = Dividend
• P = Price per share.
14. COST OF EQUITY
• The cost of equity capital depends upon the market
value of shares, which in turn depends upon the
dividends paid and the rate of dividend depends on
the degree of financial and business risks.
• The various approaches to the computation of cost of
equity are as follows:
1. Dividend price approach
2. Dividend Plus Growth Approach
3. Earning Price Ratio or Earning Yield Approach
4. Capital Asset Pricing Model
15. 1. Dividend Price Approach
• Cost of Equity is given as
Ke = (D/P) x 100
• Where,
• D= dividend/share
• P = market price /share
16. 2. Dividend + growth approach
• Cost of Equity is given as
Ke = (D/P) + G
Where,
D = expected Dividend
P = market price/share
G= growth in dividend
17. 3. Earning Price ratio/ Earning yield
Approach
• Cost of Equity is given as,
Ke = (E/P) x 100
• Where,
• E = earning/ share
• P = market price / share
18. 4. Capital Asset Pricing Model
• Cost of Equity = Yield on long term bond + risk
premium
= Rf + B (Rm – Rf)
Where,
Rf = Risk free rate
B = Beta(Risk)
Rm = market return
20. Weighted Average Cost of Capital
(WACC)
WACC is the overall cost of capital
WACC is calculated by giving Weightage to
cost of each source of fund by assigning
portion of each source of fund to the total
fund.
21. Limitations of WACC
• Some Limitations of WACC are as follows:
1. Difficulty in the Determination of Weights
2. Problem with Choosing Capital Structure
3. Other Limitations
