Introduction Importance Element of cost of capital

2.  Definition
 The cost of capital is the rate of return the company has
to pay to various suppliers of funds in the company.
 There is a variation in the costs of capital due to the fact
that different kinds of investment carry different levels of
risk which is compensated for by different levels of
return on the investment.
 In operational terms, cost of capital refers to the discount
rate that would be used in determining the present value
of the estimated future cash proceeds and eventually
deciding whether the project is worth undertaking or not.
 The cost of capital is visualized as being composed of
several elements.
 Elements are the cost of each component of capital.
 The term “component” means the different sources from
which funds are raised by a firm.
 The cost of each source or component is called as
specific cost of capital.

3.  Importance
1. The cost of capital can be used as a tool to evaluate the
financial performance of top management.
2. The actual profitability of the project is compared to the
actual cost of capital funds raised to finance the project.
3. If the actual profitability of the project is on the higher side
when compared to the actual cost of capital raised, the
performance can be evaluated as satisfactory.
4. It is an important element, as basic input information in
capital investment decisions, in the present value method
of discount cash flow techniques;
5. the cost of capital is used as the discount rate to calculate
the NPV.
6. The cost of Capital acts as a determinant of capital mix in
the designing of balanced and appropriate capital structure.
7. The cost of capital can be used in making financial decision
such as dividend Policy, capitalization of profit, rights issue
and working capital, bonus issue and capital structure.

4.  The cost of Capital differs according to the
situation.
 The different situations are as follows:-
1. Cost of existing debentures which are not
redeemable but can be traded in market.
2. Cost of new debentures where there is a mention
of flotation costs issue expenses.
3. Cost of Redeemable debentures.
4. Cost of new EIS where there is Floatation cost.
5. Cost of new EIS using capital asset Pricing Model
(CAPM)
6. Cost of new EIS on the basis of realized Yield.
7. Weighted Average cost of capital (WACC) using
book values as weights. WACC using market
values as weights

5.  Cost of Equity (KE)
 Cost of Retained Earnings (Ke)
 Cost of Preferred Capital (Kp)
 Cost of Debt (Kd)

6.  The funds required for the project are raised from the equity shareholders
which are of permanent nature.
 These funds need not be repayable during the lifetime of the organization.
 Hence it is a permanent source of funds.
 The equity shareholders are the owners of the company.
 The main objective of the firm is to maximize the wealth of equity
shareholders.
 Equity share capital is the risk capital of the company. If the company's
business is doing well the ultimate and worst sufferers are the equity
shareholders who will get the return in the form of ends from the company
and the capital appreciation from their investment.
 If the company comes for liquidation due to losses, the ultimate and worst
sufferers are the equity shareholders.
 Sometime they may not get their investment back during the liquidation
process.
 Profits after tax less dividends paid out to the shareholders, are funds, that
belong to the equity shareholders which have been reinvested in the
company and therefore, those retained funds should be included in the
category of equity, or equity may be defined as the minimum rate of return
that a company on the equity financed portion of an investment project so
that market of the shares remain unchanged.

7. 1) Dividend Method or Dividend Price Ratio Method
 As per this method the cost of capital is defined as
the discount rate that gets the present value of all
expected future dividends per share with the net
proceeds of the sale (or the current market price) of a
share.
 This method is based on the assumption that the
future dividends per share is expected to be constant
and the company is expected to earn at least this
yield to keep the shareholders content.
KE=D1/PE
 Where,
 KE = Cost of Equity
 D1 = Annual Dividend per year
 PE = Ex-dividend market price per share