The Cost of Capital is the minimum rate of return a firm requires as a
condition for undertaking an investment.
Cost of Capital is the rate of return that could be earned on an
investment with similar risk
It is used to evaluate new projects of an organization, as it is the
minimum return that investors expect for providing capital to the
Thus, the cost of capital is a benchmark that a new project has to
Characteristics of Cost of Capital
1) Return at minimum risk
2) Cost of Capital includes premium for Business
3) The suppliers of funds for invested projects will
expect a premium for increased Business Risk
4) Cost of Capital includes premium for Financial
5) Financial Risk arises because of higher debt
content in its capital structure
Cost Of Capital for various sources of finance:-
COST OF DEBT CAPITAL
• The effective rate that an organization pays on its
•This can be measured in either before- or after-tax returns
• The after-tax cost is seen most often, because Interest
expense is deductible
Kd = ----- X100
NP= Net Proceeds
There are two types of
Short- Term Debt:-
Redeemable debt is debt that is paid after the completion
of pre-decided period.
Irredeemable debt is debt that has no specific redemption
date or maturity period.
Cost of Redeemable Debt:
Kd= ------------------ x100
Note: The formula for Irredeemable Debt is same as Short-Term
Kd(After Tax)= Kd(Before Tax) x (1-T)
Cost of Preference Share Capital
It is the amount which is payable to preference
shareholders in the form of dividend with fixed rate.
If we don’t pay the dividend to pref. shareholders, it
will affect on capability to receive funds from this
There will no adjustment of tax rates because,
dividend on pref. share capital is payable on net profit
after tax adjustment.
-------- x 100
Kp = Costof preferencesharecapital
• It is that part of cost of
capital which is payable to
• Every shareholder gets
shares for getting return on
• An organization must earn
more than cost of equity
capital in order to leave
unaffected the market value
• Cost of equity capital is minimum rate which will be equal to the
present value of future dividend per share with current price of a share.
Ke = DPS/MP
Dividend yield method:-
Dividend yield Growth Method:-
G= Growth Rate
• According to this method, cost of equity capital is minimum
rate which we have to earn on market price of a share.
EPS=Earning per share
Earning yield method:-
Cost of retained earnings:-
• In the absence of any
information relating to
addition of cost of re-
investment and extra
burden of personal tax, the
cost of retained earning is
considered to be equal to
the cost of equity.
• However, the cost of
retained earnings differs
from the cost of equity
when there is flotation cost
to be paid by the
re-investment and personal
tax rate of shareholders
Kr= -------------------- X100
Kr= Cost of Retained Earnings
Ti=Income Tax Rate
Tc = Capital Gain Tax Rate
1) Weighted Average Cost of Capital can be
defined as the average of the costs of each
source of finance employed by the
organization properly weighted by the
proportion they held in the Capital Structure
of the Company.
2) The Capital Structure of business enterprise
is made of an appropriate mixture of number
3) They obtain capital from various sources
after taking into consideration a number of
factors such as-
The Capital Structure and After Tax Cost of Capital of the specific sources
of AB Ltd. Is as follows:
SOURCES AMOUNT(`) COST OF CAPITAL
Debt 3,00,000 4.77%
Preference Capital 2,00,000 10.53%
Equity Capital 4,00,000 14.59%
Retained Earnings 1,00,000 14.00%
Calculate the Weighted Average Cost of Capital.
WEIGHT AFTER TAX
Debt 3,00,000 .3 .0477 .01431
Preference Capital 2,00,000 .2 .1053 .02106
Equity Capital 4,00,000 .4 .1459 .05836
Retained Earning 1,00,000 .1 .1400 .01400
WACC .10773 OR
One of the main objectives of any business organization is to reduce or
minimize the cost of capital.
For calculating cost of capital, we have two sources of funds : Owned funds
and Borrowed funds
Owned funds include Equity Shares, Preference Shares, and Retained
Borrowed funds include Debentures.
Certain measures or formulas are used to calculate these Cost of Capital.
When these are calculated, After and Before Tax effect must be considered.
Thus, in Financial management, Cost of Capital plays a vital role in taking
all the financial decision.