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  2. 2. Definition:- Meaning:- The Cost of Capital is the minimum rate of return a firm requires as a condition for undertaking an investment. Milton H.Spencer  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 company  Thus, the cost of capital is a benchmark that a new project has to meet
  3. 3. Characteristics of Cost of Capital 1) Return at minimum risk 2) Cost of Capital includes premium for Business Risk 3) The suppliers of funds for invested projects will expect a premium for increased Business Risk 4) Cost of Capital includes premium for Financial Risk 5) Financial Risk arises because of higher debt content in its capital structure
  4. 4. Investm ent decision Dividend policy Efficiency Wealth Maxim ization Performance Capital Structure
  5. 5. Cost Of Capital for various sources of finance:- COST OF DEBT CAPITAL • The effective rate that an organization pays on its current debt. •This can be measured in either before- or after-tax returns • The after-tax cost is seen most often, because Interest expense is deductible Short- Term Debt Long- Term Debt Redeemable Irredeemable
  6. 6. Long-Term Debt:- I Kd = ----- X100 NP Where, I= Interest NP= Net Proceeds There are two types of Long-Term Debt:- Redeemable Debt Irredeemable Debt Short- Term Debt:-
  7. 7. 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: I+(RV-NP)/n Kd= ------------------ x100 (RV+NP)/2 Note: The formula for Irredeemable Debt is same as Short-Term Debt Capital Kd(After Tax)= Kd(Before Tax) x (1-T)
  8. 8. 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 source. There will no adjustment of tax rates because, dividend on pref. share capital is payable on net profit after tax adjustment. Formula: Kp(AfterTax)= DPS -------- x 100 NP Kp(BeforeTax)=Kp(AfterTax)/1- TaxRate where, Kp = Costof preferencesharecapital DPS=Dividendpershare
  9. 9. • It is that part of cost of capital which is payable to equity shareholders. • Every shareholder gets shares for getting return on it. • An organization must earn more than cost of equity capital in order to leave unaffected the market value
  10. 10. Methods of Cost of Equity share capital
  11. 11. • 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. Formula:- Ke = DPS/MP Where, Ke=Costof EquityShareCapital DPS=Dividendpershare MP=MarketPrice Dividend yield method:- Dividend yield Growth Method:- Formula:- Ke= DPS/MP+G% Where, DPS=Dividendper share MP= MarketPrice G= Growth Rate
  12. 12. • According to this method, cost of equity capital is minimum rate which we have to earn on market price of a share. Formula:- Ke=EPS/MP Where, EPS=Earning per share MP=Market Price Earning yield method:-
  13. 13. 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 shareholders on re-investment and personal tax rate of shareholders exists. Formula:- D(1-Ti) (1-B) Kr= -------------------- X100 MP(1-Tc) Where, Kr= Cost of Retained Earnings D=Dividend Ti=Income Tax Rate B= Brokerage Tc = Capital Gain Tax Rate MP=Market Price
  14. 14. 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 of securities. 3) They obtain capital from various sources after taking into consideration a number of factors such as- i. Ownership
  15. 15. Illustration:- 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.
  16. 16. SOURCES AMOUNT (`) WEIGHT AFTER TAX COST WEIGHTED COST 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 10.773% Solution:
  17. 17. CONCLUSION  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 Earnings.  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.
  18. 18. Prepared by: Anjali Nebhwani Nimita Vyas Radhika Khatri