Concepts of Cost of capital, how to calculate costs of different sources of capital

1. Cost of Capital
CA Shilpi Taparia

2. Meaning
 It is the return expected by the providers
of capital (shareholders, lenders & debt-
holders) on their contribution to the
business.
 When a company borrows money from
such providers, it has to pay an additional
amount over principal, such amount is
cost of capital

3. Importance
 To evaluate different investment options,
company must consider cost of funds to
be borrowed for such investment
 To make a Finance Decision, manager can
simply compare cost of different sources
of capital

4. Cost of Long Term Debt
 Long term Debt includes long term loan
from Financial institutions, capital from
issuing debentures or bonds, etc.
Cost of
Long term
Debt
Cost of
Irredeemable
Debt
Cost of
Redeemable
Debt

5. Cost of Irredeemable Debentures
Kd = Interest (1-tax rate)
Net proceeds
Net Proceeds is Issue Price minus Issue
expenses
OR
Current Market Price

6. Cost of Redeemable Debentures
Kd= I(1-t) + (RV-NP)/n
(RV+NP)/2
I= Interest
t= Tax Rate
RV= Redemption Value
NP= Net Proceeds/ Current Market Price
n= Remaining life of Debentures

7. Cost of Preference Share Capital
 A specified rate of dividend is paid on
preference share capital on its face value.
However, such amount is not tax-
deductible
Cost of
Preference
capital
Cost of
Irredeemable
Preference
Capital
Cost of
Redeemable
Preference
Capital

8. Cost of Irredeemable Preference
Capital
Kp = Preference Dividend
Net proceeds
Net Proceeds is Issue Price minus Issue
expenses
OR
Current Market Price

9. Cost of Redeemable Preference
Capital
Kd= PD + (RV-NP)/n
(RV+NP)/2
PD= Preference Dividend
RV= Redemption Value
NP= Net Proceeds/ Current Market Price
n= Remaining life of Preference shares

10. Cost of Equity Share Capital

11. Dividend Price Approach
Ke= Expected Dividend
Market Price
It is assumed that dividend per share is expected
to remain constant every year. This approach is
also known as Dividend Valuation Model

12. Earning- Price Approach
Ke= Current EPS
Market Price
It is assumed that Cost of Equity is based on
expected earnings of the company

13. Growth Approach/ Gordon’s Model
Ke= Next expected Dividend+ Growth rate
Current Market Price
It is assumed that dividend per share is expected
to grow at a constant rate every year.
Growth rate can also be expressed as
multiplication of retention ratio & rate of return
on invested funds. g= b*r

14. Realised Yield Approach
It computes cost of equity based on past
records of dividends actually realised by
shareholders.
However, this method is not practical if earnings
do not remain stable.

15. Capital Asset Pricing Approach
(CAPM)
This approach takes into account risk-
return trade offs to calculate cost on
equity.
Ke = Rf + B(Rm- Rf)
Ke= Cost of Capital
Rm= Market rate of Return
Rf= Risk free rate of return
B= Beta
Rm- Rf= Market risk premium

16. Contd…

17. Cost of Retained Earnings

18. Contd…

19. Weighted Average Cost of Capital

20. Contd…

21. Contd…