2. Cost of capital
• Cost of capital represents the return
a company needs in order to take
on a capital project
• Cost of capital encompasses the
cost of both equity and debt
• Sources of Cost of capital
1.Equity share capital
2.Preference share capital
3.Debts
4.Reserves
4. Weighted average
cost of capital
• Calculation of a firm's cost
of capital in which each
category of capital is
proportionately weighted.
• Incorporates all sources of a
company’s capital—
including common stock,
preferred stock
5. Computation cost of capital of equity
• Market price-50
• Dividend price-20
Cost of capital Ke =
20
50
×100 =40%
6. Computation of WACC
Capital structure Cost Cost of capital
Equity capital 10,00,000 18%
Debentures 6,00,000 8%
Preference shares 4,00,000 7%
Term loans 2,00,000 12%
Total 22,00,000
*Tax=30%
7. Capital
structure
Cost Cost of
capital
Weights WACC
Equity capital 10,00,000 18% 0.46 8.28
Debentures 6,00,000 5.6% 0.27 1.51
Preference
shares
4,00,000 7% 0.18 1.26
Term loans 2,00,000 8.4% 0.09 0.756
Total 22,00,000 1 11.806
Weighted Average cost of capital Kw=11.806
8. Conclusion
• Determine if a project is
sufficiently profitable to the cost
(risk) of financing.
• Take better decisions
• Returns company make for each
Rupee
A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the capital used to finance the project; otherwise, the project will not generate a return for investors.
If equity share expected return is 10% then the cost of capital is 10%
If interest on loan is 5% then cost of capital is 5%
1. Importance to Capital Budgeting Decision: Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
2. Importance to Structure Decision: Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.
3. Importance to Evolution of Financial Performance: Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
4. Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.
If equity share expected return is 10% then the cost of capital is 10%
If interest on loan is 5% then cost of capital is 5%
If equity share expected return is 10% and interest on loan is 5% then cost of capital is between 5-10% so we use WACC to weight the investments and get cost of capital %
Applying the WACC to the estimated rate of return for new projects and ventures is a simple way to determine if a project is sufficiently profitable to offset the cost (risk) of financing.
Risks change of laws, market value drop
Suppose that a company yields returns of 20% and has a WACC of 11%. This means the company is yielding 9% returns on every dollar the company invests. In other words, for each dollar spent, the company is creating nine cents of value.
Discount Rate in Net Present Value Calculations
Net present value (NPV) is the widely used method of evaluating projects to determine the profitability of the investment. WACC is used as discount rate or the hurdle rate for NPV calculations. All the free cash flows and terminal values are discounted using the WACC.
