The document discusses the cost of capital and how it is calculated for different sources of financing. It defines cost of capital as the minimum rate of return a firm requires to undertake an investment. It then provides formulas to calculate the cost of various sources including debt, preferred shares, common equity, and retained earnings. It also discusses weighted average cost of capital (WACC), which is a weighted average of the costs of each source of financing used by a company. An example is provided to demonstrate how to calculate WACC.

1. COST
OF
CAPITAL

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. 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. Investm
ent
decision
Dividend
policy
Efficiency
Wealth
Maxim
ization
Performance
Capital
Structure

6. 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

7. 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:-

8. 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)

9. 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

10. • 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

11. Methods of Cost of
Equity share
capital

12. • 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

13. • 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:-

14. 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

16. 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

17. 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.

18. 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:

19. 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.

20. Prepared by:
Anjali Nebhwani
Nimita Vyas
Radhika Khatri