This document discusses the cost of capital, which refers to the minimum rate of return that a company must earn on its investments to ensure value creation for shareholders. It defines cost of capital and outlines its importance and components, including the costs of different sources of financing like debt, preference shares, retained earnings, and equity. The document also examines various methods for calculating the costs of these components and weighted average cost of capital (WACC), which represents the average rate of return a company should earn on its portfolio of existing investments to satisfy its shareholders and lenders.

1. COST OF CAPITAL
Dr.S.VADIVEL RAJA, Assistant professor,
PG and RESEARCH Department of Commerce,
Dr.S.VADIVEL RAJA,
Assistant professor,
PG and RESEARCH Department of Commerce,
Vivekananda College
Thiruvedakam west - 625234

2. FIANCIAL MANAGEMENT
 FINANCE
It means provision of money at the time when it is required. (Money used to
purchase things the business needs or want)
 MANAGEMENT
It is the process of planning, organizing,
leading and controlling the efforts of
organizational members and of using
all other organizational resources to
achieve the stated organisational goals.
 FINANCIAL MANAGEMENT
It refers to the management of flow of funds ins

3.  SCOPE OF FINANCIAL MANAGEMENT
Traditional Approach
Mordern Approach
 MAIN OBJECTIVES
Profit Maximization
Wealth Maximization
 FUNCTIONS
Forecasting Financial Requirements
Financial Decision
Investment Decision
Dividend Decision
 SIGNIFICANCE
Effective utilization of resources
Ascertaining firm perform in future
Co-ordination between various functional areas
Scientific analysis
Mobilizing saving

4. COST OF CAPITAL
 MEANING OF COST OF CAPITAL
It is also Known as cut-off rate, minimum required rate of
return,rate of interest, hurdle rate, target rate, etc,
Financing its operations, a firm can raise long term funds (debt, equity
& preference shares ) The firm has to service these funds by paying
interest, dividend respectively.
 DEFINITION
The cost of capital is the minimum rate of return or cut-off rate for capital
expenditures.
-Solomon Ezra
cost of capital is the minimum rate of return the firm requires from investment
in order to increase the value of the firm in the market rate
-Hamplon John.J

5.  COMPONENTS OF COST OF CAPITAL
Return at zero risk
premium for business risk
premium for financial risk
 IMPORTANCE OF COST OF CAPITAL
Capital budgeting decision
Designing the capital structure
Deciding about the method of financing
Performance of top management
Decision making

6.  FACTORS DETERMININGTHE COST OF CAPITAL
General economic conditions
Market conditions
Operating and financing decisions
Amount of financing
 TYPES OF COST OF CAPITAL
Historical cost and Future cost
Explicit cost and Implicit cost
Specific cost and Composite cost
Average cost and Marginal cost

7. COMPUTATION FOF
COST OF CAPITAL
Specific cost
- Cost of Debt
- Cost of preference
share
- Cost of Equity
- Cost Retained earnings
Composite cost
Weighted Average Cost
of Capital(WACC)

8. I.Cost of Debt
Cost of Irredeemable Debt
(Issue at Par, Premium,
Discount)
i)Cost of
debt before
tax (Kdb)
Kdb =
Interest/NP
ii)Cost of debt aftere tax
(Kda)
Kdb = Interest-(1-Tax
savings/NP
Cost of Redeemable Debt
( Issue and Redeem at Par,
Premium, Discount)
i)Cost of debt before
tax (Kdb)
Kdb = Annual cost of
before tax/ Average
value of debt
Annual cost = Interest
+ Exp – Income
Avg value of debt(AV)
= NP+ RV/2
ii)Cost of debt
after
tax(Kda)=
Annual cost-
Tax
savings/Avg
value of debt

9. II.Cost of Preference Share
Capital
Cost of
Irredeemable
Preference Share
i)Cost of
Preference
Share (Kp)KP
= Annual
Preference
Dividend/NP
Cost of
Redeemable
preference
Share
i)Cost of Redeemable preferenc
share(Kp)
Kp = Annual cost / Average value
of RPS
Annual cost = pre dividend interest
+ Exp – Income
Avg value of RPS (AV) = NP+ RV/2

10. III.Cost of Equity Capital
Dividend Yield
(or) Dividend
Price Method
Cost of
equity(ke) =
D1/ NP
Existing
(Ke)= D1/ MP
Dividend
price plus
growth
Method
Ke = D1/NP
+g
Earnings/
price(EP)
Method
Ke = EPS/NP
Realized
Yield Method
-Find the ROI
- Present value
of cash inflows
IIR=LR+
postive NPV/
Diff in
calculated PV*
Diff in rate
-
Capital Assets
Pricing Model
(CAPM)
Ke = Rf +
β(Rm –Rf)

11. IV.Cost of Retained
Earnings
Cost of retained earnings (Kr) = Ke (1-t) (1-b)
Where, ke = cost of equity capital
t = tax rate
b = brokerage

12. V. WEIGHTED AVERAGE COST OF CAPITAL (WACC)
 The following steps are to be taken to calculate WACC
 Calculate the cost of specific sources of funds(ex,
Ke,Kd,Kp).
 Multiply the cost of each source by its proportion in capital
structure.
 Add the weighted component costs to get the firm’s WACC
Sources of funds Amt Proportion to
total
After tax cost Weighted cost
Debt
Pref share capital
Retained earnings
Equity share
capital
Xx
Xx
Xx
Xx
W1
W2
W3
W4
Kda
Kp
Kr
Ke
Kda* W1
Kp* W2
Kr * W3
Ke * W4
Total XX WACC XXX