The document discusses the concept of cost of capital. It defines cost of capital as the minimum required rate of return on funds committed to a project or firm based on the riskiness of cash flows. It then covers the basic aspects of cost of capital including it representing a rate of return rather than an actual cost, and comprising a risk-free rate, business risk premium, and financial risk premium. The document also discusses approaches to calculating the cost of different sources of capital like equity, debt, and retained earnings, as well as weighted average cost of capital and marginal cost of capital.

1. Cost of Capital

2. Meaning
 The project’s cost of capital is the minimum
required rate of return on funds committed to the
project, which depends on the riskiness of its cash
flows.
 The firm’s cost of capital will be the overall, or
average, required rate of return on the aggregate of
investment projects.

3. Basic Aspects on the Concept of Cost of
Capital
The above definitions indicates that the following three
basic aspects of the concept of cost of capital. They
are
 Rates of Return - Cost of Capital is not a Cost as
such in fact it is the rate of return that a firm requires
to earn from its investment projects.
 Minimum Rate of Return – cost of capital of any
firm is that minimum rate of return that will at least
maintain the market value of the shares.

4.  Cost of Capital Comprises of Three Components (1)

The risk less cost of the particular type of
financing (rj)

The business risk premium, (b) and

The financial risk premium (f)
Symbolically cost of capital may be represented as
Ko = rj + b + f

5. Importance / Significance of Cost of
Capital
 Designing Optimal Corporate
Capital Structure
 Investment Evaluation / Capital
Budgeting
 Financial Performance Appraisal

6. Flotation Costs
 A new issue of debt or shares will
invariably involve flotation costs in
the form of legal fees, administrative
expenses, brokerage or underwriting
commission

7. Approaches to Calculate of Cost of Equity
(Ke)
 (i) Dividends capitalisation approach
Ke = D / CMP or NP
Where: Ke = cost of equity
D = Dividends per share
CMP = Current market price per share, NP = Net proceed
per share
This method assumes that investor give prime importance
to dividends and risk in the firm remains unchanged and it
does not consider the growth in dividend.

8. Earnings Capitalisation Approach (E/MP Approach)
Ke = E / CMP or NP
Where
 Ke = cost of equity
 E = earnings per share
 CMP = current market price per share
 NP = net proceeds per share

9. Dividend Capitalisation plus growth rate approach
 Computation of cost of equity capital based on a fixed
dividend rate may not be appropriate, because the
future dividend may grow. The growth in dividends
may be constant perpetually or may vary over a
period of time. It is the best method over dividend
capitalisation approach, since it considers the growth
in dividends.

10. Cost of Capital Under
Constant Growth Rate
Perpetually
 The formula for computation of cost of
equity under constant growth rate is :
 Ke =(D/NP or CMP) + g
 Where: Ke = cost of equity capital
D = dividends per share, NP = net
proceeds per share, CMP = current
market price per share, g = growth
rate (%)

11. Cost of Capital Under
Variable Growth Rate
 Compound growth rate in dividends can be
computed with the following formula.
gr = Do (1 + r)n = Dn
where: gr = growth rate in dividends
Do = first year dividend payment,
(1 + r)n = present value factor for ‘nth’ year
Dn = last year dividend payment

12. Bond Yield Plus Risk Premium Approach
 According to this approach the rate of
return required by the equity
shareholder of a company is equal to
 Ke = yield on long-term bonds + risk
premium

13. Capital Asset Pricing Model Approach (CAPM)
 Capital Asset Pricing Model (CAPM) was
developed by William F. Sharpe. This is
another approach that can be used to
calculate cost of equity. From cost of
capital point of views, CAPM explains the
relationship between the required rate of
return, or the cost of equity capital and the
non-diversifiable or market risk of the firm
that is beta (β).

14.  Symbolically,
 Ke = Rf + (Rmf – Rf) β
Where: Ke = cost of equity capital
Rf = the rate of return required on a risk
free security (%)
β = the beta coefficient
Rmf = market return

15. COST OF RETAINED EARNINGS
(Kre)
 Retained earnings is one of the internal sources to
raise finance. Retained earnings are those / part
of earnings that are retained by the form of
investing in capital budgeting proposals instead of
paying them as dividends to shareholders
 The opportunity cost of retained earning is the rate
of return the shareholders forgoe by not putting
his/her funds elsewhere, because the management
has retained the funds

16.  The opportunity cost can be computed with the following formula
Kre = Ke { (1 – Ti) / (1 – Tb)} x 100
Where: Ke = cost of equity capital [(D / NP )+ g]
 Ti = tax rate
 Tb = cost of purchase of new securities / brokerage
commission
 D = expected dividend per share
 NP = net proceeds of equity share / market price
 g = growth rate in (%)

17. Cost of Preference Shares
Preference share is one of the types of shares issued
by companies to raise funds from investors.
Preference share is the share that has two
preferential rights over equity shares, (i) preference
in payment of dividend, from distributable profits, (ii)
preference in the payment of capital at the time of
liquidation of the company.

18. Cost of Irredeemable Preference Share / Perpetual Preference
Share:
 The share that cannot be paid till the liquidation of
the company are called as irredeemable preference
shares. The cost is measured by the following
formulas.
Kp (without tax) =D/MP or NP
Where: Kp = cost of preference share
D = dividend per share
MP = market price per share
NP = net proceeds

19. Cost of irredeemable preference stock
(with dividend tax)
Kp (with tax) =D (1 + Dt)/MP or NP
where Dt = tax on preference dividend

20. Cost of redeemable Preference Share
 Kp={D+(f+d+pr-pi)/N}/(RV+NP)/2
 D=dividend per share
 f=Flotation cost(Rs)
 d=Discount on issue of preference share (Rs)
 Pr=Premium on redemption of preference shares(Rs)
 Pi=Premium on issue of preference share (Rs)
 N=Term of preference shares.
 Rv=Redeemable value of preference shares
 Np=Net proceeds realized.

21. Cost of Debentures
Cost of Irredeemable Debt / Perpetual debt
 Perpetual debt provides permanent funds to the firm,
because the funds will remain in the firm till liquidation.
Computation of cost of perpetual debt is conceptually
relatively easy. Cost of perpetual debt is the rate of return
that lender expect (i.e., fixed interest rate). The coupon
rate or the market yield on debt can be said to represent an
approximation of cost of debt. Bonds / debentures can be
issued at (i) par / face value, (ii) discount and (iii) premium.

22.  The following formulae used to compute cost
of debentures or bond.
(i) Pre-tax cost = Kdi = I/P or NP x 100
(ii) post-tax cost = IKd = I (1 - t)/ P or NP x
100
Where: I = interest, P = principle amount
or face value,N P = net proceeds,t = tax
rate

23. Cost of redeemable Debt
 Kd={I(1-t)+(f+d+pr-pi)/N}/(RV+NP)/2
 I= Intrest (Rs)
 t=Tax rate
 f=Flotation cost(Rs)
 d=Discount on issue of debt (Rs)
 Pr=Premium on redemption of debt(Rs)
 Pi=Premium on issue of debt (Rs)
 N=Term of debt.
 Rv=Redeemable value
 Np=Net proceeds realized.

24. Computation of weighted average Cost
of Capital (WACC)
 The term cost of capital (Ko) means the overall
composite cost of capital, defined as the weighed
average of the cost of each specific type of fund. It is
also known as composite cost or weighted average
cost of capital (WACC)
 Steps of finding WACC
 Determination of the type of funds to be raised and
their individual share in the total capitalisation of the
firm
 Computation of cost of each type of funds.

25.  Assigning weights to specific
costs.
 Multiplying the cost of each of the
sources by the (appropriate)
assigned weights.
 Adding the total weighted cost to
get over all cost of capital.

26.  WACC=(ke x we)+ (kd X wd)
 =ke X{E/(D+E)}+ kd X {D/(D+E)}
 ke –cost of equity
 kd –cost of debt
 we-proportion of equity in the financing mix
 wd-proportion of debt in the financing mix
 D=Value of debt (Rs)
 E=Value of equity (Rs)

27. Marginal cost of capital (MCC)
 Companies may rise additional funds
for expansion .The cost of additional
funds is called marginal cost of capital.
 The weighted average cost of new or
incremental capital is known as the
marginal cost of capital