Cost of Capital,Meaning,Computation of Specific Costs,Cost of Debt,Cost of Preference Shares,Cost of Equity Capital,Cost of Retained Earnings ,Weighted Average Cost of Capital

1. Cost of Capital
Financial Management

2. Cost of Capital
• The cost of capital is an important element as
a basic input information in capital investment
decision. The cost of capital constitutes the
integral part of investment decision.
• It provides a yardstick to measure the worth
of investment proposals and thus performs
the role of accept-reject criterion.
• It is also referred to as cut-off rate, target rate,
hurdle rate, minimum required rate of return,
standard return and so on.

3. Accept-reject rule
• The accept-reject rules require that a firm
should avail of only such investment
opportunities as promise a rate of return
higher than the cost of capital and vice-versa.
• Rate of Return > Cost of Capital = Accept =
Market Price of Shares = Wealth of
Shareholders.
• The cost of capital, thus provides a rational
mechanism for making optimum investment
decision.

4. Meaning
• In operational terms:
“Cost of capital refers to the discount rate that
would be used in determining the present
value of the estimated future cash proceeds
and eventually deciding whether the project is
worth undertaking or not.”
• “The cost of capital is visualised as being
composed of several elements. These
elements are the cost of each component of
capital. The term ‘component’ means the
different sources from which funds are raised
by a firm.”

5. Computation of Specific Costs
• The first step in the measurement of the cost
of capital of the firm is the calculation of the
cost of individual source of raising funds.
• The specific costs have to be calculated for:
- Debt (including debentures)
- Preference Shares
- Equity Capital
- Retained Earnings

6. Cost of Debt
• It is relatively easy to calculate. The cost of
funds raised through debt in the form of
debentures or loan from FIs.
• To calculate for this we need data regarding:
- The net cash peoceeds/inflows from specific
source of debt
- The net cash outflow in terms of the amount
of periodic interest payment and repayment of
principal in instalments or in the maturity year.
• Interest rate is the basis of cost as it is legal
commitment.

7. Cost of Preference Shares
• The computation of the cost of preference
shares is conceptually difficult as compared to
the cost of debt.
• In the case of debt, the interest rate is the
basis of calculating cost, because payment of a
specific amount of interest is a legal
commitment on the part of the firm. There is
no such obligation in regard to preference
dividend.

8. • They are having fixed right to receive the dividend
and also having preferential right as regard to
payment of principal as compared to ordinary
shareholders.
• Nevertheless, firms can be expected to pay the
stipulated dividend, if there are sufficient profits.
• The stipulated dividend on preference shares, like
the interest on debt, constitutes the basis for the
calculation of the cost of preference shares.
• The cost of preference capital may be defined as
the dividend expected by the preference
shareholders.

9. Cost of Equity Capital
• It is the most difficult and controversial cost to
measure.
• The return to the equityholders solely
depends upon the discretion of the company
management.
• Apart from the absence of any definite
commitment to receive dividend, the equity
shareholders rank at the bottom as claimants
on the assets of the company at the time of its
liquidation.

10. • It may therefore, appear that equity capital
does not carry any cost. But this is not true. As
it is also certain cost.
• When equity holders invest their funds they
also expect returns in the form of dividends.
• If the company does not meet the
requirements/expectations of its shareholders
and pays dividends, it will have an adverse
effect on the market price of shares
• Relatively the cost of equity capital is higher, it
involves the highest degree of financial risk.

11. Cost of Retained Earnings
• Retained earnings, as a source of finance for
investment proposals, differ from other source
like debt, preference shares and equities.
• There is no obligation, formal or implied, on a
firm to pay a return on retained earnings.
• Retained earnings may appear to carry no cost
since they represent funds which have not
been raised from outside.
• The contention that retained earnings are free
of cost, however, is not correct. On the
contrary, they do involve cost like any other
source.

12. • Retention of earnings does have implication
for the shareholders of the firm. If earnings
were not retained, they would have been paid
out to the ordinary shareholders as dividends.
• When, earnings are thus, retained,
shareholders are forced to forego dividends.
• The dividends foregone by the equityholders
are, in fact, an opportunity cost. Thus retained
earnings involve opportunity cost.

13. • “Therefore, the cost of retained earnings may
be defined as opportunity cost in terms of
dividends foregone by withheld from the
equity shareholders.”

14. Weighted Average Cost of Capital
• The overall composite cost of capital defined
as weighted average of the cost of each
specific type of fund.
• The use of weighted average and not the
simple average is warranted by the fact that
the proportion of various sources of funds in
the capital structure of a firm are different.
• To be representative, therefore, the overall
cost of capital should take into account the
relative proportions of different sources and
hence the weighted average.

15. • The computation of the over-all cost of capital
involves the following steps:
1) Assigning weights to specific costs.
2) Multiplying the cost of each of the sources by
the appropriate weights.
3) Dividing the total weighted cost by the total
weights.

16. • For Ex:
Cost of Debt 8%
Cost of Preference Share 14%
Cost of Equity Funds 17%
Capital Structure:
Debt 3,00,000
Preference Shares 2,00,000
Equity Capital 5,00,000
10,00,000
Calculate the weighted average cost of capital?

17. Sources Amt. Weight Cost Weighted Cost
(1) (2) (3) (4) (3x4)
Debt 3,00,000 30 X 8 = 240
Pref. Capital 2,00,000 20 X 14 = 280
Equity Cap. 5,00,000 50 X 17 = 850
10,00,000 100 1370
1370
100
WACC = 13.7%