This document discusses the cost of capital and how it is calculated. It defines cost of capital as the minimum required rate of return that suppliers of capital require as compensation for time and risk. The cost of capital is used to evaluate investment decisions, design debt policy, and appraise financial performance. It is calculated as a weighted average of the cost of debt and equity. The cost of debt is based on interest rates, while the cost of equity is based on expected returns required by shareholders to compensate for risk. The weighted average cost of capital (WACC) is then determined by weighting the costs of each component by the proportion of debt and equity in the firm's capital structure.

1. The Cost of Capital
JITHIN K THOMAS
BIMS

2. Cost of Capital
• The cost of capital to a firm is the minimum
required rate of return, which the suppliers of
capital require.
• It is the price of obtaining capital.
• It is the compensation for time and risk.

3. SIGNIFICANCE OF THE COST OF CAPITAL
• Evaluating investment decisions
• Designing a firm’s debt policy
• Appraising the financial performance of top
management
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4. Source of Capital
• A firm obtain capital for investment in the
form of equity and debt.
• A firms cost of capital will the Weighted
Average Cost of debt and equity.

5. Debt
• Debt includes all interest bearing borrowings.
• Its cost is return (yield), which lender expects
from their investment.
• Coupon Rate – annual contracted rate
• Interest charges are tax deductable for a firm
• Cost of debt should be calculated after
adjusting for tax shield

6. COST OF DEBT
• Debt Issued at Par
• Debt Issued at Discount or Premium
• Tax adjustment
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7. Cost of Debt
• Debt Issued at Par
• Debt Issued at Discount or Premium
• kd (1-T)
• Where kd is the before tax cost of debt and T is the tax rate

8. Equity
• Equity includes paid – up capital and reserves
and surplus.
• Equity has no explicit cost as payment of
dividend is not obligatory.
• It involves an opportunity cost

9. Opportunity Cost
• The Opportunity cost of equity is the rate of
return required by shareholders on securities
of comparable risk
• It is the price which the company must pay to
attract capital from shareholders.

10. Cost of Equity
• Shareholders expect to receive dividends and
capital gain
• where DIV1 is expected dividend per share P0 is the market price
today and g is the expected growth.
• When a company issues new share capital, it has to
offer shares at a price, which much less than the
prevailing market price. Therefore the cost of
retained earnings will be less than the cost of new
issue of equity.

11. Calculation of WACC
• Calculate cost of Equity and Debt
• Weights is assigned according to the capital
structure
• Product of component costs and weight is
summed to determine WACC