Cost of Capital Calculation

1. COSTOFCAPITAL
CALCULATION

2. COST OF CAPITAL
INTRODUCTION
Finance is defined as the provision of money at the time it is
needed.
Finance function may be defined as the procurement of funds
and their effective utilization.
FINANCIALREQUIREMENTS OFBUSINESS
 SHORT TERM FINANCIAL REQUIREMENTS
 LONG TERM FINANCIAL REQUIREMENTS

3. FINANCIALREQUIREMENTS
SHORTTERMFINANCIALREQUIREMENTS
Short term funds required for meeting working capital needs. They are usually
required for a period up to one year. The requirement of these funds is usually met
by taking short term loans or getting the bill discounted from the commercial
banks.
LONGTERMFINANCIALREQUIREMENTS
long term funds required to a great extend for meeting the fixed capital
requirements of the business. They are required for a period exceeding one year.
These funds are raised by business by business from sources which provide, in an
uninterrupted way, the use of fund for a long period, viz., shares, debentures,
loans from specialized financial institution

4. Sources of finance
Shares (both equity
& preference)
Security financing
Debentures
Internal financing
Retained earnings &
depreciation fund
Loan financing
Short term & long
term loans
SOURCES OFFINANCING

5. MEANING
COSTOFCAPITAL
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its
market value and attract funds. Cost of capital is the required rate of return on its investments which
belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the
market value of the shares will fall and it will result in the reduction of overall wealth of the
shareholders.
Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. Cost of capital is also called as cut-off rate,
target rate, hurdle rate and required rate of return.

6. Cost of capital is the rate of return the firm required from
investment in order to increase the value of the firm in the
market place
COSTOFCAPITAL
DEFINITION
JOHN J. HAMPTON
A cut-off rate for The allocation of capital to investment of
projects. It is the rate of return on a project that Will leave
unchanged the market price of the stock
C. VAN HORNE

7. Assumptions of Cost of Capital
Cost of capital is based on certain assumptions which are closely
associated while calculating and measuring the cost of capital. It is to be
considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3.It consist of three important risks such as zero risk
level, business risk and financial risk.

8. COMPONENTS OF COST CAPITAL
COMPONENTS
Return at zero
risk level
Premium for
business risk
Premium for
financial risk

9. RETURN AT ZERO RISK LEVEL
The expected rate of return when a project
involves no risk whether business or
financial.
Premium for Business Risk
Business Risk refers to the variabillity in operating
profit(EBIT) due to change in sales. When the business
risk is more than normal, the suppliers of fund will
expect higher rate of return.
PREMIUM FOR FINANCIAL RISK
Financial risk refers to the risk on account of pattern of capital
structure (debt-equity mix). A firm having higher a higher debt
content in its capital structure is more risky compared to a firm
which has low debt content. Therefore the suppliers of fund would
therefore expect a higher rate of return from
such a fund
K =Ro + b + f
K – cost of capital
Ro – return at zero risk level
b - premium for business risk
F – premium for financial risk

10. CLASSIFICATION OFCOSTOFCAPITAL
Explicit cost
Implicit cost
Future cost
Historical cost
Cost of capital
Specific cost
Combined cost
Average cost
Marginal cost

11. EXPLICIT COST – The internal rate return the firm pays for financing. This cost arises
when the funds are raised.
IMPLICIT COST -Implicit cost is the rate of return associated with the best
investment opportunity for the firm and its shareholders that will be forgone if the
projects presently under consideration by the firm were accepted.
Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained earnings and loans is
called as specific cost of capital.
The composite or combined cost of capital is the combination of all sources of capital.
It is also called as overall cost of capital.
CLASSIFICATION OFCOSTOFCAPITAL

12. CLASSIFICATION OFCOSTOFCAPITAL
HISTORICAL AND FUTURE COST
Historical cost is the cost which as already been incurred for financing a particular
project. It is based on the actual cost incurred in the previous project.
Future cost is the expected cost of financing in the proposed project. Expected cost is
cost is calculated on the basis of previous experience.
AVERAGE AND MARGINAL COST
Average cost of capital is the weighted average cost of each component of capital
employed by the company. It considers weighted average cost of all kinds of financing
such as equity, debt, retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is
the additional cost of capital when the company goes for further raising of finance.

13. IMPORTANCE OF COST OF CAPITAL

14. COMPUTATION OF COST OF CAPITAL
Kd = (1 – T) R
Kd = Cost of debt
T = Tax rate
R = debenture interest rate
COST OF DEBT
COST OF DEBT IRREDEEMABLE DEBT
DEBT ISSUED AT PAR

15. COMPUTATION OF COST OF CAPITAL
COST OF DEBT
DEBT ISSUED AT PREMIUM
Kd =
I
(1-T)
NP
Kd = Cost of debt
I= Annual interest payment
NP =Net proceeds
T = Tax rate
NP = Face value + premium

16. COMPUTATION OF COST OF CAPITAL
COST OF DEBT
DEBT ISSUED AT DISCOUNT
I
Kd = (1-T)
NP
Kd = Cost of debt
I= Annual interest payment
NP =Net proceeds
T = Tax rate
NP = Face value - Discount

17. COMPUTATION OF COST OF CAPITAL
COST OF REDEEMABLE DEBT
I +(P-NP)/n
Kd (before tax) = (P+NP)/2
Kd (after tax) = Kd(before tax) x (1-T)
I = Annual interest payment
P= Par value of debenture
NP = Net proceeds
n = Number of years to maturity

18. COMPUTATION OF COST OF CAPITAL
COST OF IRREDEEMABLE PREFERENCE SHARES
Dp
Kp =
Np
Kp = cost of preference share capital
Dp = fixed preference dividend
Np = Net proceeds of preference shares

19. COMPUTATION OF COST OF CAPITAL
COST OF REDEEMABLE PREFERENCE SHARES
Dp + (RV-Np)/n
Kp =
(RV+ Np)/2
Kp = cost of preference share capital
Dp = fixed preference dividend
Np = Net proceeds of preference shares
RV = Redemption value
n = Number of years to redemption

20. COMPUTATION OF COST OF CAPITAL
COST OF EQUITY CAPITAL
APPROACHES
Dividend price (D/P) approach
Dividend price plus growth (D/P + g)
approach
Earning price (E/P) approach
Realized yield approach.

21. COMPUTATION OF COST OF CAPITAL
COST OF EQUITY CAPITAL
Dividend price (D/P) approach
D
Ke =
NP
Ke = Cost of equity capital
D = Dividend per share
Np = Net proceeds of an equity share
D
Ke =
MP
Ke = Cost of equity capital
D = Dividend per share
MP = Market price of an equity share
COST OF EQUITY ON THE BASIS OF
MARKET PRICE

22. COMPUTATION OF COST OF CAPITAL
COST OF EQUITY CAPITAL
Dividend price plus growth (D/P + g) approach
D
Ke = +g
NP
Ke = Cost of equity capital
D = Expected Dividend per share
Np = Net proceeds of an equity share
g= Growth in expected dividend

23. COMPUTATION OF COST OF CAPITAL
COST OF EQUITY CAPITAL
Earning price (E/P) approach
E
Ke =
NP
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share

24. COMPUTATION OF COST OF CAPITAL
COST OF EQUITY CAPITAL
Realized yield approach
Ke = PVf xD Ke = Cost of equity capital
PVf = Present value of discount factor
D= Dividend per share

25. COMPUTATION OF COST OF CAPITAL
COST OF RETAINED EARNINGS
Kr = Ke(1-t) (1-b) Kr= Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b= Brokerage cost

26. COMPUTATION OF COST OF CAPITAL
WEIGHTED AVERAGE COST OF CAPITAL
XW
Kw =
W
Kw = Weighted average cost of capital
X= Cost of specific sources of finance
W= Weight, proportion of specific sources of finance