The cost of capital is the rate of return that a company must provide to its investors in order to attract investment. It represents the price paid to investors for the capital provided. From the investor's perspective, it is the sacrifice made by postponing present needs for future returns. The cost of capital is used to evaluate investment alternatives, design capital structure, and assess financial performance. It is calculated as a weighted average of the costs of different capital sources like bonds, preferred stock, and common equity. Factors like economic conditions, market risk, operating decisions, and financing decisions impact the cost of capital. The weighted average cost of capital (WACC) provides the minimum return required by both debt and equity investors in a company.

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Financial Management
Cost Of Capital

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What Is Cost Of Capital?
Definition:
 From firm’s viewpoint cost of capital is the price
paid to the investor for the capital provided by
him
 From investor’s viewpoint cost of capital is the
measurement of the sacrifice made by him in
order to invest with a view to get a fair return
in future on his investments as a reward for the
postponement of his present needs
 In other words, the cost of raising funds is the
firm’s cost of capital.

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Utilities Of Cost Of Capital
Designing a firm’s capital structure
Evaluation of investment alternative
Assessment of financial performance

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Bonds
Preferred Stock
Common Stock
Each of these offers a rate of return to
investors.
This return is a cost to the firm.
“Cost of capital” actually refers to the
weighted cost of capital - a weighted
average cost of financing sources.
How can the firm raise capital?

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Factors Affecting Cost of
Capital
General Economic Conditions
 Demand for and supply of capital
 Level of expected inflation
 These are reflected in the riskless rate of return
Market Conditions
 When the economy is doing well, most companies
do well. This reduces the risk that the company
will fail.
 When the economy is doing poorly, many companies
will also do poorly. This increases the risk that a
company will fail.
 Marketability of securities when seller wants to
sell.

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Operating and Financing Decisions
 Affect business risk- Business risk is the
variability in returns on assets that is affected by the
company’s investment decisions
 Affect financial risk-Financial risk is the increased
variability of returns to common stockholders as a
result of using debt and preferred stock
Amount of Financing
Cost of capital increases as the financing
requirements become larger because:
-As increasingly larger security issues are floated in
the market, additional floatation costs
-Investors’ required rates of return increase as the
firm seeks more and more capital without evidence of
the firm to absorb this capital

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Components Of Cost Of
Capital
Cost of Debt
Cost of Equity Share Capital
Cost of Retained Earnings
Cost of Preference Share Capital

8. Cost of Debt Capital
Debt may be in the form of debentures,
bonds, term loans from financial institutions
and banks
The debt carries a fixed rate of interest
payable by the firm to the debenture holders
whether the company makes profit or not.
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9. Concept of Net Proceeds
When debt capital is raised, certain expenses
like issue , advertisement, , printing,
underwriting, brokerage expenses occur (also
known as floatation cost or FC)
These expenses reduce the actual amount of
debt capital received by a firm
Net proceeds is the actual debt capital received
by a firm after incurring floatation cost.
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10. Calculation of Net Proceeds
Net Proceeds (or NP) is important to be
determined as it is used in calculation of cost
of debt capital.
NP when debentures are issued at par = Par
value - FC
NP when debentures are issued at premium=
Par value + Premium - FC
NP when debentures are issued discount = Par
value – Discount - FC
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WACC
The Weighted Average Cost of Capital is the
weighted average cost of various sources of
finance.
WACC tells us the return that both stakeholders -
equity owners and lenders - can expect. WACC, in
other words, represents the investors'
opportunity cost of taking on the risk of putting
money into a company.
Investors use WACC as a tool to decide whether
or not to invest. The WACC represents the
minimum rate of return at which a company
produces value for its investors.

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Steps
i. Calculate the cost of each specific
source of fund.
ii. Assign weights to specific costs based
on its proportion in the capital structure.
iii. Multiply cost of each source by its
proportion in the capital structure.
iv. Add the weighted component costs to
get the firm’s WACC

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Balance Sheet
Assets Liabilities
WACC = .40 x 10% (1-.4)
+ .10 x 11.9%
+ .50 x 16.25% = 11.72%
WACC= k0 = %Bonds x Cost of Bonds x (1-T)
+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%)1,000
Common Stock(16.25%)5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
Computing WACC-using New Common Shares

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Assumptions
Future proposals do not vary
Balanced Debt and Equity
Analysis based on current costs
Existing capital structure is optimal

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Summary
Cost of Capital is the rate of return which
the company must earn to satisfy the
investor who have provided long term
finance.
WACC is the weighted average cost of
various sources of finance.
WACC is an important tool in determining
an optimal capital structure.

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Cost of Capital can be calculated using book
values as weights
The Cost of Capital helps in the goal
maximization of shareholder’s wealth by
designing a capital structure which
minimizes the overall cost of capital.

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