FINANCIAL MANAGEMENT
PERSONAL SKILL DEVELOPMENT
ACTIVITY
COST OF CAPITAL
(CONCEPT, SIGNIFICANCE, COST OF DEBENTURE, COST OF
PREFERENCE SHARE)
CONTENTS
Acknowledgment..................................0
Concept of Cost of Capital....................1
What is Cost of Capital?........................1
Significance............................................2
Cost of Debentures................................4
Numerical..............................................5
Cost of Preference Share Capital...........6
Numerical..............................................7
Conclusion.............................................8
ACKNOWLEDGEMENT
We extend my sincere appreciation to all those who have contributed to the
completion of this project titled "Exploring the Cost of Capital" as a
requirement for the subject of Financial Management.
We would like to express our deepest gratitude to Mr. Varun Batra for their
unwavering support, guidance, and invaluable feedback throughout the duration
of this project. Their expertise and dedication have been pivotal in shaping the
content and direction of this research.
We are indebted to the authors and researchers whose seminal works have
served as the cornerstone of my study on the cost of capital. Their
comprehensive analyses and insights have provided a solid foundation for this
project.
We extend my gratitude to my peers and friends for their encouragement and
constructive critique, which have played a crucial role in refining the concepts
and arguments presented in this work.
Furthermore, We wish to thank my family for their constant encouragement and
understanding during the course of this project. Their unwavering support has
been a source of strength and motivation.
This project stands as a testament to the collective effort and support of all those
mentioned above, and for that, We are sincerely grateful.
Upasana Tyagi, Isha Kumari, Chetna Arora
BBA LLB (Hons.) 1A
DME LAW SCHOOL
Concept Of Cost of Capital
For a variety of capital budgeting plans, a company needs money. Various investor categories,
such as equity shareholders, preference shareholders, debt holders, depositors, etc., may
provide these money. While giving the company the money, these investors will be expecting
a minimal return from the company. Investor perception of risk and the firm's risk-return
characteristics determine the minimal return that investors demand. Consequently, the
company needs to give this return to investors in order to raise money. Naturally, the income
from the proposal where the funds are being utilized would be used to pay for this return to
investors.
Therefore, the proposal needs to make at least that amount in order to cover the firm's investors'
expenses. The minimal return that the project must achieve in order for the company to consider
it is the return that will be paid to the investor. In summary, then, the cost of capital is the
lowest return that the company has to earn on its proposals in order to break even, while the
cost of acquiring money is the minimum needed rate of return of the company.
What is Cost of Capital
The minimal rate of return that a business must achieve on its investments to meet the demands
of its different investors—debt holders, equity shareholders, preference shareholders, and
depositors—is referred to as cost of capital. It stands for the expense an organization bears
while obtaining capital from these investors.
Investor perception of risk and the firm's risk-return profile both affect the cost of capital.
Investors need to feel rewarded for taking on risk, thus the company has to make enough money
to cover these costs. The company generates money from its investment recommendations,
which is how it earns this return.
The benchmark return that the company has to attain on its investments to pay for the cost of
capital and guarantee profitability is, in essence, the cost of capital. It plays a key role in
decision-making procedures like capital budgeting since investments need to provide returns
greater than their cost of capital in order to be deemed beneficial.
Page | 1
Significance
Maximizing Shareholder Wealth: Cost of capital helps in achieving the objective of
maximizing shareholder wealth by ensuring that the firm earns a return higher than its cost of
capital.
Utilization of Excess Returns: Surplus returns above the cost of capital can be utilized for
shareholder benefit, such as increased dividends or reinvestment for future growth.
Capital Budgeting Decision Making: It serves as a crucial parameter in capital budgeting
decisions, guiding the selection of projects with returns exceeding the cost of capital to enhance
the firm's overall value.
Determining Financial Structure: Cost of capital assists in determining the optimal financial
structure by minimizing the overall cost of funds from different sources, thereby maximizing
the firm's value.
Enhancing Market Value: Projects with returns higher than the cost of capital increase the
firm's market value, while those falling below diminish it, emphasizing the importance of
aligning investments with the cost of capital.
Balancing Risk and Return: It helps in balancing risk and return, as investors expect to be
compensated for the risk they undertake, and the firm must generate returns sufficient to meet
these expectations.
Strategic Planning: Understanding the cost of capital aids in strategic planning by providing
insights into the firm's financial performance and the viability of investment opportunities.
Market Perception: Investors' perception of a firm's ability to earn returns above its cost of
capital influences its market perception and attractiveness to potential investors.
Competitive Positioning: Firms with lower cost of capital are better positioned competitively,
as they can undertake projects more efficiently and generate higher returns for shareholders.
Long-Term Sustainability: By ensuring that investments generate returns above the cost of
capital, firms can sustain growth and profitability over the long term, benefiting both
shareholders and stakeholders.
Cost Of Debt
The cost of debt is the total interest amount or effective interest rate a company owes on debt
instruments like bonds and loans. In other words, the cost of debt is the minimum interest rate
debt holders need to offer financing support to borrowers. The total debt cost can be before or
after tax.
Page | 2
Debt holders determine the annual interest rate based on the borrower’s credit score. A lower
credit rating results in higher costs and vice versa. Lenders also scrutinize business financial
statements to assess borrowers’ creditworthiness and loan repayment capabilities.
Importance of Cost of Debt
1. Profitability -The cost of capital is the weighted average of the cost of debt and cost of
equity. Companies paying higher interest expenses end up reducing their net income. As a
result, they can’t deliver the equity return shareholders desire. This lower rate of equity also
keeps potential investors away. The higher debt cost, on the other hand, means creditors are
less likely to offer additional debt.
2. Risk -The Small Business Credit Survey shows that 36% of small businesses don’t receive
funding because of poor credit scores. Lenders consider a company’s existing debt and credit
ratings before lending money. The more the company owes in debt, the more the risk of
defaulting on payments. Since higher debt amounts result in lower credit ratings, they’re less
likely to get money from future borrowers.
3. Capital structure -Organizations use a mix of debt and equity to finance business
operations. Increasing liabilities show higher debt obligations, which they must pay regardless
of revenue. That’s why financial analysts usually examine a company’s credit rating, debt type,
loan term, and interest rates to understand its capital structure. Equities, on the other hand, are
more expensive than debt. That’s why most companies use debt to reduce their cost of capital.
Balancing debt and equity is critical to maximizing profitability and reducing financial risks.
Components of Cost of Debt
1. Interest rate is an annual percentage of the principal amount a creditor charges a lender on
the outstanding loan amount. Organizations usually use loans to fund operations and buy
assets, making the interest rate the cost of money. That’s why the same amount of money can
be expensive when the interest rate is high and vice versa.
2. Flotation cost refers to the legal, registration, audit, and underwriting fees a business incurs
while issuing new securities. Even though flotation costs are considerably less for loans, they
can add to the total cost of capital in case of high loan amounts.
3. Risk premium is the higher rate of return borrowers pay lenders over and above the risk-
free return rate. Investors consider risk premiums a form of compensation for their relatively
risky investments. The premium amount may vary depending on the borrowing company’s
financial health, overall economic outlook, and industry.
4. Tax savings refer to the interest amount a business entity shows as the deductible amount
from its income while calculating income taxes.
Page | 3
Ques: B Ltd. issues Rs. 1,00,000, 8% Debentures at a premium of 10%. The tax rate applicable
to the company is 60%. Compute the cost of debt capital.
Answer:-
Ques: A company issues Rs. 20,00,000, 10% redeemable debentures at a discount of 5%. The
costs of floatation amount to Rs. 50,000. The debentures are redeemable after 8 years. Calculate
before tax and after tax. The cost of debt assures a tax rate of 55%.
Answer:-
Page | 4
Cost of Preference Share Capital
Companies can raise funds by the issue of preference share capital also. The preference
share capital is differentiated from equity share capital on account of two basic
features, namely :
(i) the preference shares are entitled to receive dividends at fixed rate in priority over
the equity shares, and
(ii) in case of liquidation of the company, the preference shareholders will get the
capital repayment in priority over the distribution among the equity shareholders.
It may be noted that there is no obligation on the firm to compulsorily pay the
preference dividend as the preference dividend is payable only when the sufficient
profit are there and the company wants to pay dividends to equity shareholders also.
The preference dividend is payable as an appropriation of profit unlike interest on
debentures which is a charge against profits.
The fixed rate of dividend on preference shares is the starting point for calculation of
cost of capital of preference share capital. Conceptually, the preference shares may
either be redeemable or irredeemable, the cost of capital may also be ascertained
accordingly.
Page | 5
Ques: ABC Ltd. issues 15% Preference shares of the face value of ` 100 each at a flotation cost
of 4%. Find out the cost of capital of preference share if (i) the preference shares are
irredeemable, and (ii) if the preference shares are redeemable after 10 years at a premium of
10%.
Answer:-
Page | 6
It may be noted that the cost of capital of preference share, kp, is higher i.e., 16.31% when it
is redeemable after 10 years at a 10% premium. The reason for this is the premium payable at
the time of redemption. In the same case, if the premium is not payable at the time of
redemption and the preference share is redeemable, instead, at ` 96 only, then the cost of
capital will be as follows :
At kₚ = 16%, the right-hand side of the equation may be written as :
= 15(PVAF(16%,10)) + 96(PVF(16%,10))
= 15(4.833) + 96(.227) = ` 94.27
As the value is less than ` 96, the rate of discount may be decreased to 15%.
At kₚ = 15%, the right-hand side of the equation may be written as :
= 15(PVAF(15%,10)) + 96(PVF(15%,10))
= 15(5.019) + 96(.247) = ` 98.99
By interpolating between 15% and 16% the value of kₚ comes to 15.63%.
So, the cost of capital is the same at 15.63% as it was when the preference shares were treated
as irredeemable. However, if the preference shares are redeemable at par i.e., ` 100, then kₚ
comes to 15.83%. This increase in the cost of capital from 15.63% to 15.83% arises because
of a premium of ` 4 payable at the time of redemption. This premium is a gain to shareholders
but reflects a cost to the company as indicated by the increase in the cost of capital.
Conclusion
In the realm of financial management, understanding the concept of Cost of Capital is
paramount for firms aiming to make informed decisions and maximize shareholder value. As
we explored in our presentation, the Cost of Capital represents the minimum rate of return that
a company must achieve on its investments to satisfy the expectations of its various investors.
Through a meticulous analysis of the cost of debt, preference share capital, and equity, we
uncovered the intricate interplay between risk, return, and financial structure. We delved into
the significance of cost of capital in guiding capital budgeting decisions, optimizing financial
structure, and enhancing market value.
Page | 7
Moreover, our examination highlighted the importance of striking a balance between debt and
equity, leveraging surplus returns, and aligning investments with the cost of capital to ensure
long-term sustainability and competitiveness. By comprehensively evaluating the components
and implications of cost of capital, firms can navigate through financial complexities with
clarity and confidence.
As we conclude our presentation, let us reaffirm our commitment to harnessing the power of
financial management principles to drive strategic growth, foster investor confidence, and
create lasting value for all stakeholders. Thank you.
Page | 8
