Business Finance Class 3

COST OF CAPITAL
• Cost of capital refers to the opportunity cost of making
a specific investment. It is the rate of return that could
have been earned by putting the same money into a
different investment with equal risk.
• Thus, the cost of capital is the rate of return required to
persuade the investor to make a given investment.
• 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
•It is also called cut-off rate, hurdle rate, target
rate, minimum required rate of return or
standard rate.
TYPES OF COST
•Component and composite cost
•Average and Marginal cost
•Explicit and implicit cost
•Component cost:- The rate of return required by
suppliers of capital for an individual source of a
company’s funding, such as debt or equity.
•Composite cost:- Also referred as Weighted
Average Cost of Capital(WACC). It is a company’s
cost to finance its business. The calculation
involves multiplying the cost of each capital
component by its proportional weight and taking
the sum of the result.
•Explicit cost:- The cost involves distribution and
based on external investment of fund by the firm
itself. Examples are cost of debt, cost of equity,
cost of preference shares as these involve
distribution in the form of dividend and interest
to the shareholders and debenture holders.
•Implicit Cost:- This cost accrues to the firm only
and does not involve any distribution. Example is
cost of retained earnings/ reserves.
IMPORTANCE OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to
decide the capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to
net present value method, present value of cash inflow must be more than the present
value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities.
A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital
helps to take decision regarding structure
• Importance to Evolution of Financial Performance Cost of capital is
one of the important determine which affects the capital budgeting,
capital structure and value of the firm. Hence, it helps to evaluate the
financial performance of the firm.
• Importance to Other Financial Decisions Apart from the above
points, cost of capital is also used in some other areas such as, market
value of share, earning capacity of securities etc. hence, it plays a
major part in the financial management.
COMPUTATION OF COST OF CAPITAL
Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Cost of Capital
It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends
of the firm to determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return
that a firm must earn on the equity financed portion of an investment project in
order to leave unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.
CAPM
• Dividend Price Approach The cost of equity capital will be that rate of
expected dividend which will maintain the present market price of
equity shares. Dividend price approach can be measured with the
help of the following formula:
• Q) A company issues 10,000 equity shares of Rs. 100 each at a
premium of 10%. The company has been paying 25% dividend to
equity shareholders for the past five years and expects to maintain
the same in the future also. Compute the cost of equity capital. Will it
make any difference if the market price of equity share is Rs. 175?
• Dividend Price Plus Growth Approach The cost of equity is calculated
on the basis of the expected dividend rate per share plus growth in
dividend. It can be measured with the help of the following formula:
• (a) A company plans to issue 10000 new shares of Rs. 100 each at a
par. The floatation costs are expected to be 4% of the share price. The
company pays a dividend of Rs. 12 per share initially and growth in
dividends is expected to be 5%. Compute the cost of new issue of
equity shares.
• (b) If the current market price of an equity share is Rs. 120. Calculate
the cost of existing equity share capital
• The current market price of the shares of A Ltd. is Rs. 95. The
floatation costs are Rs. 5 per share amounts to Rs. 4.50 and is
expected to grow at a rate of 7%. You are required to calculate the
cost of equity share capital.
• Earning Price Approach Cost of equity determines the market price of
the shares. It is based on the future earning prospects of the equity.
The formula for calculating the cost of equity according to this
approach is as follows.
A firm is considering an expenditure of Rs. 75 lakhs for expanding its
operations.
The relevant information is as follows :
Number of existing equity shares =10 lakhs
Market value of existing share =Rs.100
Net earnings =Rs.100 lakhs
Compute the cost of existing equity share capital and of new equity capital
assuming
that new shares will be issued at a price of Rs. 92 per share and the costs of
new issue will
be Rs. 2 per share.
• Realized Yield Approach It is the easy method for calculating cost of
equity capital. Under this method, cost of equity is calculated on the
basis of return actually realized by the investor in a company on their
equity capital.
 Capital Asset Pricing Model
The CAPM states that the expected return on equity [E(Ri)] is the sum
of the risk-free rate of interest (Rf) and a premium for bearing market
risk, βi[E(Rm)-Rf]
For example, say you’re looking at a stock worth $50 per share today
that pays a 3% annual dividend. The stock’s beta is 1.5, making it riskier
than the overall market. Also, assume that the risk-free rate is 3% and
this investor expects the market to rise in value by 5% per year.
6%=3%+1.5×(5%−3%)
• Cost of Debt
• Cost of debt is the after tax cost of long-term funds through
borrowing. Debt may be issued at par, at premium or at discount and
also it may be perpetual or redeemable.
• Debt Issued at Par
• Debt issued at par means, debt is issued at the face value of the debt.
It may be calculated with the help of the following formula
• (a) A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate
applicable to the company is 50%. Compute the cost of debt capital.
(b) 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.
2.Cost of Preference Share
 4. Cost of Retained Earnings
•May be defined as the opportunity cost in terms of
dividends foregone by/withheld from the equity
shareholders.
•Cost of the retained earnings is the same as the cost
of an equivalent fully subscribed issue of additional
shares, which is measured by the cost of equity
capital.
 Weighted Average Cost of Capital(WACC)
•Weighted average cost of capital is the rate that a
company is expected to pay on average to all its
security holders to finance its assets.
• The WACC is commonly referred to as the firm’s
cost of capital
 Marginal Cost of Capital
•The Marginal cost of capital is the weighted average
cost of the last dollar of new capital raised by a
company.
•It is the composite rate of return required by
shareholders and debt-holders for financing new
investments of the company
•Marginal cost of capital rises as the company raises
more and more.