Module - 2

Cost Of capital (Part - 1)

Introduction
The cost of capital is the company's cost of using funds provided by creditors and
shareholders. A company's cost of capital is the cost of its long-term sources of
funds: debt, preferred equity, and common equity.

Ezra Solomon defines “Cost of capital is the minimum required rate of earnings
or cutoff rate of capital expenditure”.

According to Mittal and Agarwal “the cost of capital is the minimum rate of
return which a company is expected to earn from a proposed project so as to
make no reduction in the earning per share to equity shareholders and its
market price”.

According to Khan and Jain, cost of capital means “the minimum rate of return
that a firm must earn on its investment for the market value of the firm to remain
unchanged”.

Significance of Cost of Capital:

1. Maximisation of the Value of the Firm: For the purpose of maximisation of

value of the firm, a firm tries to minimise the average cost of capital. There
should be judicious mix of debt and equity in the capital structure of a firm
so that the business does not to bear undue financial risk.

2. Capital Budgeting Decisions: Proper estimate of cost of capital is important

for a firm in taking capital budgeting decisions. Generally cost of capital is
the discount rate used in evaluating the desirability of the investment
project. In the internal rate of return method, the project will be accepted if
it has a rate of return greater than the cost of capital. In calculating the net
present value of the expected future cash flows from the project, the cost of
capital is used as the rate of discounting. Therefore, cost of capital acts as a
standard for allocating the firm’s investable funds in the most optimum
manner. For this reason, cost of capital is also referred to as cutoff rate,
target rate, hurdle rate, minimum required rate of return etc.

3. Decisions Regarding Leasing: Estimation of cost of capital is necessary in

taking leasing decisions of business concern.

4. Management of Working Capital: In management of working capital the

cost of capital may be used to calculate the cost of carrying investment in
receivables and to evaluate alternative policies regarding receivables. It is
also used in inventory management also.

5. Dividend Decisions: Cost of capital is significant factor in taking dividend

decisions. The dividend policy of a firm should be formulated according to
 the nature of the firm— whether it is a growth firm, normal firm or declining
firm. However, the nature of the firm is determined by comparing the
internal rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k
which indicate growth firm, normal firm and decline firm, respectively.

6. Determination of Capital Structure: Cost of capital influences the capital

structure of a firm. In designing optimum capital structure that is the
proportion of debt and equity, due importance is given to the overall or
weighted average cost of capital of the firm. The objective of the firm should
be to choose such a mix of debt and equity so that the overall cost of capital
is minimised.

7. Evaluation of Financial Performance: The concept of cost of capital can be

used to evaluate the financial performance of top management. This can be
done by comparing the actual profitability of the investment project
undertaken by the firm with the overall cost of capital.

Explicit Costs

Explicit costs are the direct, out-of-pocket payments a company makes in the
course of conducting business. These costs are recorded in the company's
financial statements and have clear dollar amounts. Examples include:

 Wages and salaries paid to employees

 Rent for office space or equipment
 Utility bills (electricity, water, internet)
 Raw materials and supplies
 Marketing and advertising expenses

Implicit Costs

Implicit costs, also known as opportunity costs, are the indirect costs associated
with using the company’s own resources. These costs do not involve direct
payment but reflect the value of opportunities foregone. Examples include:

 The potential income an owner could earn by working elsewhere instead of

in their own business
 The rental income foregone by using a company-owned building for business
operations instead of renting it out
 The interest income foregone by investing in a project rather than keeping
the money in a savings account

Together, explicit and implicit costs give a more comprehensive view of the true
cost of running a business. Implicit costs are often overlooked but can
significantly impact a company’s profitability and decision-making.
Significance of Cost of Capital

The cost of capital is a crucial financial metric for any business or investment project.
Here's why it's significant:

 Investment Decisions: The cost of capital serves as a benchmark for evaluating

the profitability of potential investments. If the expected return on an investment
exceeds the cost of capital, it's considered a good investment.
 Financing Choices: Businesses need to decide whether to finance their
operations through equity, debt, or a combination of both. The cost of capital
helps in determining the most cost-effective financing mix.
 Performance Measurement: Investors and analysts use the cost of capital to
assess a company's performance. A company that consistently earns a return
above its cost of capital is generally seen as creating value for its shareholders.
 Risk Assessment: The cost of capital reflects the risk associated with a particular
business or investment. Higher risk typically leads to a higher cost of capital,
which in turn affects the required return on investment.
 Strategic Planning: Businesses use the cost of capital to make strategic
decisions, such as expansion, mergers, and acquisitions. It ensures that these
decisions are financially viable and align with the company's long-term goals.

Understanding and managing the cost of capital can significantly impact a company's
financial health and growth potential.

Factors Affecting Cost of Capital

Companies must adapt their financial strategies and capital structures to

navigate changing market conditions and maintain competitive financing costs,
and understanding the factors that affect the cost of capital can help you assess
and manage your cost of funds effectively. Let’s break down some of the key
factors that influence a company’s cost of capital.

 Various market conditions: Broadly speaking, the prevailing economic

and financial market conditions significantly impact cost of capital.
Interest rates, stock market performance, and overall economic stability
can influence the cost of debt and equity capital.
 Industry-specific factors: Different industries have varying risk profiles
and capital cost expectations. Highly regulated industries, emerging
markets, and cyclical sectors may have different cost of capital
considerations.
 Market sentiment: Investor sentiment and market dynamics can lead to
fluctuations in a company's cost of equity. Positive news or strong market
performance can lower the cost of equity capital, while negative
sentiment can increase it.
 Company's risk profile: The risk associated with a company affects its
cost of capital. Investors and lenders demand higher returns when a
 company is perceived as riskier. Factors include the company's
creditworthiness, stability, and historical financial performance.
 Interest rates: As mentioned, changes in interest rates directly affect the
cost of debt capital. When interest rates rise, the cost of borrowing
increases, impacting the overall cost of capital.
 Credit rating: A company's credit rating plays a crucial role in
determining the cost of debt capital. A higher credit rating typically leads
to lower interest rates on loans and bonds.
 Inflation: Inflation erodes the purchasing power of money over time.
Companies often require a higher nominal return to compensate for
expected inflation, which can increase the cost of capital.
 Financial leverage: The use of financial leverage, or debt financing,
affects the cost of equity. Higher leverage can increase perceived risk,
leading to higher equity costs.
 Capital structure: The mix of debt and equity in a company's capital
structure influences the overall cost of capital. Companies need to strike a
balance between debt and equity financing to minimize their cost of
capital.
 Taxation: Tax laws can impact the after-tax cost of debt. Interest
expenses on debt are often tax-deductible, reducing the effective cost of
debt financing.
 Regulatory environment: Regulations can affect the cost of capital by
imposing restrictions on specific financial instruments or influencing
capital structure decisions.

Equity Shares

Equity shares, also known as common shares, represent ownership in a

company. Shareholders of equity shares have voting rights, allowing them to
participate in key decisions, such as electing the board of directors. They also
have the potential to receive dividends, which are distributed from the
company's profits. The value of equity shares can fluctuate based on the
company's performance and market conditions.

Preference Shares

Preference shares are a type of stock that gives shareholders preferential

treatment regarding dividends and asset distribution. Holders of preference
shares receive dividends before equity shareholders and typically have a fixed
dividend rate. However, preference shareholders usually do not have voting
rights. In case of liquidation, preference shareholders are paid before equity
shareholders but after debt holders.

Debentures
Debentures are a type of long-term debt instrument used by companies to raise
funds. They are essentially loans taken by the company from investors and are
backed only by the creditworthiness and reputation of the issuer. Debenture
holders receive regular interest payments and, upon maturity, the principal
amount is repaid. Unlike shares, debentures do not confer ownership in the
company.

Retained Earnings

Retained earnings refer to the portion of a company's net income that is kept
within the company rather than distributed to shareholders as dividends. These
retained earnings are reinvested in the business to fund growth, pay off debt, or
save for future use. Over time, retained earnings contribute to the company's
equity and can significantly impact its financial health and ability to expand.

(Measurement of specific Cost of capital and overall cost of capital

- Refer previous notes)

Module - 2
Capital Structure (Part - 2)
Introduction

Capital structure refers to the mix of debt and equity that a company uses to finance
its operations and growth. It's essentially how a company funds itself and manages its
financial resources.

 Equity: This includes common shares, preferred shares, and retained earnings.
Equity financing means raising capital by selling shares of the company. Equity
holders own a part of the company and share in its profits through dividends and
capital gains.
 Debt: This includes loans, bonds, and debentures. Debt financing involves
borrowing money that must be repaid over time with interest. Debt holders do not
own a part of the company but have a claim on its assets in case of liquidation.
 Optimal Capital Structure: Companies strive to find the right balance between
debt and equity to minimize their cost of capital and maximize shareholder value.
The optimal capital structure varies by company and industry, depending on
factors like business risk, tax considerations, and financial flexibility.

The capital structure affects a company's risk profile, cost of capital, and overall
financial health. A well-balanced capital structure can enhance a company's ability to
withstand economic fluctuations and pursue growth opportunities.

What is Capital Structure

The most crucial component of starting a business is capital. It acts as
the foundation of the company. Debt and Equity are the two primary types of
capital sources for a business. Capital structure is defined as the combination of
equity and debt that is put into use by a company in order to finance the overall
operations of the company and for its growth.

The meaning of Capital structure can be described as the

arrangement of capital by using different sources of long term funds which
consists of two broad types, equity and debt. The different types of funds that
are raised by a firm include preference shares, equity shares, retained earnings,
long-term loans etc. These funds are raised for running the business.

 Equity Capital

Equity capital is the money owned by the shareholders or owners. It consists of

two different types

a) Retained earnings: Retained earnings are part of the profit that has been kept
separately by the organisation and which will help in strengthening the business.
b) Contributed Capital: Contributed capital is the amount of money which the
company owners have invested at the time of opening the company or received
from shareholders as a price for ownership of the company.

 Debt Capital

Debt capital is referred to as the borrowed money that is utilised in business.

There are different forms of debt capital.

1. Long Term Bonds: These types of bonds are considered the safest of the
debts as they have an extended repayment period, and only interest
needs to be repaid while the principal needs to be paid at maturity.
2. Short Term Commercial Paper: This is a type of short term debt
instrument that is used by companies to raise capital for a short period of
time

Optimal Capital Structure

Optimal capital structure is referred to as the perfect mix of debt and equity
financing that helps in maximising the value of a company in the market while at
the same time minimises its cost of capital.

Capital structure varies across industries. For a company involved in mining or

petroleum and oil extraction, a high debt ratio is not suitable, but some
industries like insurance or banking have a high amount of debt as part of their
capital structure.

Financial Leverage
Financial leverage is defined as the proportion of debt that is part of the total
capital of the firm. It is also known as capital gearing. A firm having a high level
of debt is called a highly levered firm while a firm having a lower ratio of debt is
known as a low levered firm.

Importance of Capital Structure

Capital structure is vital for a firm as it determines the overall stability of a firm.
Here are some of the other factors that highlight the importance of capital
structure
 1. A firm having a sound capital structure has a higher chance of increasing
the market price of the shares and securities that it possesses. It will lead
to a higher valuation in the market.
2. A good capital structure ensures that the available funds are used
effectively. It prevents over or under capitalisation.
3. It helps the company in increasing its profits in the form of higher returns
to stakeholders.
4. A proper capital structure helps in maximising shareholder’s capital while
minimising the overall cost of the capital.
5. A good capital structure provides firms with the flexibility of increasing or
decreasing the debt capital as per the situation.
6. With the right capital structure, a company can fund its growth and
expansion plans more effectively.
7. Maintaining an optimal capital structure helps improve a company's
credit rating.

Factors Determining Capital Structure

Following are the factors that play an important role in determining the capital
structure:

 Business Risk: The inherent risk associated with a company's operations. Firms
with higher business risk typically opt for a lower debt ratio to avoid financial
distress.
 Company Size: Larger companies often have more access to capital markets and
can obtain financing at lower costs, thus having more flexibility in their capital
structure decisions.
 Growth Rate: Companies with high growth rates may rely more on equity
financing to avoid the risks associated with high levels of debt.
 Profitability: More profitable companies generate significant internal funds
(retained earnings) and may have less need for external debt or equity financing.
 Tax Considerations: Interest on debt is tax-deductible, which can make debt
financing more attractive for companies seeking to reduce their tax liabilities.
 Market Conditions: Prevailing market conditions, such as interest rates and
investor sentiment, can impact the attractiveness of debt versus equity financing.
 Industry Norms: Industry standards and practices can influence a company's
capital structure decisions. Companies often compare their debt-to-equity ratios
with industry averages.
 Management Style: The risk tolerance and financial philosophy of a company's
management team play a significant role in shaping capital structure decisions.
 Asset Structure: Companies with tangible, long-term assets can often support
higher levels of debt, as these assets can be used as collateral for loans.
 Financial Flexibility: Companies need to maintain financial flexibility to
respond to unexpected opportunities or challenges. This often means balancing
debt and equity to ensure adequate liquidity.
 Control Considerations: Issuing new equity can dilute the ownership stakes of
existing shareholders. Companies may prefer debt to maintain control over the
business.
 Access to Capital Markets: The ease with which a company can access capital
markets affects its ability to raise funds through debt or equity.

By carefully considering these factors, a company can design a capital structure that
supports its strategic goals, minimizes costs, and manages risks effectively.

Financial structure
Financial Structure is a combination of different types of long-term as well as
short-term sources of funds.

Financial structure refers to the configuration of debt and equity in your capital.
This composition defines how the company’s assets, operations, and investments
are financed.

The financial structure will directly influence the cost of capital, risk exposure,
and valuation of your business. Striking the right balance in financial structure is
pivotal for optimizing a company’s performance, ensuring sustainable growth,
and maximizing shareholder value.

Difference between Capital Structure and Financial Structure

The main differences between Capital and Financial Structure are as follows:
 Capital Structure Financial Structure

Definition

Capital Structure is a combination of Financial Structure is a combination of different

different types of long-term sources of types of long-term as well as short-term sources of
funds. funds.

Balance Sheet

The Capital Structure is a part of the The Financial Structure includes all the items in
Liabilities section of the Balance Sheet. the Liabilities section of the Balance Sheet.

Scope

Capital Structure has a narrower scope Financial Structure has a broader scope compared
compared to Financial Structure. to Capital Structure.

Financial Instruments

The instruments under Capital Structure The instruments under Financial Structure include
include the following: the following:

 Equity Shares  Equity Shares

 Preference Shares  Preference Shares
 Debentures  Debentures
 Long-term Borrowings  Long-term Borrowings
 Retained Earnings  Retained Earnings
 Account Payable
 Short-term Borrowings

Capital Structure theories

 The Net Income Approach

The Net Income Approach to capital structure theory was proposed by David
Durand in 1952. This theory suggests that a company can increase its overall
value by minimizing its cost of capital through the use of debt financing1. Here's
a breakdown of the key points:
Key Concepts of the Net Income Approach:

 Cost of Debt vs. Cost of Equity: The theory assumes that the cost of debt
(interest payments) is lower than the cost of equity (dividends and capital
gains). Therefore, by increasing the proportion of debt in the capital
structure, a company can reduce its overall cost of capital.
 Weighted Average Cost of Capital (WACC): The Net Income Approach
focuses on minimizing the WACC, which is the weighted average of the costs
of debt and equity. By increasing debt, the WACC decreases, leading to an
increase in the firm's value.
 Optimal Capital Structure: The theory posits that there is an optimal
capital structure where the WACC is minimized, and the value of the firm is
maximized. This optimal structure involves a higher proportion of debt
relative to equity.
 Assumptions: The approach assumes that the cost of equity and the cost of
debt remain constant regardless of changes in the capital structure. It also
assumes that there are no taxes and that the use of debt does not change the
risk perception of investors.

The Net Income Approach suggests that by increasing the proportion of cheaper
debt in the capital structure, a company can reduce its overall cost of capital and
increase its value. However, it's important to balance this with the risks
associated with higher debt levels, such as increased financial distress and
bankruptcy risk.

 The Net Operating Income (NOI) Approach

The Net Operating Income (NOI) Approach, also proposed by David Durand, is
an alternative to the Net Income Approach for understanding the impact of
capital structure on a company's value and cost of capital. Here's a detailed
explanation:

Key Concepts of the Net Operating Income (NOI) Approach:

 Independence of Firm Value: The NOI approach asserts that the value of a
firm is independent of its capital structure. This means that changes in the
proportions of debt and equity do not affect the overall value of the firm.
 Constant Weighted Average Cost of Capital (WACC): According to this
approach, the WACC remains constant regardless of changes in the capital
structure. This is because the increase in the cost of equity due to higher
leverage exactly offsets the benefits of cheaper debt financing.
 Cost of Equity Increases with Leverage: As the company increases its use
of debt, the risk to equity holders also increases. Consequently, the cost of
equity rises, reflecting the higher required return by equity investors due to
increased financial risk.
 No Tax Advantage: The NOI approach assumes that there are no tax
benefits associated with debt financing. This means that interest payments
 on debt do not provide any tax shield, which is a key difference from the
traditional trade-off theory.

The Net Operating Income Approach suggests that the capital structure of a
company does not influence its overall value. Instead, it emphasizes that any
increase in debt is precisely balanced by an increase in the cost of equity,
keeping the WACC constant.

 The Modigliani-Miller (MM) approach

The Modigliani-Miller (MM) approach to capital structure, developed by Franco

Modigliani and Merton Miller in the 1950s, is a foundational theory in corporate
finance. It suggests that a company's capital structure does not affect its
overall value. Here are the key points:

 Assumptions

 No Taxes: There are no taxes, so interest payments are not tax-deductible.

 No Transaction Costs: Buying and selling securities incur no costs.
 Symmetric Information: All investors have access to the same information.
 No Bankruptcy Costs: There are no costs associated with bankruptcy.
 Equal Borrowing Costs: Borrowing costs are the same for all investors and
companies.

 Propositions

 Proposition I: The value of a leveraged firm (one with debt) is the same as
the value of an unleveraged firm (one without debt). This means that the
capital structure does not affect the firm's market value.
 Proposition II: The cost of equity increases as the firm's debt-equity ratio
increases. This is because equity holders demand a higher return to
compensate for the increased risk of financial distress.

Later, Modigliani and Miller introduced taxes into their model, leading to the
trade-off theory of leverage. This theory suggests that the tax benefits of debt
(interest tax shields) can increase the value of a leveraged firm compared to an
unleveraged firm.

(Arbitrage process and Traditional approach to capital

structure ,Refer the previous notes given)