Financial Management III Semester B.

Com

COST OF CAPITAL
Cost of capital is the rate of return the firm requires from investment in order
to increase the value of the firm in the market place. In economic sense, it is the cost
of raising funds required to finance the proposed project, the borrowing rate of the
firm. Thus under economic terms, the cost of capital may be defined as the weighted
average cost of each type of capital.
There are three basic aspects about the concept of cost
1. It is not a cost as such: The cost of capital of a firm is the rate of return which
it requires on the projects. That is why; it is a ‘hurdle’ rate.
2. It is the minimum rate of return: A firm’s cost of capital represents the
minimum rate of return which is required to maintain at least the market
value of equity shares.
3. It consists of three components. A firm’s cost of capital includes three
components
a. Return at Zero Risk Level: It relates to the expected rate of return when
a project involves no financial or business risks.
b. Business Risk Premium: Business risk relates to the variability in
operating profit (earnings before interest and taxes) by virtue of
changes in sales. Business risk premium is determined by the capital
budgeting decisions for investment proposals.
c. Financial Risk Premium: Financial risk relates to the pattern of capital
structure (i.e., debt-equity mix) of the firm, In general, a firm which
has higher debt content in its capital structure should have more risk
than a firm which has comparatively low debt content. This is because
the former should have a greater operating profit with a view to
covering the periodic interest payment and repayment of principal at
the time of maturity than the latter.
1
Page

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

Significance of Cost of Capital

The cost of capital is significant because of the following cases;
1. Capital Budgeting Decisions: The concept of cost of capital can serve as a
discount rate for selecting the capital expenditure projects. The capital
budgeting decision after all is the matching of the costs of the use of funds
with the returns of the employment of funds. Thus the financial manager can
arrive at the break-even point in the capital structure the point at which the
rate of return of a given project equals the cost of procuring funds for that
project.
2. Capital Structure Decisions: The concept of cost of capital is an important
consideration in capital structure decisions. It helps to devise an optimal
capital structure with an ideal debt-equity mix based on minimum costs
Classification of cost of capital
Cost of capital can be brought as under:

Explicit Cost and Implicit Cost

Future Cost and Historical Cost

Specific Cost and Combined Cost

Average Cost and Marginal Cost
1. Explicit Cost and Implicit Cost
The explicit cost of any source of finance may be defined as the discount rate
that equates the present value of the cash inflows (that are incremental to the taking
of the financing opportunity) with the present value of its expected cash outflows. In
other words, the explicit cost is the internal rate of return the firm pays for
financing.
The implicit cost may be defined as 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. When the
earnings are retained by a firm, the implicit cost is the income which the
shareholders could have earned if such earnings would have been distributed and
invested by them.
In short, the explicit cost arises when the capital is raised and implicit cost of
capital arises whenever funds are used.
2
Page

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

2. Future Cost and Historical Cost

If future cost is the expected cost of funds for financing a project, historical
cost is the cost which has already been incurred for financing a particular project. In
financial decision making process, the relevant cost is future cost.
3. Specific Cost and Combined Cost
The cost of each component of capital, i.e., equity shares, preference shares,
debentures, loan, etc., is called the specific cost of capital. The firm should consider
the specific cost, while determining the average cost of capital.
When specific costs are combined to find out the overall cost of capital, it is
called the combined cost or composite cost. In other words, the combined or
composite cost of capital is inclusive of all costs of capital from all sources (i.e.,
equity shares, preference shares, debentures and other loans). This concept of capital
is used as a basis for accepting or rejecting the proposal in capital investment
decisions although various proposals are financed through various sources.
4. Average Cost and Marginal Cost
Average cost of capital is the weighted average of the cost of each component
of funds invested by the concern. But the weights are in proportion of the shares of
each component of capital in the total investment.
Marginal cost of capital is the cost of additional amount of capital which is
raised by a firm
Approaches of cost of capital
1. Traditional Approach
As per this approach, the cost of capital of a firm relates to its capital structure. In
other words, the cost of capital of the firm is the weighted average cost of debt and
the cost of equity. However, the raising of funds by way of debentures is cheaper.
This is mainly due to the following facts:
a. Usually, interest rate is less than dividend rates.
b. Interest is allowed as an expense while taxable profit of the company is
computed. But dividend is not allowed as an expense.
The main argument in favour of this approach is that the weighted average cost of
capital will go up with every increase in the debt content in the total capital
employed. However, the debt content in the total capital employed must be
maintained at a proper level as the cost of debt is a fixed burden. Moreover, when
the debt content goes up beyond a certain level, the investors consider the company
3
Page

too risky and their expectations from equity shares will go up.

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

2. Modigliani and Miller Approach

Under this approach, the total cost of capital of a company is constant and
independent of its capital structure. In other words, a change in the debt-equity ratio
does not affect the total cost of capital.
The main arguments of MM approach are:

The total market value of the firm and its cost of capital are independent of its
capital structure. The total market value of the firm can be calculated by
capitalising the expected stream of operating earnings at a discount rate
considered appropriate for its risk class.

The cut-off rate for investment purposes is completely independent of the way in
which investment is financed.
Assum
Assumptions
umptions of MM Approach
1. Perfect Capital Market: Trading of securities takes place in perfect capital
market. This indicates that:
a. Investors have full-fledged freedom to buy and sell securities.
b. As investors are completely knowledgeable and rational persons, they
can know at once all information and changes.
c. The buying and selling of securities does not involve costs such as
broker’s commission, transfer fees, etc.
d. The investors can borrow against securities on the same basis as the
firms can do so.
2. Homogeneous
Homogeneous Risk Classes: In case the firms expected earnings have identical
risk features, they should be considered to belong to a homogeneous class.
3. Same Expectations:
Expectations All investors have the same expectations of the net
operating income (EBIT) of firm which is used for its evaluation. There is 100
per cent dividend payout, i.e., all the net earnings of the firm are distributed to
the shareholders,
4. No Corporate Taxes: At the formulation stage of hypothesis, Modigliani and
Miller assume that there are no corporate taxes, However, they have removed
this assumption later on.
Computation of Cost Of Capital
Computation of the cost of capital involves: (i) computation of specific costs
and (ii) computation of composite cost.
4
Page

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

I. Computation of Specific Costs:

Costs: It is the computation of the cost of each
specific source of finance such as debt, preference capital and equity
capital.
1. Cost of Debt:
Debt: It is the rate of return which is expected by lenders. This is
actually the interest rate specified at the time of issue. Debt may be issued at
par, at premium or discount. It may be perpetual or redeemable.
Debt Issued at Par: The cost of debt issued at par is the explicit interest rate adjusted
further for the tax liability. It is computed in accordance with the following formula:

Debt Issued at Premium or Discount: When the debentures are issued at a premium
(more than the face value) or at a discount (less than the face value) the cost of debt
should be computed on the basis of net proceeds realised on account of issue of such
debentures.

Cost of Redeemable Debt: When debentures are redeemed after the expiry of a fixed
period, the cost of debt before tax can be computed with the help of the following
Formula
5
Page

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

2. Cost of Preference Share Capital

Even though it is not legally binding on the part of the company to pay preference
dividend, it is generally paid as and when the company earns enough profits. The
failure to pay preference dividend is a matter of serious concern on the part of the
equity shareholders. They may even lose control of the company as the preference
shareholders will enjoy the right to take part in the general meeting with equity
shareholders under certain conditions if the company fails to pay preference
dividend. The accumulation of arrears of preference dividend may adversely affect
the right to equity shareholders.

Cost of Redeemable Preference Shares:

The cost of redeemable preference shares is the discount rate which equates the net
proceeds of sale of preference shares with the present value of future dividend and
repayment of principal. But the cost of preference share capital is not adjusted for
taxes as it is not a charge against profit but an appropriation of profit.

3. Cost of Equity Capital

Cost of equity capital may be 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 its stock.
a. Dividend Price (DIP) Method
According to this approach, the cost of equity capital is computed against a required
rate of return in terms of future dividends. Thus cost of capital is defined as “the
discount rate that equates the present value of all expected future dividends per
6
Page

share with the net proceeds of the sale (or the current market price) of a share”. In

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

other words, the cost of equity capital will be that rate of expected dividends which
will maintain the present market price of equity shares

b. Dividend Price Plus Growth Method

In this approach, the cost of equity capital is calculated on the basis of the expected
dividend rate plus the rate of growth in dividend. But the rate of growth is
ascertained on the basis of the amount of dividends paid by the company for the last
few years.

c. Earning Price Approach

This method is based on the assumption that the shareholders capitalise a stream of
future earnings for evaluating their shareholdings. Thus the cost of capital relates to
that earning percentage which can keep the market price of the equity shares
constant. This approach recognises both dividend and retained earnings.
7
Page

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

d. Realised Yield Approach

Under this approach, the cost of equity capital should be ascertained on the basis of
return actually realised by the investors on their investment (i.e., on equity shares).
Thus in this approach, the past records in a given period regarding dividends and
the actual capital appreciation in the value of the equity shares held by the
shareholders should be taken to calculate the cost of equity capital.
4. Cost of Retained Earnings
Generally, the companies do not distribute the whole of the profits earned by them
by way of dividend among their shareholders. A part of such profits is retained by
them for future expansion of the business. This portion of profit is known as retained
earnings or ploughing back of profit. The cost of retained earnings is the earnings
foregone by the shareholders. In other words, the opportunity cost of retained
earnings may be taken as the cost of retained earnings. It is equal to the income what
a shareholder could have earned otherwise by investing the same in alternative
investment.
The following adjustments are required for determining the cost of retained
earnings.
a. Income Tax Adjustment: The dividends receivable by the shareholders are
subject to income tax. Thus the dividends actually received by them are the
amount of net dividend (i.e., gross dividends less income tax).
b. Brokerage Cost Adjustment: The shareholders cannot utilise the whole
amount of dividend received from the company for the purpose of investment
as they have to incur some expenses by way of brokerage, commission, etc. for
purchasing new shares against the dividend.

II. Composite or Weighted Average Cost of Capital

The term cost of capital is used to denote the overall composite cost of capital or
weighted average of the cost of each specific type of funds i.e., weighted average
cost. In other words, the composite or weighted average cost of capital is the
combined specific costs used to find out the overall cost of capital. The computation
8
Page

of weighted average cost of capital involves the following steps:

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

a. Calculate the cost of each specific source of funds.

b. Assign proper weights to specific costs.
c. Multiply the cost of each source by the appropriate weight.
d. Divide the total weighted cost by the total weights to get the overall cost of
capital.
Assignment of Weights
This involves the determination of the proportion of each source of funds in the total
capital structure of the company. For this purpose, the following three possible
weights may be used.

Book Value Weights used for actual or historical weights.

Market Value Weights used for current weights.

Marginal Value Weights used for proposed future financing.
Book Value Weights
Under this method, the relative proportions of various sources to the existing capital
structure are used to assign weights. The advantages of these weights are as follows:
1. Book values are easily available from the published annual report of a
company.
2. All companies set their targets of capital structure in terms of book values
rather than market value,
3. The analysis of capital structure on the basis of debt equity ratio also depends
on book value.
Market Value Weights
Theoretically, the use of market value weights for computing the cost of capital is
more appealing due to the following facts:
1. The market values of the securities are approximate to the actual amount to
be obtained from the sale of such securities.
2. The cost of each specific source of finance is computed in accordance with
the prevailing market price.
However, there are some practical difficulties for using market value weights. They
are as
1. Frequent fluctuation in the market value of securities is a common
phenomenon.
2. Market values of securities are not readily available like book values. But book
values are available from the published records of the company.
9
Page

St.Berchmans College [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com

3. The book value and not the market value is the base for analysing the capital
structure of the company in terms of debt-equity ratio.
Marginal Value Weights
Under this method, weights are assigned to each source of funds in proportions of
financing inputs the firm intends to employ. This method is based on a logic that the
firm is with the new or incremental capital and not with capital raised in the past.

10
Page

St.Berchmans College [2010-11] sebastiank.s@in.com