Cost of capital

Cost of capital of a firm is the minimum rate of return expected by its investors. It is the weighted average cost of various sources of finance used by a firm. It may be defined as the cost of obtaining funds.
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Computation of cost of capital

A. Computation of specific source of finance B. computation of weighted average cost of capital.

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Cost of debt
i.
I Kdb= P
(When issue is at par)

Kdb=before tax cost of debt I=interest P=principal

ii. Kdb=

I NP (When issued at premium or discount)

NP=Net Proceeds
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iii. Cost of debt after tax

Kda= Kdb(1-t)=

(1-t)

NP

Kda=after tax cost of debt t=rate of tax Cost of Redeemable Debt iv. Before tax cost of debt 1 I+ n (RV-NP) Kdb= 1 2 (RV+NP)
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v. After tax cost of debt I+ 1 (RV-NP) (1-t) n 1 (RV+NP) 2

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Kdb=

Cost of preference capital

Kp=

(when issued at par)

P
D

Kp=

NP

(when issued at Premium or discount)

Cost of redeemable preference shares MV-NP D+ n 1 (MV+NP) 2 D=annual preference dividend Kpr=cost of redeemable preference shares MV=maturity value NP=net proceeds
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Kpr=
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Cost of equity share capital

Dividend yield method or dividend/price ratio method

D MP

D Ke= OR NP

Ke=cost of equity capital D=expected dividend per share NP=net proceeds per share MP=market price per share
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Dividend yield plus growth in dividend method

D0(1+g) D1 + G = Ke= NP NP
Ke= cost of equity capital D= expected dividend per share at the end of the year NP=net proceeds G=growth rate of dividends D0=previous years dividend

+ G

Earnings yield method EPS NP EPS=earning per share NP=net proceeds

Ke=

Where,the cost of existing capital is to be calculated:

Ke=

EPS MP

MP= market price per share

Earnings available for equity shareholders

EPS=
Number of equity shares
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Cost of retained earnings

The cost of retained earnings may be considered as the rate of return which the existing shareholders can obtain by investing the after tax dividends in alternative opportunities. It is the opportunity cost of dividends foregone by the shareholders.
Kr=
D1
NP + G
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Cost of retained earnings

Kr=(

D NP

+ G) x (1-t)x(1-b)

Kr=Ke (1-t) x (1-b) D=expected dividend G=growth rate NP= net proceeds of equity issue T= tax rate b= cost of purchasing new securities, brokerage cost Ke= rate of return available for new shareholders.
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Computation of weighted average cost of capital

Weighted average cost of capital is the average cost of the costs of various sources of financing.

XW Kw= W

Kw= weighted average cost of capital X = cost of specific source of finance W= weight proportion of specific source of finance.

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