Cost of Capital

Meaning
Cost of Capital means cost of obtaining funds i.e. average rate of return that the investors in a firm would expect for supplying funds to the firm. OR It is the minimum rate of return which a firm, must and is expected to earn on its investments so as to maintain the market value of its shares

Significance of Cost of capital

Helpful in capital Budgeting Helpful in capital structure decisions Helpful in evaluating the financial performance Basis for other financial decisions like dividend policy, working capital decisions etc.

Classification of Cost of capital

Historical cost and Future cost Specific cost and composite cost Explicit cost and Implicit cost Average cost and Marginal cost

Computation of Cost
Cost of Specific Source of finance Composite Cost of Capital

Cost of Debt
In case of Irredeemable debt Kdb = I/P Kdb = Before tax cost of debt I = Interest P = Principal Kdb = I/NP Where NP= Net proceeds Kda = Kdb(1-t) t = tax rate

Redeemable debt Kdb = I + 1/n (RV-NP)/ (RV+NP) Kda = Kdb (1-t) At Premium = I + 1/n (RV-NP)/ (RV+NP)

Cost of Preference Capital

Kp = D/P Where D = Annual Preference dividend P = preference Share Capital (Proceeds) Kp = D/NP Redeemable Preference Shares Kpr = D+1/n( MV-NP)/1/2 (MV+NP) Where MV = Maturity value of Preference shares

Cost of Equity Share Capital

Dividend yield Method Ke = D/NP or D/MP Where D = Expected dividend per share NP =Net Proceeds per share MP = Market Price per share Dividend yield plus growth in dividend method Ke = D1 /NP + G Or D0 (1+g) / NP + G

Earning Yield Method Ke = Earnings per share / Net Proceeds Or = Earnings per share / Market Price per share

Cost of Retained Earnings

Kr = D /NP + G Where Kr = Cost of retained earnings D = expected dividend NP = Net Proceeds of share issue G = Rate of Growth

Weighted Average cost of Capital

Weighted Av. Cost of capital is the average cost of the costs of various sources of financing. Also known as Composite cost of capital Weights are assigned either on Book value basis or Market Value basis.

Marginal Cost of Capital

Cost of Capital of the additional funds is called the Marginal Cost of Capital. If the additional financing uses more than one source, say a combination of debt and equity, then the WACC of new financing is called the Weighted Marginal Cost of Capital ( WMCC)

Calculation of WMCC
1. The WMCC is calculated on the basis of market value weights because the new funds are to be raised at the market values. 2. The specific cost of capital can be accurately calculated.