Cost of CapitalCost of Capital

RaghavendraM.B.A, M.Phil, NCFM, (Ph.D)

Senior Asst. ProfessorDept. of MBAMITE

Cost of capitalCost of capital Cost of capital constitutes an integral Cost of capital constitutes an integral

part of investment decision. It provides part of investment decision. It provides a yardstick to measure the worth of a yardstick to measure the worth of investment proposal, and thus performs investment proposal, and thus performs the role of accept-reject criterion.the role of accept-reject criterion.

Also known as Also known as cut-off rate, target rate, cut-off rate, target rate, hurdle rate, minimum required rate of hurdle rate, minimum required rate of return, standard returnreturn, standard return… and so on.… and so on.

DefinitionDefinition It is defined as the minimum rate

of return that a firm must earn on its investments, for the market value of the firm to remain unchanged.

Significance of Cost of Significance of Cost of CapitalCapital

It is useful as a standard for:It is useful as a standard for: Evaluating Investment DecisionsEvaluating Investment Decisions Designing a firm’s debt policyDesigning a firm’s debt policy Appraising the financial Appraising the financial

performance of top mgtperformance of top mgt

Components of Cost of Components of Cost of capitalcapital

Cost of DebtCost of Debt Cost of preference sharesCost of preference shares Cost of equity capitalCost of equity capital Cost of retained earningsCost of retained earnings

Weighted Average Cost of CapitalWeighted Average Cost of Capital

ICost of Debt Kd = --------- (1 - T)

NP

Where I = Annual Interest Payment

T = Corporate Tax Rate

NP = Net Proceeds from Debts

Cost of Redeemable Debt (at par, premium or discount)

RV - NP

I + --------------- n

Kd= ------------------------------- (1 - T) RV + NP ------------- 2

Where I = Annual Interest Payment RV = Redeemable Value on Maturity NP = Net Proceeds from sale n = No. of years to Maturity T = Corporate Tax Rate

DCost of Preference Capital Kp = ---------------

NP

Where D = Preference Dividend

NP = Net Proceeds

(Please note: Preference shares may be issued at par, premium or discount, floatation cost may or may not be incurred. Same formula is used.)

Cost of Redeemable Preference Shares:

RV - NP

D + --------------- n

Kp = -------------------------------

RV + NP ------------ 2

Where D = Annual Dividend Payment RV = Redeemable Value on Maturity NP = Net Proceeds from sale n = No. of years to Maturity

Cost of Equity

1. Dividend Yield Method

2. Dividend Growth Model

3. Price Earning Method

4. Capital Asset Pricing Model

Cost of Equity

(Dividend Yield Method)

Annual Dividend per ShareCost of Equity = ----------------------------------------

Ke Market Price per Share

Cost of Equity

(Dividend Growth Model)

Annual Dividend per Share GrowthCost of Equity = ----------------------------------- + in

Ke Market Price per Share Dividend

Cost of Equity

(Price Earning Method)

Earning per ShareCost of Equity = --------------------------------

Ke Market price per Share

Cost of Equity

Capital Asset Pricing Model (CAPM)

Cost of Equity = Rf + B ( Rm - Rf)

Where Rf = Risk free Rate of Return

Rm = Expected Market Rate of Return

B = Beta Co-efficient of the Investment

Cost of Retained Earnings

Retained earnings accrue to a firm only because of some sacrifice made by the shareholders in not receiving the dividends out of the available profits.

“Cost of retained earnings is the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities”.

Kr = Cost of Equity Capital X ( 1 - T )

Where T = Tax Rate of Individuals

Weighted Average Cost of Weighted Average Cost of CapitalCapital(WACC)(WACC)

Is the average cost of the costs of various sources of financing. It is also known as composite cost of capital.

The weights may be given on the basis of book value or market value weights.

Usually market value weights are preferred, because it represent real or true value to the investment.

Practical problems using Practical problems using cost of capitalcost of capital