COST OF CAPITAL

The cost of capital is the expected return that is required on

investments to compensate you for the required risk. It represents the
discount rate that should be used for capital budgeting calculations.
The cost of capital is generally calculated on a weighted average basis
(WA!.

It is alternatively referred to as the opportunity cost of capital or the
required rate of return.

It is calculated based on the expected average rate of return of
investors in a "rm
CALCULATING COST OF CAPITAL

Numerical Example :
#oon Investments $alance %heet shows&

$onds ' ())*)))
ommon shares ' ())*)))
+etained ,arnings ' -))*)))
.............
' /))*)))
000000000
$onds:
1 Annual interest rate 23
1 4ears to maturity is 5 years

ommon shares&
1 %hares held -))*)))
1 urrent share price '/
1 #arket return over next year -(3
1 $eta (somewhat risky! -.-/
1 Treasury bills currently yield 63

1 Tax rate (/3
Calculation of Cost of Capital:
7irst* determine market values
1 $onds&
78 0 '())*)))
Interest per year 0 '())*))) x ).)2 0 '-(*)))
9 (number of years! 0 5
i (interest rate! 0 23
:8 (present value of the bonds!
%
: 0 ..........
(-;rt!


' ())*)))
: 0 .............
<- ; ().)2!
5
=

' ())*)))
: 0 ..............
-./6

: 0 '-(5*>?).-(


Lets cec! it out:
Interest per year 0 '-(5*>?).-( x ).)2 0 '?*?5(.(-
Interest for nine years 0 ' ?*?5(.(- x 5 0 ' ?)*-(5.>>
Amount to be paid at maturity 0
' -(5*>?).-( ; ' ?)*-(5.>> 0 ' ())*))) (this is the face value!.

1 ommon %hares&
-))*))) shares x ' / 0 ' /))*)))

Secon"# "etermine $ei%tin%s &ase" on mar!et 'alues:
$onds ' -(5*>?) ).()2(
ommon shares ' /))*))) ).?5@>
............... .........

' 2(5*>?)

-.))))
(should always be -!
Tir"# "etermine costs:
1 ommon shares&
+ate of return 0 +isk.free rate (treasury bills rate! ; <market return
over next year 1 risk free rate=$eta
0 ).)6 ;().-( .).)6!-.-/
0 ).)6 ; ).)5(
0 ).-@(
1 $onds&
:8 0 ' -(5*>?)
78 0 ' ())*)))
i (after tax! 0 ' -(*))) (- 1 ).(/!
0 ' -(*))) x ).?/
0 ' 5*)))
,Aective rate 0 ' 5*)))B' ())*))) 0 ).)6/ or 6./3

Finall(# "etermine cost of capital
Weightings osts Weightings x osts
$onds ).()2( ).)6/ ).))5@
ommon %hares ).?5@> ).-@( ).-)6>
.........
).--6-
000000
ost of apital 0 --.6-3