COST OF CAPITAL

The term cost of capital refers to the minimum rate of return a firm must earn on its investment.
Then

only the market value of the companys equity shares can be maintained (without fall). If a firm fails to earn a expected minimum rate, it will tend decrease the market value of shares of that company and which in turn will result in he reduction of overall wealth of the company.

According to hunt, william cost of capital defined as the rate that must be earned on the net proceeds to provide the cost element of burden at the time they are due

IT IS NOT ACTUAL CAPITAL It really means the rate of return on investment. IT IS THE MINIMUM RATE It refers to the minimum rate that will result in at least maintaining the value of equity shares.

It comprises three components RETURN AT ZERO RISK LEVEL Normal or expected rate when there is no risk in business. PREMIUM FOR BUSINESS RISKS When there is a high risk (variability in EBIT) the investor will expect high rate of return. PREMIUM FOR FINANCIAL RISKS In general it may be said that a firm having higher debt content in its capital structure, is more risky as compared to a firm which ahs comparatively low debt content. When risk is more, expected rate will also be more.

 The

above three components may be put in the form of the following equation. Symbolically: K=ro + B +f Where , K = Cost of Capital ro = Return at Zero Risk level B = Business Risk Premium f = Financial risk Premium

Cost of capital may be classified into the following types on the basis of nature and usage:
Explicit

and Implicit Cost Explicit cost- is the rate that the firm pays to procure Implicit cost -is the rate of return associated with the

financing.
best investment opportunity for the firm and its shareholders that will be forgone if the projects presently under consideration by the firm were accepted.

Average and Marginal Cost Historical and Future Cost Specific and Combined Cost Fixed and semi variable cost Controllable and un controllable cost

 Capital

Budgeting Decision: Designing the corporate financial structure: Decision about the method of financing: Optimum resources mobilization: Evaluation of performance of top management Other areas of decision making:

 Conceptual

controversies regarding the relationship between cost of capital and capital structure Historic cost and future cost Problems in computation of cost of equity Problems in computation of retained earnings Problems in assigning weights

COST OF CAPITAL
COST OF EQUITY COST OF DEBT COST OF PREFERED CAPITAL

COST OF RETAINED EARNINGS

COST OF OVERALL CAPITAL

 Cost of Debt-

Generally, the cost of debt (Debentures and Long term debt) is defined in terms of the required rate of return that the debtinvestment must yield to protect the shareholders interest Cost of Preference sharesPreference shares are the fixed cost bearing securities where the rate of dividend is fixed in advance at the time of their issue.

 Cost of equity shares -

--Dividend Price Approach-the cost of equity share capital is calculated on the basis of a required rate of return in terms of future dividends to be paid on equity shares for maintaining their present market price, --Dividend Price Plus Growth Approach-the cost of equity share capital is determined on the basis of the expected dividend rate plus the rate of growth in dividend

--Earnings Price Approach (or) Earnings price Ratio (or) Earnings yield method--Here the earning per share determines the market price of equity shares. --Realized yield approach--This is based on the actually realized rate of return by shareholders in the past. The cost of equity share capital is computed on the basis of past records of dividends actually realized by the equity shareholders COST OF RETAINED EARNINGSRetained Earnings are the accumulated amount of undistributed profits belonging to the equity shareholders,

 Weighted

Average, and not the simple average, is relevant in calculating the overall cost of capital. The composite cost of all capital lies between the least and the most expensive funds. This approach enables the maximization of corporate profits and the wealth of the equity shareholders by investing the funds in a project earning in excess of the cost of its capital-mix. Book Value Approach: Market Value Approach: