Cost of

Capital
 Introduction
 The cost of capital is the cost of a
company's funds
(both debt and equity)or,from an
investor's point of view "the expected
return on a portfolio of all the
company's existing securities".
 It is used to evaluate new projects of a
company as it is the minimum return
that investors expect for providing
capital to the company, thus setting a
benchmark that a new project has to
meet.
 Definition
 “The cost of capital is the minimum required
rate of earnings or the cut-off rate of
expenditure” -Solomon Ezra

 “The cost of capital represents a cut-off rate

for the allocation of capital to investments of
projects. It is the rate of return on a project
that will leave unchanged the market price of
the stock.” -James C. Van Horne
What does cost of capital
mean?
 The cost of capital is the rate of
return that capital could be
expected to earn in an alternative
investment of equivalent risk.

 Costof capital includes the cost of

debt and the cost of equity
 Importance of Cost of
Capital
The concept of cost of capital is
crucial in financial management.
Like any other source of finance
has a cost and cannot, therefore,
be used in the most effective
manner unless that cost can be
accurately determined and taken
into account.
 TYPES OF COST OF
CAPITAL
1)COST OF EQUITY (Ke)
2) COST OF TERM LOAN(Kt)
3)COST OF DEBT (Kd)
4)COST OF PREFRENCE SHARES (Kp)
5)COST OF RETAINED EARNINGS
 Cost of Equity
 The annual rate of return that an
investor expects to earn when
investing in shares of a company
is known as the cost of equity. It is
denoted by Ke.

 Formula-
Ke = D X 100
P
Cost of term loan
 Costof debt capital is associated with
the amount of interest that is paid on
currently outstanding debts. It is
denoted by Kt.

Formula-
 Cost of Debt = I (1 - TAX)
I = Interest
 Cost of Debenture
Cost of debenture capital is
associated with the amount of
interest that is paid on
currently outstanding debts. It
is denoted by Kd.
Formula-
 Cost of Debenture = I (1 - TAX)+ (f-p)/n
---------------------------
(f+p)/2
Cost of Preference shares
 The preference share capital is different from
equity share capital on account of two basic
features :
 1)the preference shares are entitled to
receive dividends at a fixed rate in priority
over equity shares.
 2)in case of liquidation of the company ,the
preference shareholders will get the capital
repayment in priority over the distribution
among the equity share holders.
 It is denoted by Kp.
Cost of Preference shares
 Cost of prefernce capital is associated
with the amount of interest that is
paid on currently outstanding
preference shares. It is denoted by Kp
Formula-
 Cost of preference = D+ (f-p)/n
SHARES ---------------------------
(f+p)/2
Cost of Retained Earnings
In accounting, retained
earnings refers to the portion
of net income which is
retained by the corporation
rather than distributed to its
owners as dividends.
 Weighted Average
Cost of Capital
A calculation of a firm's cost
of capital in which each
category of capital is
proportionately weighted.
Formula-
 WACC = TOTAL WEIGHTED COST X 100
TOTAL CAPITAL
Capital Structure
Capital structure refers to the
way a corporation finances its
assets through some combination
of equity, debt, or hybrid
securities. A firm's capital
structure is then the composition
or 'structure' of its liabilities.
 Debt financing
 Debt financing is basically money
that you borrow to run your
business.

Types-
 Long term debt financing .
 Short term debt financing.
 Capital Budgeting
 Capitalbudgeting is the planning
process used to determine whether
a firm's long term investments such
as new machinery, replacement
machinery, new plants, new
products, and research development
projects are worth pursuing.
Pay back period
 Thelength of time required to
recover the cost of an investment.

 Formula-
 Return On New
Invested Capital
Acalculation
used, either by a firm
or investors, to determine the
amount of return that a firm
could earn on additional
contributed capital.
 Risk
The chance that an
investment's actual
return will be different than
expected.This includes the
possibility of losing some or
all of the original investment.