-CONCEPT & SIGNIFICANCE

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„ The term cost of capital refers to the maximum rate of
return a firm must earn on its investment so that the
market value of company's equity shares does not fall.
„ This is an consonance with the overall firm's objective of
wealth maximization.
„ This is possible only when the firm earns a return on the
projects financed by equity shareholders' funds at a rate
which is at least equal to the rate of return expected by
them. If a firm fails to earn return at the expected rate, the
market value of the shares would fall and thus result in
reduction of overall wealth of the shareholders.
„ Thus, a firm's cost of capital may be defined as "the rate of
return the firm requires from investment in order to
increase the value of the firm in the market place".
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„ When we say a firm has a Dzcost of capitaldz of, for
example, 12%, we are saying:
º The firm can only have a positive NPV on a project if
return exceeds 12%
º The firm must earn 12% just to compensate investors
for the use of their capital in a project
„ Thus cost of capital depends primarily on the
USE of funds, not the SOURCE of funds
„ For the purpose of assessment and
encashment of opportunities, the finance
manager needs a Benchmark rate.
„ This rate is called the discount rate or the
hurdle rate.
„ If the returns exceed the benchmark, accept
the project or else reject it.
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    Cost of capital may be used as the
measuring road for adopting an investment proposal. The firm,
naturally, will choose the project which gives a satisfactory return on
investment which would in no case be less than the cost of capital
incurred for its financing. In various methods of capital budgeting, cost
of capital is the key factor in deciding the project out of various
proposals pending before the management. It measures the financial
performance and determines the acceptability of all investment
opportunities.

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           The cost of

capital is significant in designing the firm's capital structure.
The cost of capital is influenced by the chances in capital
structure. A capable financial executive always keeps an eye
on capital market fluctuations and tries to achieve the sound
and economical capital structure for the firm. He may try to
substitute the various methods of finance in an attempt to
minimise the cost of capital so as to increase the market price
and the earning per share.
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     A capable financial executive
must have knowledge of the fluctuations in the capital market and should
analyse the rate of interest on loans and normal dividend rates in the market
from time to time. Whenever company requires additional finance, he may
have a better choice of the source of finance which bears the minimum cost
of capital. Although cost of capital is an important factor in such decisions,
but equally important are the considerations of relating control and of
avoiding risk.

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       The cost of capital can be used to

evaluate the financial performance of the top executives. Evaluation of the
financial performance will involve a comparison of actual profitabilities of
the projects and taken with the projected overall cost of capital and an
appraisal of the actual cost incurred in raising the required funds.

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! " The concept of cost of capital is also important in many
others areas of decision making, such as dividend decisions, working capital
policy etc.



 

„ A firmǯs overall cost of capital must reflect the
required return on the firmǯs assets as a whole
„ If a firm uses both debt and equity financing, the
cost of capital must include the cost of each,
weighted to proportion of each (debt and equity)
in the firmǯs capital structure
„ This is called the Weighted Average Cost of
Capital (WACC)
„ WACOC will be one single number that will
take into account the expectations of all the
suppliers of capital.
„ In order to develop the single number, we
need to consider the cost of suppliers of all
kinds of capital, individually.
„ Then consider the proportion of each kind of
capital
„ Then the weighted average is calculated.
„ WACOC = we x re + wp x rp + wd x rd
„ where,
we = proportion of Equity
re = cost of Equity
wp = proportion of Preference capital
rp = cost of Preference capital
wd = proportion of Debt
rd = cost of Debt
 6  

„ COST OF REDEEMABLE DEBT:

P0 = υ [ Ct / (1 + rd) t + R / (1 + rd) N ]

WHERE, P0 = current market price of debenture

Ct = coupon payments (interest)
r d = cost of debenture
R = redemption value
N = no. of periods left to maturity
„ COST OF PERPETUAL DEBT:
P0 = Ct / rd

Post Ȃ tax Cost of Debt

= rd ( 1 Ȃ T)
where T = corporate tax rate
‰
  
 
 
„ fixed rate or floating rate?
„ The coupon rate in case of fixed rate bonds
are decided on the basis of capital market
conditions prevailing at the time of issue.

„ If the firm is visiting the capital market for the

first time????





„ Cost on due diligence, road shows,

advertising, printing application forms,
underwriting etc.

„ Costs associated with the mobilization of

funds.

„ These costs increase the cost of debt

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„ In order to be consistent with the conditions

prevailing in the capital market the debt may
be issued at a discount/ premium to the face
value.
„ Redemption of the debenture may also be at
a discount / premium to the face value.

„ Floatation cost would increase the cost of the

debt while premium over the face value
would reduce it.
„ rd = C(1 Ȃ T)+(f + d/p + pm/dm)/N
(P0 + R)/ 2
 6 "##$  "Ú %

„ P0 = υ [ Dt / (1 + rP) t + R / (1 + rP) N ]
WHERE, P0 = current market price of preference
shares
Dt = dividend payments
r p = cost of preference share capital
R = redemption value
N = no. of periods left to maturity
 6 &'Ú
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„ Cost of equity capital is the most difficult to

ascertain due to the absence of any
obligation to pay any explicitly stated cost.
„ However, it does not mean that the cost of
equity is zero.
·

„ #

$%
$
&
re = D/ Po
Where D = Dividend
NP/MP/Po = net proceeds or market
price or current market price.
Ke/re = cost of equity
„ #

$%
$'$($
&
re = (D1/Po)+g
Where g = growth rate
Also dividend for current year(D1) = D0 x (1+g)
„ Y  $%
$
&
re = EPS/Po
Where EPS = earnings per share
EPS = PAT Ȃ preference dividend (if any)
no. of equity shares
„ Realised yield method:
re = Actual dividend distributed/Po
„ $"$ $
$D"
&
re = rf + Ⱦ x (rm Ȃ rf)
Where rf = expected return on risk free securities
Ⱦ = expected risk of the project
rm = expected return on the market
6! 
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„ $$
&
rd = interest payment/Po (at par)
rd = interest payment/Po - discount
(at discount)
rd = interest payment/Po + premium
(at premium)
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rd = Interest payments (1 Ȃ tax rate)/Po (at par,
discount, premium)
„ Floatation cost :
rd = Interest payments (1 Ȃ tax rate)/Po (at par,
discount, premium)
Po = Po Ȃ floatation cost
„ Redeemable debt:
re = interest payment + (RV Ȃ Po)/n
(RV + Po)/2
After tax:
re = interest payment + (RV Ȃ Po)/n x (1 Ȃ tax rate)
(RV + Po)/2
Where RV = redeemable value (at par, premium or
discount)
Po could also be at par, premium or discount