COST OF CAPITAL

MEANING, CONCEPT, DEFINITION

The cost of capital is minimum rate of return expected by its investors. It is the
weighted average cost of various sources of finance used by a firm. The capital
used by firm may be in form of debt, retained earnings, and equity shares. The
concept of cost of capital is very important in the financial management. A
decision to invest in particular depends on cutoff rate or cost of capital expected by
firm. In case a firm is not able to achieve even the cutoff rate, the market value of
share will fall down. In fact, cost of capital is the minimum rate of return expected
by its investors which will maintain the market value of shares at its present level.
The investors have cost of capital of a firm or minimum rate of return expected by
its investors has a direct relation with the risk involved in the firm. Generally,
higher the risk involved in a firm, higher is the cost of capital.

Cost of capital for a firm may be defined as the cost of obtained funds, i.e
the average rate of return that the investors in

A firm would expect for supplying funds .in the words of Hunt, William and
Donaldson, “cost of capital may be defined as the rate that must be earned on net
proceeds to provide the cost elements of the burden at the time they are due”.

James c.van Horne defines cost of capital as “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 stock”

According to Solomon Ezra ,”cost of capital is the minimum required rate of

earnings or cutoff rate of capital expenditure “.

Thus, we can say that cost of capital is that minimum rate of return which a firm,
must and is expected to earn on its investments so as to maintain the market value
of its shares.
IMPORTANCE
The concept of cost of capital is very important in the financial management. It
plays a crucial role in both capital budgeting as well as decisions relating to
planning of capital structure. Cost of capital concept can also be used as a basis for
evaluating the performance of a firm and it further helps management in taking so
many other financial decisions.

1 AS AN ACCEPTANCE CRITERION IN CAPITAL BUDGETING

In other words of James T.S PosterField “the concept of cost of capital has
assumed growing importance largely because of the need to devise a rational
mechanism for making the investment decisions of firm. Capital budgeting
decisions can be made by considering cost of capital. According to the present
value method of capital budgeting , if present value of expected returns from
investment is greater than or equal to the cost to the cost of investment, the project
may be accepted ;otherwise ; the project may be rejected.

2 AS A DETERMINANT OF CAPITAL OF CAPITAL MIX IN

CAPITAL STRUCTURE DECISIONS.
Financing the firms assets is a very crucial problem in every business and as a
general rule there should be a proper mix of debt and equity capital in financing a
firm assets. While designing an optimal capital structure, the management has to
keep in mind the objective of maximizing the value of firm and minimizing the
cost of capital.

3 AS A BASIS FOR EVALUATING THE FINANCIAL

PERFORMANCE.
The actual profitability of the project is compared to the projected overall cost of
capital and actual cost of capital of funds raised to finance the project if the actual
profitability of the project is more than projected and the actual cost of capital, the
performance may be said to be satisfactory.
4. AS A BASIS FOR TAKING OTHER FINANCIAL DECISIONS.
The cost of capital is also used in making other financial decisions such
as dividend policy, capitalization of profits, making the right issue and
working capital.
CLASSIFICATION OF COST
1. Historical Cost and Future Cost : Historical costs are book costs which
are related to the past. Future costs are estimated costs for the future. In
financial decisions future costs are more relevant than the historical costs.
However, historical costs act as guide for the estimation of future costs.
2. Specific Cost and Composite Cost: Specific costs refers to the cost of
a specific source of capital while composite cost is combined cost of various
sources of capital. It is a weighted average cost of capital. In case more than
one form of capital is used in the business, it is the composite cost which
should be considered for decision making and not specific cost. But where
only one type of capital is employed the specific cost of that type of capital
may be considered. In capital structure decisions, it is the weighted average
cost of capital which should be given consideration.
3. Explicit Cost and Implicit Cost: The firm or company pays some
amount to finance the funds like interest on debt, preference dividend, equity
dividend. Implicit cost is the cost associated with the best alternative
opportunity forgone. Opportunity cost of earning dividend on
reserves/surplus being distributed among equity shareholders.
4. Average Cost and Marginal Cost: An average cost refers to the
combined cost of various sources of capital such as debentures, preference
shares and equity shares. It is the weighted average cost of the costs of
various sources of finance. Marginal costs of capital refers to the average
cost of capital which has to be incurred to obtain additional funds required
by a firm. In investment decisions, it is the marginal cost which should be
taken into consideration.
DETERMINANTS OF COST OF CAPITAL
It has already been stated that cost of capital plays a crucial role in
the decisions relating to financial management. However, the determination
of cost of capital is not an easy task because of both conceptual problems as
well as uncertainities of proposed investment and the pattern of financing.
The major problems concerning the determination of cost of capital are
discussed as below:

Problems in determination of cost of capital

1. Conceptual controversies regarding the relationship
between the cost of capital and the capital structure:
Different theories have been propounded by the different authors
explaining the relationship between capital structure, cost of capital
and the value of firm. According to the Net Income Approach and the
traditional theories both the cost of capital as well as the value of the
firm have a direct relationship with the method and level of financing.
On the other hand, Net Operating Income and Modigilani and Miller
Approach prove that the cost of capital is not affected by changes in
the capital structure.
2. Historic cost and future cost: another problem in the
determination of cost of capital arises on account of the difference of
opinion as regards the concept of cost itself. It is argued that historic
costs are book costs which are related to the past and are irrelevant in
the decision making process. In their opinion, future estimated costs
are more relevant for decision making.
3. Problems in computation of cost of equity: The computation of
cost of equity capital depends upon the expected rate of return by
investors. But the quantification of expectations of equity
shareholders is a very difficult task bcause there are many factors
which influence their valuation about a firm.
4. Problems in the computation of cost of retained earnings: It
is sometimes argued that retained earnings don’t involve any cost. But
in reality, it is the opportunity cost of dividends foregone by its
 shareholders. Since shareholders may have different opportunities for
investing their dividends, it becomes very difficult to compute the cost
of retained earnings.
5. Problems in assigning weights: For determining the weighted
average cost of capital, weights have to be assigned to the specific
cost of individual sources of finance. The choice of using the book
value of the source or the market value of the source poses another
problem in the determination of cost of capital.

Computation of cost of capital

Computation of overall cost of capital of a firm involves:
A. Computation of cost of specific source of finance
B. Computation of weighted average cost of capital

COMPUTATION OF SPECIFIC SOURCE OF FINANCE

Computation of each specific source of finance viz, debt, preference
shares capital, equity share capital and retained earnings is discussed as below:

1. COST OF DEBT
A company may raise debt in a variety of ways. It may borrow funds from
financial institutions or public either in the form of public deposits or
debentures for a specified period of time at a certain rate of interest. A
debenture or bond may be issued at par or at a discount or premium. The
contractual rate of interest forms the basis for the calculating the cost of
any form of debt. For example, a company issues Rs.1,00,000 10%
debentures at par ; the before tax cost of this debt issue will also be 10%.
By way of formula, before-tax-cost of debt may be calculated as:

Kdb : I/P
Where I= Interest
 P= Issue price or current market value or paid up
par value
Issue price= par value+ prem. on issue of debt- discount
on issue of debt- floating charges

Cost of debt after tax

KDA = I(1-t)/P *100

Where T= taxes
Cost of redeemable debt
Usually, the debt is issued to be redeemed after a certain period during the life time
of a firm. Such a debt issue is known as Redeemable Debt. The cost of redeemable
debt capital may be calculated as :

Before tax cost of debt

Kdb = I+1/n(RV- NP)

(RV+NP)/2
After tax cost of debt

Kdb = I(1-t)+1/n(RV- NP)

(RV+NP)/2
 Where RV= Redemption value i.e. par value + Prem. on redemption
NP= No. of years after which redemption will take place
t= Tax rate

COST OF PREFERENCE CAPITAL

The cost of preference capital is a function of the dividend expected by investors.
Preference capital is never issued with an intention not to pay dividends. Although
it is legally binding upon the firms to pay the dividends on preference capital, yet it
is generally paid when the firm makes sufficient profits. The failure to pay
dividends, although doesnt cause bankruptcy, yet it can be a serious matter from
the ordinary shareholders point of view. It will affect the fund raising capacity of
the firm. Hence, dividends are usually paid regularly on preference shares except
when there are no profits to pay dividends. The cost of preference capital which is
perpetual can be calculated as:

Cost of Irredeemable Preference Shares

KP= D/P *100 0

Cost of Redeemable Preference Shares

Kpr = D+1/n(RV-NP)
1/2(RV +NP)
Where D= Preference dividend
P 0 = Either net proceeds or Market value or Paid up par value

COST OF EQUITY CAPITAL

The cost of equity is the maximum rate of return that the company must earn on
equity financed portion of its investment in order to leave unchanged the market
price of its stock. The cost of equity capital is a function of the expected return by
its investors. The cost of equity is not the out-of-pocket cost of using equity capital
as the equity shareholders are not paid dividend at a fixed rate every year.
Shareholders invest money in equity shares on the expectations of getting dividend
and the company must earn this minimum rate so that the market price of the
shares remains unchanged. Whenever company wants to raise additional funds by
the issue of new equity shares, the expectations of the shareholders have to be
evaluated. The cost of equity share capital can be calculated in the following ways:

 DIVIDEND MODEL (NO GROWTH SITUATION) : According

to this method, the cost of equity capital is the discount rate that equates
the present value of expected future dividends per share with the net
proceeds of a share. The basic assumptions underlying this method are that
the investors are that the investors give prime importance to dividends and
risk in the firm remains unchanged. The dividend price ratio method
doesn’t seem to consider growth in dividend. The method is suitable when
company has stable earnings and stable dividend policy over a period of
time.

KE = D/P *100 0

 DIVIDEND MODEL (GROWTH SITUATION): When the

dividends of the company are expected to grow at a constant rate and the
dividend pay out ratio is constant this method may be used to compute the
cost of equity capital. According to this method the cost of equity capital is
based on the dividends and the growth rate.

KE = D /P *100 + G
1 0

Where D1 = Dividend after one year

D1 = D0*(1+G)
G = Growth rate of dividend

 EARNING PER SHARE MODEL (NO GROWTH

SITUATION): According to this method , cost of equity capital is the
discount rate that equates the present value of expected future earnings per
share with the net proceeds of a share.
 KE = Earning Per Share
PO
Where EPS= Total Earning for Equity Shareholders
No. of Equity Share

 CAPITAL ASSET PRICING MODEL (CAPM): The value of an

equity share is a function of cash inflows expected by the investors and the
risk associated with the cash inflows. It is calculated by discounting the
future stream of dividends at the required rate of return , called
capitalization rate. The required rate of return depends upon the element
of risk associated with investment in shares.

COST OF RETAINED EARNINGS

It is sometimes argued that retained earnings donot involve any cost because a
firm is not required to pay dividends on retained earnings. However, the
shareholders expect the return on retained profits. The cost of retained earnings
may be considered as the rate of return which the existing shareholders can obtain
by investing the after tax dividends in the alternative opportunities of equal
qualities. It is thus opportunity cost of dividends foregone by the shareholders.
Cost of retained earning can be calculated with the help of following formula:

CASE I: When brokerage cost is given

 KR= KE (1-t) (1-b)
Where KR = Cost of Retained Earning
KE = Cost of Equity Share
b = Brokerage rate in %
t = Tax rate

CASE II : In all other cases

KR= KE
WEIGHTED AVERAGE COST OF CAPITAL
Weighted average cost of capital is the average cost of capital of various sources of
financing. Wt average cost of capital is also known as composite cost of capital,
overall cost of capital or average cost of capital. Once the specific cost of
individual source of finance it’s determined, we can compute the wt average cost
of capital by putting weights to the specific costs of capital in proportion of the
various sources of funds to the total. The weights may be giving either by using
book value of the source or market price of the source.the market value weights is
preferred to book value weighs because market value represents true value of the
investors. However,the market value weights suffer from the following
limitations :

1) It is very difficult to determine market value because of frequent fluctuation

2) with the use of market value weights, equity capital gets greater importance.
SOME PRACTICAL PROBLEMS
a) X ltd issues Rs 50000 8%debentures at par. The tax rate application to the
company is 50%.compute the cost of debt capital.

b) Y ltd issues Rs 50000 8% debentures at premium of 10%.the tax rate is

applicable to the company is 60%.compute cost of debt capital.

c) A ltd issues Rs 50000 8% debentures at a discount of 5%. The tax rate is

50%.compute the cost of debt capital.

d) B ltd issues Rs 100000 9% debentures at premium of 10%.the cost of flotation

are 2%. The tax rate applicable is 60%. Compute cost of capital
A company issues 10000 10% preference shares of Rs 100 each .cost of issue is
Rs 2 per share. Calculate cost of preference capital if these shares are issued
(a)at par (b) at premium of 10 % (c) at a discount of 5%.
A company issues 1000 75 preference shares of Rs 100 each at premium of 10 %
redeemable after 5 years at par. Compute the cost of preference capital?
A company issues 1000 equity shares of Rs 100 each at premium 10 % the
company has been paying 20% dividend to equity shareholders for the past five
years and expects to maintain for future also. Compute the cost of equity
capital. will it make difference if market price of equity shares is Rs 160?

A company plans to issue 1000 new shares of Rs 100 each at par. the flotation
cost are expected to be 5% of the share price . The company pays a dividend of
Rs 10 per share initially and growth in dividends is expected to be 5%.compute
cost of issue of new equity shares?

b) If current market price of equity share is Rs 150. Calculate the cost of equity
share capital?
A firm cost of equity is 15 % the average tax rate of shareholder is 40% and it is
expected that 2% is brokerage cost that shareholder will have to pay while
investing their dividends in alternative securities. What is cost of retained
earnings?

Q. X ltd has provided following figures regarding cost of various sources of

finance
10%debentures Rs100 each- Rs1,00,00,00
12% Preference shares Rs10 each Rs500000
200000 Equity shares Rs10 each Rs2000000
Retained earnings Rs500000
The market value of debentures, preference shares, equity shares are
Rs105, 13, 20 respectively.
Cost of debt 6%, preference 10%, equity 15%
Find out overall cost of capital by
i. Book value weights
ii. Market value weights