Unit 2

Cost of capital
MEANING OF COST OF CAPITAL

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and
the debt-holders) to the business as a compensation for their contribution to the total capital. When
an entity (corporate or others) procured finances from either sources as listed above, it has to pay
some additional amount of money besides the principal amount. The additional money paid to
these financiers may be either one off payment or regular payment at specified intervals. This
additional money paid is said to be the cost of using the capital and it is called the cost of capital.
Definition of cost of capital
J. C. Van Horne, "Cost of capital is 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 un-changed the market price of the
stock"
Lawrence J. Gitman, "The cost of capital is the rate of return a firm must earn on its
investments for the market value of the firm to remain unchanged. It can also be thought of
as the rate of return required by the market suppliers of capital in order to attract needed
financing at a reasonable price"
SIGNIFICANCE OF THE COST OF CAPITAL

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 as a basis for evaluating the
performance of a firm and it further helps management in taking so many can
also be used other financial decisions
1. As an Acceptance Criterion in Capital budgeting: In the 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 the firm'. Capital budgeting
decisions can be made by considering the cost of capital. According to the
present value method of capital budgeting, if the present value of
expected returns from investment is greater than or equal to the cost of
investment, the project may be accepted; otherwise; the project may be
rejected. The present value of expected returns is calculated by
discounting the expected cash inflows at cut-off rate (which is the cost of
capital). Hence, the concept of cost of capital is very useful in capital
budgeting decision.
2. As a Determinant of Capital Mix in Capital Structure Decisions: Financing
the firm's 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's assets. While designing an optimal capital strucutre, the
management has to keep in mind the objective of maximising the value
of the firm and minimising the cost of capital. Measurement of cost of
capital from various sources is very essential in planning the capital
structure of any firm.

3. As A Basis for Evaluating the Financial Performance: In the words of S.K.

Bhattacharya the concept of cost of capital can be used to 'evaluate the
financial performance of top management. The actual profitability of the
project is compared to the projected overall cost of capital and the actual
cost of capital of funds raised to finance the project If the actual
profitability of the project is more than the 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,
capitalisation of profits, making the rights 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 cost refers to the cost of a specific
source of capital while composite cost is combined cost of various sources of
capital. It is the 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 the 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: An explicit cost is the discount rate which
equates the present value of cash inflows with the present value of cash
outflows. In other words, it is the internal rate of return.
Implicit cost also known as the opportunity cost is the cost of the opportunity
foregone in order to take up a particular project. For example, the implicit cost
of retained earnings is the rate of return available to shareholders by investing
the funds elsewhere.

5. 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 cost 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.

Computation of cost of capital

1. Computation of specific source of finance
2. Computation of weighted average cost of capital
Computation of weighted average cost of capital
1. Cost Of Debt
The cost of long-term debt has two basic components. One is the annual
interest, and the other arises from the amortization of discounts given or
premiums received when the debt is initially issued. In order to simplify
the calculations in this section, annual interest payments on debts are,
only, taken into account.
Features of debentures or bonds:
(i) Face Value: Debentures or Bonds are denominated with some
value; this denominated value is called face value of the debenture.
Interest is calculated on the face value of the debentures. E.g. If a company
issue 9% Non- convertible debentures of `100 each, this means the face
value is ` 100 and the interest @ 9% will be calculated on this face
value.
(ii) Interest (Coupon) Rate: Each debenture bears a fixed interest
(coupon) rate (except Zero coupon bond and Deep discount bond).
Interest (coupon) rate is applied to face value of debenture to calculate
interest, which is payable to the holders of debentures periodically.
(iii) Maturity period: Debentures or Bonds has a fixed maturity
period for redemption. However, in case of irredeemable debentures
maturity period is not defined and it is taken as infinite.
(iv) Redemption Value: Redeemable debentures or bonds are
redeemed on its specified maturity date. Based on the debt covenants
the redemption value is determined. Redemption value may vary from
the face value of the debenture.
(v) Benefit of tax shield: The payment of interest to the debenture
holders are allowed as expenses for the purpose of corporate tax
determination. Hence, interest paid to the debenture holders save the
tax liability of the company. Saving in the tax liability is also known as tax
shield.

(i) Cost of debt, irredeemable debentures

COST OF PREFERENCE SHARE CAPITAL
 The preference share capital is paid dividend at a specified rate on face value of preference
shares. Payment of dividend to the preference shareholders are not mandatory but are
given priority over the equity shareholder. The payment of dividend to the preference
shareholders are not charged as expenses but treated as appropriation of after tax profit.
Hence, dividend paid to preference shareholders does not reduce the tax liability to the
company. Like the debentures, Preference share capital can be categorized as redeemable and
irredeemable.

Cost of Redeemable Preference Shares

Preference shares issued by a company which are redeemed on its maturity is called
redeemable preference shares. Cost of redeemable preference share is similar to the cost
of redeemable debentures with the exception that the dividends paid to the
preference shareholders are not tax deductible. Cost of preference capital is
calculated as follows:

Cost of Irredeemable Preference Shares

The cost of irredeemable preference shares is similar to calculation of
perpetuity. The cost is calculated by dividing the preference dividend with the
current market price or net proceeds from the issue. The cost of irredeemable
preference share is as below:
Cost of Irredeemable Preference Share (KP) = PD/NP

Where,
PD = Annual preference dividend
NP= Net proceeds in issue of preference shares
Cost of equity capital
Cost of retained earning

The cost of retained earnings is calculated by using the following formula

= rate of return available to shareholder