COST OF CAPITAL

Cost of Capital
• Cost of capital is the required return necessary to make
a capital budgeting project.

• Cost of capital includes the cost of debt and the cost of

equity, and is used by companies internally to judge
whether a capital project is worth the expenditure of
resources, and by investors who use it to determine
whether an investment is worth the risk compared to the
return.
Cost of Capital
• Cost of capital refers to the opportunity cost of making a
specific investment. It is the rate of return that could have
been earned by putting the same money into a different
investment with equal risk. Thus, the cost of capital is the
rate of return required to persuade the investor to make a
given investment.
Cost of Capital Funding Sources

• Sources of funding for capital budgeting vary from

company to company and depend on factors such
as operating history, profitability, creditworthiness.
Cost of Capital Funding Sources
The firms different sources of financing are:

Debt financing : Debt financing is basically money that you

borrow to run your business.

Types:
Long term debt financing.
Short term debt financing.
Cost of Capital Funding Sources
The firms different sources of financing are:

Debt financing : Debt financing is basically money that you

borrow to run your business.

Types:
Long term debt financing.
Short term debt financing.
Cost of Capital Funding Sources
The firms different sources of financing are:

Owned Capital
• Owned capital also refers to equity capital. It is sourced
from promoters of the company or from the general public
by issuing new equity shares. Promoters start the
business by bringing in the required capital for a startup.
Cost of Capital Funding Sources
The firms different sources of financing are:

Government grants and subsidies

• Government agencies provide financing such as grants
and subsidies that may be available to your business.
Weighted Average Cost of Capital
• A calculation of a firms cost of capital in which each
category of capital is proportionately weighted.

• A firm's cost of capital from various sources usually differs

somewhat between the different sources of capital. "Cost
of capital" may vary, that is, for funds raised with bank
loans, the sale of bonds, or equity financing.

• As a result, Weighted average cost of capital (WACC)

represents the appropriate "cost of capital" for the firm as
a whole.
Weighted Average Cost of Capital
• A calculation of a firms cost of capital in which each
category of capital is proportionately weighted.

• A firm's cost of capital from various sources usually differs

somewhat between the different sources of capital. "Cost
of capital" may vary, that is, for funds raised with bank
loans, the sale of bonds, or equity financing.

• As a result, Weighted average cost of capital (WACC)

represents the appropriate "cost of capital" for the firm as
a whole.
Weighted Average Cost of Capital
• WACC is the average after-tax cost of a company’s
various capital sources, including common
stock, preferred stock, bonds, and any other long-term
debt. In other words, WACC is the average rate a
company expects to pay to finance its assets.
Weighted Average Cost of Capital
Formula:

Where:
• E = Market value of the firm’s equity
• D = Market value of the firm’s debt
•V=E+D
• Re = Cost of equity
• Rd = Cost of debt
• Tc = Corporate tax rate
How to Calculate WACC

• WACC is calculated by multiplying the cost of each capital

source (debt and equity) by its relevant weight, and then
adding the products together to determine the value.

• In the above formula, E/V represents the proportion of

equity-based financing, while D/V represents the
proportion of debt-based financing.

• WACC formula is the summation of two terms – [(E/V) *

Re] and [(D/V) * Rd * (1-Tc)]. The former represents the
weighted value of equity-linked capital, while the latter
represents the weighted value of debt-linked capital.
Cost of Capital Funding Sources
The firms different sources of financing are:

Debt financing : Debtfinancing 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 firms long term investments such as new
machinery, replacement machinery, new plants, new products, and
research development projects are
• 15. Pay back period Thelength of time required to recover the cost
of an investment. Formula-
• 16. Return On New Invested Capital A calculationused, either by a
firmor investors, todetermine the amount ofreturn that a firmcould
earn on additional
Weighted Average Cost of Capital
Formula:
• WACC = TOTAL WEIGHTED COST X 100 TOTAL
CAPITAL