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Cost of Capital
Cost of Capital
Caselet 1
• SAIL is one of the leading producers of steel in India. As
steel is a highly capital as well as labour intensive
industry it requires high amounts of capital. During the
1990s the company borrowed heavily at a high interest
rate of 17% to finance its expansion and modernization
plans. After 2000 the money market conditions
improved and the interest rates declined to around
11%. The 6% decline in the cost of debt could give a
large savings in cash out flow on interest payments.
SAIL replaced its old high cost debt with fresh new debt
carrying low interest rate and in turn reduced its cost
of capital.
Key Financial Issues
• Capital
• Sources of capital
• Cost of capital
Significance
• Capital refers to funds that remain with the co.
for a long period of time and provide financial
support for long term uses
• Comes from various sources, each with its own
cost
• Cost of capital is the overall cost of all the sources
of capital considered together
• It is important for the co. to know its cost of
capital in order to know whether its investments
/ ventures are worthwhile or not
Significance
• Broadly capital refers to the long term sources of
financing that are generally required for financing
long term uses / investments
• Capital expenditure on setting up new plant,
expansion of operations, replacement of old
machinery, modernization, product
improvement, new product development,
product promotion and marketing etc.
• Typically such uses take place over long time
periods and require prolonged financial support
Significance…
• Multiple sources of capital
• Collectively they appear in the liabilities side of the
balance sheet
• Each source has a specific cost
• It reflects the rate of return expected by the provider
of that source of capital
• Cost of capital refers to the average cost of all the
sources of capital used by the firm
• It is the minimum rate of return that the firm should
earn on its capital employed
Contents
• Sources of capital
• Costs of specific sources of capital
• Concept of WACC
• Determination of weights / proportions
• Divisional & Project Cost of Capital
• Floatation Costs & Cost of Capital
• Interrelationship between investment &
financing
Sources of Capital
• Two broad categories:
• Shareholders’ funds (Equity)
• Debt
k wiki
Weighted Average Cost of Capital
• k = WACC,
• wi = weight of i’th source of capital
• ki = Post-tax cost of the i’th source
WACC…
• 7. Calculate the WACC given the following
data:
Source Book Value Market Value Cost (%)