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Capital Cost
Capital Cost
Cost of capital refers to the payment that a firm has to make to the suppliers of capital. This
include dividend payment to equity or preference and interest payment to debentures. The
term cost of capital is generally used in the sense of the overall cost of capital
Ko=kew1+krw2+kpw3+kdw4
Ko=Overall cost of capital
ke = Cost of equity
Kr =cost of retained earning
kp = cost of preference shares
Kd =after tax cost of debt
W1= proportion equity to total capital
W2 = proportion of retained earnings to total capital
Relevance of cost of capital
It is important criterion in many decision making areas.
In investment decisions to decide about profitability of the
proposal
Leveraging that is equity and debt mix to reduce the average
cost of capital
In working capital management
In performance evaluation
Specific or explicit cost
An explicit cost is a cost that occurs, is easily identified, and is
accounted for in business documents or financial statements. It
represents clear, obvious cash outflows that reduce a business's
bottom-line profitability. Examples of explicit costs would be
items such as wage expenses, rent, or lease costs; it is easy to
identify the sources of those cash outflows and the
business activities to which the expenses are attributed.
Implicit costs can also be called imputed, implied or notional
costs. Businesses don’t necessarily record implicit costs for
accounting purposes because money does not change hands.
These costs represent loss of potential income and not of profits.
A company may choose to include these costs as the cost of
doing business since they represent possible sources of income.
Difference Between Implicit and Explicit Costs
Implicit costs are technically not incurred and therefore cannot
be measured accurately for accounting purposes. There are no
cash exchanges in the realization of implicit costs. However, they
are important costs to ascertain because they help managers
make effective decisions on behalf of the company.
Cost of equity share capital
Earnings/price model
Dividend growth model
Earnings growth model
Capital asset pricing model
Earnings/price model
Ke=E/P
E= earning per share
P= current market price per share
Dividend growth model
Ke =(D/P)+g
D= dividend per share at the end of a period
P= current market price
G=growth rate in dividend
Earnings growth Model
Ke= (E/P)+g
Ke =(D/P(1-f))+g
F= floating charges
Capital asset pricing model
On this basis, the most commonly accepted method for calculating cost of equity
comes from the Nobel Prize-winning capital asset pricing model (CAPM): The cost of
equity is expressed formulaically below:
Where:
Kr=Ke(1-t)(1-C)
C= Commission,brokerage
External yield criterion
Kr = Ke =(D/P)+g
Kr = Ke= (E/P)+g
Cost of preference share
When preference shares are issued at par or at a premium or
discount
Kp =D/I
D= Annual dividend
I = Net proceeds of the preference shares
issued
Preference shares are paid after tax so no
need for adjustment of tax
When preference shares are issued at a premium or discount and
are redeemable after the expiry of a given perion(n) the
following formula is used:
kp =D+(1/n(P-I))½(P+I)
D= Annual dividend payable
P= Face value of preference shares
I= Issue price of shares
Tax on dividends
A domestic company is required to pay tax at 10% on the
amount of dividend paid to its sharholders(both equity and
preference).Accordingly in computing the cost of equity and cost
of preference, ‘D’ should be adjusted by the factor(1+t) where t
represents the rate of dividend tax
Ke =(D(1+t)/P)+g
Cost of Debt
Debt issued at par
Kd = r(1-t)
r= Interest rate payable
t= Marginal tax rate of the firm
Redeemable debt issued at a discount or
premium
Kd = (C+(1/n)(P-I))(1-t)/(1/2)(P+1)
c= Fixed interest charges per annum
P=Face value of the debenture
I= Price at which the debenture or bond
is sold
t=Marginal tax rate
Perpetual debt
Debts may be issued for a perpetuity.or calculating the explicit
cost of debt, the formula for a perpetuity would be as follows:
Kd = (C/I)(1-t)