COST OF CAPITAL

MUHAMMAD ISAMESAL
What is Cost Of Capital
“The cost of capital is the minimum required rate of
earnings or the cut-off rate of expenditure.” – Solomon
Erza

“The cost of capital represents a cut-off rate for the

allocation of capital to investment project. It is the rate of
return on a project that will leave unchanged the market
price of stock.” – James Van Home
 • The cost of capital aids business and investors in
evaluating all investment opportunities. It does
What is the so by turning future cash flows into present value
importance of by keeping it discounted.
• The cost of capital can also aid in making key
Cost Of company budget calls that use company financial
Capital? sources as capital.
• In a cost of opportunity scenario, the cost of
capital can be used to evaluate the progress of
ongoing project and investment by matching up
the progress of those investments against the
cost of capital.
TYPES OF COST OF
CAPITAL
1. COST OF EQUITY
2. COST OF DEBT
3. COST OF PREFERENCE SHARES
4. COST OF RETAINED EARNINGS
COST OF EQUITY
The annual rate of return that an investor expects to earn when investing in shares of a
company is known as the cost of equity.

A. Retained Earnings
Management should retain earnings only if they earn as much as stockholder’s next best
investment opportunity

Cost of Retained Earning = opportunity cost of common stockholders’ funds

Cost of retained earnings must equal common stockholders required rate of return
Cost of Retained Earnings

Three methods to determine Cost of Retained Earnings

1. Capital Asset Pricing Method (CAPM)

2. Risk Premium Model
3. Dividend Growth Model or Discounted Cash Flow (DCF)
 B. New Common Stock

COST OF If retained earnings cannot provide all the equity capital that
is needed, firms may issue new shares of common stock
EQUITY
Uses Dividend Growth Model but must adjust for flotation
cost of the stock
COST OF DEBT

Cost of debt capital is associated with the

amount of interest that is pain on
currently outstanding debts.
 COST OF PREFERENCE SHARES
The preference share capital is different from equity
share capital on account of two basic features :
1. The preference shares are entitled to receive
dividends at a fixed rate in priority over equity
shares
2. In case of liquidation of the company , the
preference shareholders will get the capital
repayment in priority over the distribution
among the equity share holders.