- Cost of capital is the minimum rate of return that a company must earn on its investments to maintain its market value and attract funds. It represents the weighted average cost of all sources of financing, including equity, debt, preferred stock, and retained earnings.
- The cost of capital is used to evaluate capital projects and determine if their expected returns are adequate. It is also used to assess the company's capital structure and evaluate financial performance.
- Cost of capital is calculated by determining the costs of individual sources of financing weighted by their proportions of total capital. This provides the overall weighted average cost of capital for the firm.
Operating leverage affects a company's operating profit and measures changes in earnings before interest and taxes relative to sales changes. It helps understand costs and pricing strategies. Degree of operating leverage quantifies how operating income changes with sales. Higher operating leverage means larger profits from increased sales but more risk, while lower leverage means smaller profits but less risk from fluctuating sales. Overall, higher leverage can be better if sales are stable but most companies prefer lower leverage.
This chapter discusses cost behavior analysis and how to classify costs as either variable or fixed. Variable costs change proportionally with activity levels, while fixed costs remain constant over a relevant range of activity. The chapter provides examples of variable costs like materials and fixed costs like rent. It also discusses mixed costs that have both fixed and variable components. Managers can use scattergraph plots of total cost versus activity levels to diagnose the behavior of different costs. The goal is to understand how costs change with production volumes to aid in planning and decision making.
This document discusses methods for calculating the cost of equity for a company. It defines cost of equity as the minimum return required to attract investors to invest in a company's common stock. Two main models are described: the capital asset pricing model (CAPM) and dividend discount model. Under CAPM, cost of equity equals the risk-free rate plus the stock's beta coefficient multiplied by the market risk premium. Under the dividend discount model, cost of equity equals dividends in the next period divided by the current stock price plus the growth rate. Examples are provided to demonstrate calculating cost of equity for Caterpillar Inc. under both models.
This document discusses cost of capital and capital structure. It defines different types of capital like equity, debt, and preference shares. It explains how to calculate the overall cost of capital by determining the costs of each capital type and weighting them. The document also summarizes different approaches to determining an optimal capital structure, including EBIT/EPS analysis, valuation approaches, and cash flow analysis. It reviews relevant, irrelevant, and neutral capital structure theories, as well as Modigliani-Miller theory which argues capital structure does not affect firm value under certain assumptions.
This document discusses various theories of capital structure, which is the mix of debt and equity used by a company to finance its operations and growth. It describes the net income approach, which argues that firm value increases with more debt due to lower costs. The net operating income approach argues that firm value is independent of capital structure. The traditional approach finds an optimal capital structure that balances these views. Modigliani-Miller theory also argues that firm value is independent of capital structure under certain assumptions. The document provides formulas and diagrams used in each theory.
The document discusses dividend policy, including the meaning of dividends and different types of dividend policies companies can adopt. It also outlines several factors that influence a company's dividend decisions, such as earnings stability, financing needs, liquidity, and growth opportunities. Finally, it describes different forms of dividends including cash, stock, scrip and property dividends, and their potential merits and demerits.
FINANCAL MANAGEMENT PPT BY FINMANLeverage and capital structure by bosogon an...Mary Rose Habagat
This document discusses leverage and capital structure. It begins by defining leverage as the use of fixed costs to magnify returns, and discusses how leverage increases risk and return. The document then outlines 6 learning goals covering topics like breakeven analysis, the different types of leverage (operating, financial, total), and theories of capital structure. It provides examples and formulas to demonstrate concepts like calculating breakeven points and measuring the degrees of different types of leverage.
This document discusses operating and financial leverage. It defines operating leverage as the use of fixed operating costs, which can increase sensitivity to sales changes. Financial leverage refers to the use of fixed financing costs. The document explains how to calculate break-even points, degree of operating leverage, and degree of financial leverage. It also shows how financing choices like debt, equity or preferred stock affect earnings per share through an EBIT-EPS analysis.
This document discusses absorption costing and marginal costing. Absorption costing treats all manufacturing costs, including fixed and variable costs, as product costs. Marginal costing treats only variable manufacturing costs as product costs and regards fixed costs as period costs. Breakeven analysis determines the level of sales or production at which total revenue equals total costs. It can be used to calculate the breakeven point, target profit, margin of safety, and the impact of changes in costs, revenues, and profits.
- The objective of for-profit firms is to maximize profits by setting the price where marginal revenue equals marginal cost, known as profit maximization.
- Profits are calculated as total revenue from sales minus the costs of resources used. Firms will produce as long as marginal cost is less than marginal revenue.
- In addition to profit maximization, firms may also pursue objectives like revenue maximization, sales maximization, or share price maximization to satisfy various stakeholders. However, achieving these other objectives ultimately depends on the firm's ability to earn profits.
This document discusses subsidies and taxation as tools to correct market failures. It explains that subsidies aim to change relative prices and are given to producers, while taxation can be specific or ad valorem and is typically levied on producers. Both subsidies and taxes can distort markets by shifting supply curves and altering price signals. Their welfare effects depend on who bears the costs and benefits.
The document discusses capital structure, which is the mix of debt and equity used to finance a firm. The value of a firm is equal to the value of its debt plus the value of its equity. The optimal capital structure maximizes firm value by balancing the debt-equity ratio. Factors that influence the capital structure decision include business risk, taxes, financial flexibility, growth opportunities, and market conditions. Leverage increases risk for shareholders but also increases potential returns, as interest payments are tax deductible. Higher debt leads to greater financial risk.
The dividend payout ratio measures the percentage of a company's net earnings that are paid out in dividends. It is calculated by dividing the total dividend amount by the net income. A lower payout ratio indicates that more earnings are being retained for reinvestment, while a higher ratio means more earnings are being distributed to shareholders. The payout ratio is important for investors to consider because it provides information about how much cash a company is willing to pay out versus reinvesting for future growth.
This document discusses different methods for evaluating portfolio performance:
- Portfolio managers evaluate performance to identify strengths and weaknesses and improve strategies. Evaluation provides feedback in the final stage of the investment process.
- Sharpe's index measures risk-adjusted return by comparing the portfolio's excess return over the risk-free rate to the total risk in the portfolio. A higher index indicates better performance.
- Treynor's index also measures risk-adjusted return but uses systematic risk (beta) rather than total risk. A higher Treynor index means more risk premium earned per unit of market risk.
- Jensen's alpha measures the excess return of a portfolio above what would be predicted by the security's beta. A positive alpha
Equity shareholders are not paid dividend at a fixed rate every year. The distribution of dividend depends upon the profitability of the company.
The cost of Equity share is the minimum rate of return company has to earn.
The cost of equity capital several models have been proposed. The cost of equity capital is calculated based on the following approaches:
Dividend price ratio approach
Earning price ratio approach
Dividend Price + Growth Rate of Earnings (p+g) Approach
Realised yield approach
This document discusses the concepts of cost and revenue and how they relate to profit maximization for firms. It defines key cost concepts like fixed vs variable costs, historical vs replacement costs, and private vs social costs. Cost is determined by factors like plant size, output level, input prices, productivity, technology, and management efficiency. In the short run, total costs increase with output while average costs initially decrease and then increase due to limitations on varying fixed costs. Maximizing profit requires increasing revenue and decreasing costs.
The document discusses the cost of capital, which is defined as the minimum rate of return that a company must earn on its investments to satisfy its investors. It outlines different sources of capital such as equity, debt, and retained earnings. It then provides formulas to calculate the specific costs of different sources of capital, including cost of debt, cost of preference shares, cost of equity, and cost of retained earnings. The document emphasizes that the cost of capital is important for companies to consider when evaluating investment projects.
This document discusses optimal capital structure and includes the following key points:
1. An optimal capital structure maximizes a company's market value while minimizing the cost of capital by striking a balance between risk and return. It occurs when the market price per share is at its maximum and cost of capital is at its minimum.
2. Several illustrations are provided to demonstrate how changes in the debt-equity mix impact total market value and overall cost of capital. Adding more debt initially increases value but can eventually increase costs if debt levels rise too high.
3. The document also defines capital structure, lists some features of an optimal structure, and outlines several theories of capital structure, including the Net Income Approach and Modigl
Target costing Prepared By Melwin MathewMelwin Mathew
Target costing is a cost management tool used to reduce the overall cost of a product over its lifecycle. It was developed by Toyota in 1965 in response to rising costs and fewer opportunities for cost reductions late in development. The target costing process involves determining a target price based on market research, then working backwards to establish a target cost per unit by determining required profit levels. The goal is to motivate cross-functional teams to innovatively design products that meet cost targets and ensure planned profit levels.
The document discusses dividend policy and its theories of relevance and irrelevance. It states that dividend policy refers to a board's decision on distributing residual earnings to shareholders. There are two choices - pay dividends or reinvest funds. The theories of irrelevance suggest dividend policy does not impact stock price or cost of capital, while relevance theories like Walter's model and Gordon's model suggest dividends are relevant. Gordon's model shows the value of a stock is equal to the present value of future perpetual dividend growth at a constant rate.
Cost of capital is the minimum rate of return that a company must earn on its investments to maintain its market value and attract funds. It considers the weighted average cost of each component of capital, such as equity, debt, and retained earnings. Calculating the cost of capital is important for capital budgeting decisions, determining the optimal capital structure, and evaluating financial performance. There are various methods to measure the specific costs of different sources of capital and calculate the overall weighted average cost of capital.
This document discusses the cost of capital and its components. It defines cost of capital as the minimum rate of return a firm must earn on its investments to maintain its market value and earnings per share. There are three components to cost of capital: the zero risk return, premium for business risk, and premium for financial risk. Cost of capital can be calculated using an equation that adds these three components. The document also discusses different types of cost of capital such as marginal vs average cost, explicit vs implicit cost, future vs historical cost, specific vs combined cost, and spot vs normal cost. Methods for calculating cost of capital include computing the specific cost of each source of funds and the composite or weighted average cost of capital.
This document discusses the cost of capital. It defines cost of capital as the minimum rate of return that a firm must earn on its investments to maintain its value. Cost of capital has several components, including the return at zero risk, and premiums for business risk and financial risk. The document also discusses the different types of capital like debt, equity and retained earnings, and how to compute the cost of each. It explains weighted average cost of capital is calculated by weighting the costs of different sources of capital by their proportions.
This document discusses the cost of capital. It defines cost of capital as the minimum rate of return that a firm must earn on its investments to maintain its value. Cost of capital has several components, including the return at zero risk level and premiums for business risk and financial risk. The document also covers the classification, computation, and importance of cost of capital. It provides formulas for calculating the costs of different sources of capital like debt, preference shares, equity, and retained earnings. It concludes with the weighted average cost of capital formula.
Cost of Capital Calculation and introduction.pptxanshikagoel52
This document discusses the calculation and components of the cost of capital. It defines cost of capital as the minimum rate of return required by a company to maintain the value of its stock. The document outlines the short-term and long-term financial requirements of businesses. It also discusses the various sources of financing including shares, debentures, retained earnings, and loans. The components of cost of capital including the return at zero risk level, premium for business risk, and premium for financial risk are defined. Methods for calculating the cost of specific sources such as debt, preference shares, equity, and retained earnings are presented.
The document discusses the concept of cost of capital, which is the minimum rate of return a firm must earn on its investments to satisfy investors and maintain its market value. It is the reward or opportunity cost for using capital from various sources like equity, debt, and retained earnings. The cost of capital is important for capital budgeting decisions, designing the optimal capital structure, and evaluating financial performance. It helps investors understand the firm's expected returns and inherent risks.
The main types of dividends are cash dividends which are payments made to shareholders in cash, bonus shares which increase the number of shares held, and special dividends which are additional non-recurring payments over regular dividends usually due to abnormal profits. Dividends can also be interim dividends paid during the year or annual dividends paid once a year. Regular cash dividends refer to the expected annual dividend payments a company aims to maintain.
Cost of capital is the minimum rate of return that a firm must earn on its investments to satisfy its investors. It incorporates the costs of different sources of capital like debt, equity, and preference shares. The cost of capital is used as a hurdle rate in capital budgeting - projects must earn more than the cost of capital to be accepted. It is also used to calculate economic value added and in leasing vs purchasing decisions. The cost of capital represents the minimum return required by investors given the risk of the firm's operations and financial structure. It is a key consideration in investment evaluation, debt policy design, and assessing management performance.
The document discusses capital structure and cost of capital. It defines financing decisions as raising funds to meet investment needs, mostly through borrowing. A company must determine its optimal debt-equity ratio or capital structure when making financing decisions. The cost of capital is also an important consideration, as the company must pay back funds in the future. Different capital structure theories, such as the net income approach and net operating income approach, provide different perspectives on optimizing capital structure and minimizing cost of capital.
In economics and accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company.
The document defines the cost of capital as the rate of return a company must pay to its various sources of funding. There is variation in cost of capital due to different levels of risk associated with different types of investments. It is used to evaluate investment projects by comparing projected returns to required returns. The cost of capital consists of the costs of different sources of funding like equity, debt, preferred stock, and retained earnings. It is an important consideration in capital budgeting and structure decisions. Methods for calculating the specific costs of different sources are also provided.
The document discusses the cost of capital. It defines cost of capital as the minimum return expected by investors for providing capital to a company. It includes the costs of debt, equity, preference shares, and retained earnings. The weighted average cost of capital takes the costs of different sources of capital weighted by their proportions. Calculating cost of capital is important for capital budgeting and evaluating new projects and investments.
This document discusses the concept of cost of capital. It defines cost of capital as the minimum required rate of return needed to justify the use of capital from both an investor and firm perspective. It also discusses the different types of capital (debt, equity, preferred shares) and methods to calculate their individual costs, including weighted average cost of capital (WACC). Factors that affect the cost of capital are also outlined.
This document discusses the cost of capital. It defines cost of capital as the minimum rate of return required to make a capital budgeting project worthwhile. It includes the cost of debt and equity. The cost of capital is a weighted average of the cost of debt and equity. The document discusses methods for calculating the cost of equity such as the dividend price approach, earnings/price approach, and capital asset pricing model approach. It also discusses factors that affect a company's capital structure and dividend decisions.
This document discusses the concept of cost of capital and how to calculate it. It explains that the cost of capital is the minimum required rate of return for a project or firm given the risks. It then outlines different methods for calculating the cost of capital, including the weighted average cost of capital (WACC) and capital asset pricing model (CAPM). The document also discusses using market values versus book values for weights and calculating divisional or project specific costs of capital.
This document discusses the cost of capital and how it is calculated. It begins by defining cost of capital as the minimum rate of return a company must earn on an investment to maintain its value. It then discusses the different costs that make up the overall cost of capital, including:
- Cost of equity, which is the rate investors use to value the company's future dividend payments. It can be calculated using the dividend valuation model or capital asset pricing model.
- Cost of debt, which is the after-tax interest rate the company pays on its borrowed funds.
- Cost of preferred shares.
It explains that the weighted average cost of capital (WACC) weights each of these costs based on the
This document discusses capital structure, leverage, and cost of capital. It defines capital structure as how a firm finances its operations through various sources of funds like debt and equity. Capital structure planning is important for long-term survival and makes the balance sheet strong. Optimal capital structure seeks to lower cost of capital and maximize firm value. Leverage refers to using assets or funds with fixed costs to magnify returns, and there are three types: operating, financial, and combined. Cost of capital includes return at zero risk, business risk premium, and financial risk premium. It is used for capital budgeting, determining capital mix, and evaluating financial performance.
The document discusses the cost of capital and defines it as the minimum return required by investors to invest in a company. It discusses the different components of cost of capital including cost of equity, cost of debt, and cost of preference shares. It also discusses weighted average cost of capital and capital structure. The importance of understanding cost of capital for financial management and capital budgeting is highlighted. Key terms discussed include debt financing, capital budgeting techniques like payback period and return on new invested capital. Risk is also introduced as a key consideration.
Controlling is the process of evaluating actual performance against planned performance to ensure objectives are met. It is a continuous process and looks both backward and forward. A good control system ensures plans are implemented successfully, employees work with commitment, and resources are used optimally. Key control techniques include budgetary control, cost control, inventory control, break-even analysis, profit and loss control, statistical analysis, and audits. Control is essential for effective management.
This document discusses the different types of working capital needed by businesses. It defines working capital as the capital required for short-term financing of current assets like cash, inventory, and receivables. Working capital is classified as either permanent/fixed or temporary/variable. Permanent working capital is the minimum level needed to operate, while temporary working capital fluctuates with seasonal or special business needs. The document also differentiates between gross working capital as total current assets and net working capital as current assets minus current liabilities.
The document discusses the nature and objectives of business. It defines business as economic activities aimed at producing and trading goods and services for profit. A business provides value to customers and society by meeting needs. Its goals include earning profit, growing, gaining power and market leadership, and providing quality products, services, and jobs. Objectives of business are both economic, like earning profit and innovating, and social, like supplying quality goods at fair prices and generating employment. Businesses also aim to satisfy human needs by treating employees and customers well. Nationally, businesses should contribute to goals like self-sufficiency and development. The nature of business today is vast and global in scope, with challenges like information overload, diversification, and environmental
This document discusses research problems and research design. It defines a research problem as a statement identifying an issue or situation to be studied. Selecting and properly defining the research problem is the first step. The document outlines various sources that can inspire research problems, such as deductions from theory, interdisciplinary perspectives, and interviews. It also discusses the importance of formulating a research problem and lists several benefits, such as providing structure and avoiding unnecessary steps. The document then defines research design as the plan and strategy for investigating research questions. It discusses the basic purposes of a research design in providing answers and controlling variance. The key parts of a research design are also outlined.
This document discusses hypothesis and sampling. It defines a hypothesis as a proposition about variables that can be empirically tested. A hypothesis guides research by making predictions to be validated. Good hypotheses are clear, specific, testable, related to theory and techniques. Hypotheses can originate from hunches, other studies, theories, culture, analogy or experience. There are different types like simple, complex, directional and non-directional. Hypotheses are important as they focus research, test theories, describe phenomena and suggest policies or new theories.
1. The document discusses capital structure, which refers to the mix of long-term financing sources like equity, debt, and retained earnings.
2. It provides definitions of capital structure and discusses factors that determine an optimal or appropriate capital structure, including profitability, risk, flexibility, and control.
3. An optimal capital structure maximizes firm value and minimizes average cost of capital, but this is difficult to achieve due to various conflicting considerations. The document examines various capital structure theories.
This document discusses research problems and research design. It begins by defining a research problem as some difficulty a researcher wants to solve, either theoretically or practically. Key components of a research problem include the individuals involved, objectives, environment, and possible outcomes. Properly identifying and formulating a research problem is important. The document then discusses research design, defining it as the conceptual framework for a research study. Key parts of research design include sampling, observation, statistics, and operational aspects. A good research design provides structure and limits errors.
This document discusses project management and the project identification process. It defines a project as having well-defined objectives and timelines. Project management is applying processes, methods, and skills to achieve project objectives on time and on budget. The key steps in project identification are conceiving project ideas from various sources, choosing the right industry, seeking opportunities, and making final decisions. Project management helps define plans, establish schedules, create teamwork, maximize resources, manage costs and risks, and handle changes. It is crucial for completing projects successfully.
This document provides an introduction to cost accounting, including definitions of key terms like cost, cost accounting, cost unit, and cost center. It describes the objectives of cost accounting and classifications of costs such as direct vs indirect costs, fixed vs variable costs, and normal vs abnormal costs. It also outlines common cost accounting methods like job costing, process costing, and operating costing and provides examples of basic and advanced cost sheets.
This document discusses labour costs and labour turnover. It defines direct and indirect labour, and how labour costs are divided. Direct labour costs are associated with altering the product, while indirect labour refers to wages for non-production workers. High labour turnover indicates instability, while low turnover can mean inefficient workers are being retained. Causes of turnover include personal reasons, unavoidable reasons like layoffs, and avoidable reasons like lack of promotion opportunities. Effects of turnover include reduced output and increased costs. The document outlines several methods for measuring labour turnover rates. Finally, it discusses remuneration systems like time rates and piece rates that are used to pay workers.
This document discusses material control and inventory management. It defines key terms like materials, inventory, and different stock levels. It describes the objectives and operations of material control like purchasing, inspection, and storage of materials. Methods to determine economic order quantity, set stock levels like reorder point, minimum and maximum levels are presented. Documentation for material procurement, storage, and issuance are covered. Pricing methods for materials issued like FIFO, LIFO, simple average and weighted average are also summarized.
This document provides an introduction to management accounting. It defines management accounting as accounting that provides financial information to assist management with planning, controlling, and decision making. Management accounting derives information from financial accounting and cost accounting. It is used internally and provides both monetary and non-monetary information for purposes such as forecasting, budgeting, and performance analysis. The document outlines the objectives, characteristics, scope, functions, and techniques of management accounting and compares it to financial accounting and cost accounting.
This document provides an overview of accounting concepts and processes. It defines accounting as the process of recording, classifying, and summarizing financial transactions, and communicating the results to interested parties. The key concepts discussed include the accounting equation, money measurement, accrual accounting, and matching principle. It also describes the accounting process, from recording transactions to preparing financial statements. Finally, it discusses the different types of accounts, books, and accounting systems used such as journals, ledgers, cash books, and subsidiary records.
This document provides an overview of entrepreneurial development and the concept of entrepreneurship. It discusses the evolution of how "entrepreneur" has been defined over time, from military expedition leaders to individuals undertaking business risks. Key individuals who contributed definitions, like Cantillon and Schumpeter, are outlined. Entrepreneurial traits like psychological, sociological, and economic factors are examined. The document also covers qualities, functions, and classifications of entrepreneurs as well as their significance for economic development through job creation, innovation, and harnessing local resources.
This document discusses capital structure, which refers to the mix of long-term financing sources like equity shares, preference shares, long-term loans, debentures, bonds, and retained earnings that comprise a firm's permanent capital. It defines capital structure according to various authors and distinguishes it from financial structure, which includes both long-term and short-term liabilities. The objectives of capital structure are to minimize the overall cost of capital and maximize firm value. Factors that determine an appropriate capital structure include profitability, solvency, flexibility, conservatism, control, and legal requirements.
This document provides an introduction to management accounting. It begins by defining the three main categories of accounting: financial accounting, cost accounting, and management accounting. It then proceeds to explain each category in more detail and provide their key objectives and characteristics. The document also compares and contrasts management accounting with financial accounting and cost accounting. Finally, it outlines the scope of management accounting and lists some of the common tools and techniques used in management accounting, such as budgeting, standard costing, ratio analysis, and discounted cash flow.
This document provides an introduction to management accounting. It begins by defining the three main categories of accounting: financial accounting, cost accounting, and management accounting. It then proceeds to explain each category in more detail and provide their key objectives and characteristics. The document also compares and contrasts management accounting with financial accounting and cost accounting. Finally, it outlines the scope of management accounting and lists some of the common tools and techniques used in management accounting, such as budgeting, standard costing, ratio analysis, and discounted cash flow.
Public Expenditure & its Classifications, Canons, Causes, Effects & Theories....Dr T AASIF AHMED
The meaning, classifications, canons, theories, effects, and trends in public spending are all included in this ppt. This has been prepared to aid students in understanding and help them achieve the best grade possible. Kindly provide your insightful opinions and recommendations. For additional details, get in touch with Dr. T. Aasif Ahmed.
Understanding Urban Land Markets: Characteristics, Influencing Factors, and G...Aditi Sh.
This presentation provides an in-depth exploration of urban land markets, focusing on their defining characteristics and influencing factors. It covers the concept and types of urban land markets, and delves into the governance structures that regulate these markets. Additionally, the presentation includes a comprehensive PESTEL analysis with real-world examples to enhance understanding of the various factors impacting urban land markets.
1. COST OF CAPITAL
Dr. S. BELLARMIN DIANA
ASSISTANT PROFESSOR
DEPARTMENT OF MANAGEMENT STUDIES
BON SECOURS COLLEGE FOR WOMEN, THANJAVUR
2. COST OF CAPITAL
Cost of capital is an integral part of investment decision as it is used to measure the worth
of investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of capital
is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are
using different sources of finance, the finance manager must take careful decision with regard to
the cost of capital; because it is closely associated with the value of the firm and the earning
capacity of the firm.
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its
market value and attract funds. Cost of capital is the required rate of return on its investments
which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected
rate, the market value of the shares will fall and it will result in the reduction of overall wealth of
the shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and concept
of the cost of capital.
• According to the definition of John J. Hampton “Cost of capital is the rate of return the
firm required from investment in order to increase the value of the firm in the market
place”.
• According to the definition of Solomon Ezra, “Cost of capital is the minimum required
rate of earnings or the cut-off rate of capital expenditure”.
• According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for the
allocation of capital to investment of projects. It is the rate of return on a project that will leave
unchanged the market price of the stock”.
• According to the definition of William and Donaldson, “Cost of capital may be defined as the rate
that must be earned on the net proceeds to provide the cost elements of the burden at the time they
are due”.
Assumption of Cost of Capital
Cost of capital is based on certain assumptions which are closely associated while calculating and
measuring the cost of capital. It is to be considered that there are three basic concepts:
3. 1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and financial risk.
Cost of capital can be measured with the help of the following equation.
K = rj + b + f.
Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
CLASSIFICATION OF COST OF CAPITAL
Cost of capital may be classified into the following types on the basis of nature and usage:
• Explicit and Implicit Cost.
• Average and Marginal Cost.
• Historical and Future Cost.
• Specific and Combined Cost.
Explicit and Implicit Cost
The cost of capital may be explicit or implicit cost on the basis of the computation of cost of
capital. Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of
return associated with the best investment opportunity for the firm and its shareholders that will
be forgone if the projects presently under consideration by the firm were accepted.
Average and Marginal Cost
Average cost of capital is the weighted average cost of each component of capital employed by
the company. It considers weighted average cost of all kinds of financing such as equity, debt,
retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is the
additional cost of capital when the company goes for further raising of finance.
Historical and Future Cost
Historical cost is the cost which as already been incurred for financing a particular project. It is
based on the actual cost incurred in the previous project.
4. Future cost is the expected cost of financing in the proposed project. Expected cost is calculated
on the basis of previous experience.
Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained earnings and loans is called as
specific cost of capital. It is very useful to determine the each and every specific source of capital.
The composite or combined cost of capital is the combination of all sources of capital.
It is also called as overall cost of capital. It is used to understand the total cost associated with the
total finance of the firm.
IMPORTANCE OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to decide the
capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to net
present value method, present value of cash inflow must be more than the present value of cash
outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses
particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take
decision regarding structure.
Importance to Evolution of Financial Performance
Cost of capital is one of the important determine which affects the capital budgeting, capital
structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market value
of share, earning capacity of securities etc. hence, it plays a major part in the financial management.
COMPUTATION OF COST OF CAPITAL
Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
5. Measurement of Cost of Capital
It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the firm to
determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return that a firm
must earn on the equity financed portion of an investment project in order to leave unchanged the
market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.
Dividend Price Approach
The cost of equity capital will be that rate of expected dividend which will maintain the present
market price of equity shares.
Dividend Price Plus Growth Approach
The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in
dividend.
D
Ke = ______+g
NP
Ke = Cost of equity capital
D = Expected Dividend per share
Np = Net proceeds of an equity share
g= Growth in expected dividend
D
Ke = ______
NP
Ke = Cost of equity capital
D = Dividend per share
Np = Net proceeds of an equity share
COST OF EQUITY ON THE BASIS OF MARKET
PRICE
D
Ke = ______
MP
6. Earning Price Approach
Cost of equity determines the market price of the shares. It is based on the future earnings prospects
of the equity.
Realized Yield Approach
It is the easy method for calculating cost of equity capital. Under this method, cost of equity is
calculated on the basis of return actually realized by the investor in a company on their equity
capital.
Cost of Debt
Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par,
at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par
Debt issued at par means, debt is issued at the face value of the debt.
DEBT ISSUED AT PREMIUM
E
Ke = ______
NP
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share
Ke = PVf xD
Ke = Cost of equity capital
PVf = Present value of discount factor
D= Dividend per share
Kd = (1 –T) R Kd = Cost of debt
T =Tax rate
R = debenture interest rate
I
Kd = ______(1-T)
NP
Kd = Cost of debt
I= Annual interest payment
NP =Net proceeds
T = Tax rate
NP = Face value + premium
7. DEBT ISSUED AT DISCOUNT
COST OF REDEEMABLE DEBT
Cost of Preference Share Capital
Cost of preference share capital is the annual preference share dividend by the net proceeds from
the sale of preference share. There are two types of preference shares irredeemable and
redeemable.
COST OF IRREDEEMABLE PREFERENCE SHARES
I
Kd = _______ (1-T)
NP
Kd = Cost of debt
I= Annual interest payment
NP =Net proceeds
T = Tax rate
NP = Face value - Discount
I +(P-NP)/n
_____________
Kd (before tax) = (P+NP)/2
I = Annual interest payment
P = Par value of debenture
NP = Net proceeds
n = Number of years to maturity
Kd (after tax) = Kd(before tax) x (1-T)
Dp
Kp = _______
Np
Kp = cost of preference share capital
Dp = fixed preference dividend
Np = Net proceeds of preference shares
8. COST OF REDEEMABLE PREFERENCE SHARES
Cost of Retained Earnings
Retained earnings is one of the sources of finance for investment proposal; it is different from
other sources like debt, equity and preference shares. Cost of retained earnings is the same as the
cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of
equity capital.
Measurement of Overall Cost of Capital
It is also called as weighted average cost of capital and composite cost of capital. Weighted average
cost of capital is the expected average future cost of funds over the long run found by weighting
the cost of each specific type of capital by its proportion in the firms’ capital structure. The
computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the help of the following formula;
Ko= Kd Wd + Kp Wp + Ke We + Kr Wr
Kr = Ke(1-t) (1-b)
Kr= Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b= Brokerage cost
Dp + (RV-Np)/n
Kp = _______
(RV+ Np)/2
Kp = cost of preference share capital
Dp = fixed preference dividend
Np = Net proceeds of preference shares
RV = Redemption value
n = Number of years to redemption
9. Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capita l is calculated in the following form ula also
XW
Kw = __________
W
Kw =Weighted average cost of capital
X= Cost of specific sources of finance
W=Weight, proportion of specific sources of finance