2. Cost of Capital - Introduction
• Firm raises required funds for investment from
shareholders, debenture holders and other providers
• Providers of these funds invest their funds in the company
with the expectation of a certain return in the form of
dividend and interest.
• The company has to pay interest and dividend to the
providers funds
• Company has to earn sufficient profits to meet the legal
obligations of payment of interest and dividend on funds
• If the company fails to earn sufficient profit to meet these
legal obligations, it cannot survive
• Thus, while investing funds, the manager has to ensure that
it earns sufficient return on funds – the criterion used for
evaluation of projects

3. Introduction contd.
Funds required can be raised either internally or
externally
The internal source (the best source) is raised through
operations and ultimately it constitutes the difference
between the amount to be paid for funds (cost) and
the amount earned with the help of funds
Finance manager has to tap the cheap source of funds
and must invest these funds in the most profitable
opportunities
Must be careful while deciding the source of funds
(financing decisions) and application of the funds
(investment decisions).
For this purpose, he must first determine the cost of the
funds, otherwise known as cost of capital

4. Meaning
The concept can be viewed from two angles:
1. Investors’ point of view
2. Companies point of view
Cost of capital is
 The minimum rate of return expected by investors
on their funds (investors’ view)
 The minimum rate of return to be earned by the
company on its assets or investments (company’s
view)
 Is the cost of obtaining funds. i.e. average rate of
returns expected by investors for supplying funds to
the firm

5. Definition
Cost of capital is
“the cut-off rate for the allocation of capital to
investments of projects. It is the rate of return on a
project that will leave unchanged the market price of
the stock” – James C. Van Horne
“the minimum required rate of earnings or cut-off
rate of capital expenditures” – Solomon Ezra
“the rate of return the firm requires from
investments in order to increase the value of the in
the market place”- john J Hampton

6. Based on the above definitions, Cost of Capital
 Is not just a cost, it is the expected rate of return and
 Is the minimum rate of return to be earned on investment
to maintain the market value of the firm
As a rate of return, it has three components –
a. Minimum rate of return at zero risk level
b. Business Risk Premium
c. Financial Risk Premium
Thus,
Cost of Capital = Normal Rate of Return at Zero Risk Level +
Premium for Business Risk + Premium for Financial Risk
Or
K = r0 + b + f

7. Significance of Cost of Capital
 As a decision criterion for capital investment
decisions – accept /reject – IRR, NPV, ARR etc.
 To determine optimum capital structure – different
sources of capital with different costs and rights –
the right mix – minimizes the overall cost of capital
 Evaluation of performance of management at
different levels – above the cost of capital
 Other financial decisions like dividend policy, right
issue, working capital management etc

8. Classification of Cost of Capital
1. Historical cost
2. Future cost
3. Specific cost
4. Composite cost / combined cost
5. Explicit cost
6. Implicit cost / opportunity cost
7. Average cost
8. Marginal cost of capital

9. Theories of Cost of Capital
• There are conflicting views
• The matter of dispute is related to the fact
whether the method and level of financing
affect the cost of capital or not
• There are important approaches (theories)
1. The Traditional Approach and
2. Modigliani Miller Approach (MM Approach)

10. Traditional Approach
• Argues that cost of capital depends upon the method
and level of financing or its capital structure
• Overall cost of capital changes according to the
changes in the capital structure or changes in the debt-
equity ratio.
• Debt – cheaper and tax savings
• Increased used in debt results in the reduction of
weighted average (overall cost of capital)
• However, increased use of debt result in increased risk
and increased cost of equity, which may result in
increasing the cost of capital after a point. Thus, the
firm has to maintain proper balance between debt and
equity in its capital structure

11. 2. Modigliani Miller Approach
• Opposite of traditional approach
• Capital structure will not affect the cost of capital or
• Cost of capital is independent upon capital structure
• Argue that method and level of financing will not affect
cost of capital
• According to them, increased use of debt though
reduce the cost of capital, increased risk induce the
shareholders to expect more on their investment and
increase the cost of equity. This results to offset the
reduced cost of debt by the increased cost of equity.
• They also have mentioned the role of “arbitrage
process” in maintaining the cost of capital

12. CALCULATION OF COST OF CAPITAL
A firm obtains funds from different sources. Because the
contractual obligations and risk differences, the cost of
each source may differ. Thus, the cost of each source is
to be determined. It is known as the component cost of
capital or specific cost of capital.
Since, the company makes use of capital raised from
different sources, combined cost of all sources of
capital is to be determined. Combined cost of capital is
also known as overall cost of capital, average cost of
capital, weighted average cost of capital (WACC)
Overall cost of capital is the cost of capital used for
decision making purposes, in determining the optimum
capital structure, investment decisions, etc

13. Determination of Cost Of Capital of a firm involves two
steps
I. Determination of specific cost of capital
II. Determination of weighted average cost of capital
Specific cost of capital
Sources of funds – (i) Debt, (ii) Preference shares (iii)
Equity Shares (iv) retained earnings
i). Cost of debt (kd)
Is the return expected by lenders. It is the cost incurred
by the firm for acquiring and using debt
Debt - an important source of funds- borrowed funds –
different sources for borrowing (?). Firm has to obey
the contractual obligations in the payment of interest
and repayment of principal.

14. Further, debentures and bonds can be issued and repaid in
different ways. Calculation of cost of debt , thus, should
consider the contractual obligations and the pricing of
issues and repayment
Debts can be issued at par, discount and at premium. Thus,
cost of debt vary according to the pricing of issues
Cost of Debt Issued at Par
Return expected by lenders or cost incurred by the firm –
interest or rate of interest
Thus, kd = I = R =
Where , INT = Interest and F = Face value of debt
Floatation cost, if any shall be deducted from face value

15. Cost of debt issued at premium or discount
Kd =
Where SP = Sales Proceeds = Face Value + Premium or Face
Value - discount . Floatation cost incurred, if any, shall
also be deducted from SP.
Tax implications
Interest paid is a tax deductible expense. Thus cost of debt is
reduced by tax rate. Then
Kd = R (1-t) where ‘R’ is the rate of interest and ‘t’ is the tax rate
To express in % multiply by 100

16. Cost of irredeemable debt (the above formula)
Cost of redeemable debt :-
ISSUED AT PAR

17. ISSUED AT DISCOUNT
ISSUED AT PREMIUM

18. Cost of Preference Share Capital
• No legal obligation to pay preference dividend
• Not a charge on profit, but an appropriation of
profit
• Non-payment will not lead to bankruptcy
• Thus, some argue that pref. share has no cost
This is not right
• Issues shares not with the intention of payment
of dividend
• Non-payment will adversely affect market value
of shares
• Thus, companies pay dividend on preference
share capitals and has cost

19. Calculation
Irredeemable Preference shares
Sales Proceeds (SP)= Proceeds from issue
= Face Value – Discount + Premium –
Floatation charges

20. Cost of Redeemable Preference Shares
Kp=
Where D= Annual dividend
RV= redeemable value
SV=Sales Value (proceeds ± discount,
premium, floatation charges etc.)
N= Number of years

21. Cost of Equity Share Capital
• No legal obligation
• Payable only when earn sufficient amount, that too at the
discretion of the board
• Thus, many argue equity capital is cost-free
• Investors invest in equity with the anticipation of dividend, if
the company fails to pay dividend, it will create problems,
reduce market value of shares, face difficulty in rising funds for
expansion
• Thus, company has to pay dividend
- is the rate of dividend expected by share holders
- If invested outside the share holders could earn dividend. Thus
equity capital has opportunity cost
- “is the discount rate that equates the present value of
expected future dividends per share with the net proceeds or
current market price”
- It is the minimum rate of return to be earned.

22. Calculation
Different methods are there
A. Dividend Yield or Dividend /Price Ratio Method
shows the interrelationship between dividend and net
proceeds (new shares) and market value (existing shares)
Where D = Dividend per share NP= Net Proceeds per share
and MP = Market Price per share
• Based on the assumption that (i) investors give
importance to dividend and (ii) risk remain constant
• This method is used when the company has stable
earnings

23. Demerits :-
a. Does not consider growth in dividend
b. Does not consider future earning or retained earnings
c. Does not consider capital gain
B. Dividend Yield Plus Growth in Dividend Method
When the dividend of the firm is expected to grow at a
constant rate and dividend pay out ratio is constant, this
method is used
Where :-
D1 = Expected dividend per share at the end of the year
NP = Net Proceeds per share ; MP = Market Price per share
Dₒ = Previous year’s dividend per share; G= Growth rate
In the case of existing shares, consider market price

24. C. Earnings Yield Method or Earnings Price Ratio
According to this method, Ke “ is the rate that equates the
present value of future earning per share with the net
proceeds (current market price) of a share
where
EPS = Earnings Per Share; NP = Net Proceeds; MP= Market Price
In the case of existing shares use the second formula
This method is better, when –
i. The EPS is expected to remain stable
ii. It is expected that the firm can raise funds at the existing
rate of earnings
iii. The market price is influenced only by EPS

25. Cost of Retained Earnings
• No cost
• but not correct, has opportunity cost, if distributed to share
holders they can invest and earn, the lost earning (benefit
forgone) of shareholders constitute the opportunity cost
Where Kr = Cost of Retained Earnings
D1= Expected Dividend at the End of The Year
NP = Net Proceeds per Share
MP = Market Price per Share
G = Growth Rate

26. However, the shareholders are not entitled to get the
entire earnings as dividend, they have to tax on the
dividend and brokerage and other expenses when
they purchase new shares or debentures or other
investments
In this case the formula will be changed into
Where
t = Tax rate
b = Rate of brokerage

27. Weighted Average (Composite /Overall)cost of Capital
So far we have discussed specific cost
A firm raises funds from different source and employ
these funds together in different assets
Each source will have different rate of earnings,
rights and liabilities
Thus, we have to calculate composite cost of capital
Also known as required rate of earnings
Is the average cost of each specified fund

28. “is the average of the cost of different sources
of capital calculated by giving weight or
importance to each source in the proportion
they hold in the total capitalization of the
firm”
“ is the weighted average cost of various
sources of finance, weight being market value
of each source of finance outstanding”

29. Calculation of Weighted Cost of Capital
Where
Kw or Ko = Weighted average cost of capital
X= cost of each component of capital
W= weight (relative importance)
Market value or book value can be used for determining the
overall cost of capital, but better to use market value
Steps
1. Determine the cost of each source (specific cost)
2. Assign weight to each source (book/ market value)
3. Multiply the cost (specific) by the weight
4. Sum all the products obtained in the third step to get
overall cost of capital

30. Marginal Cost of Capital
• Marginal = additional
• Marginal cost of capital is the weighted average cost
of the new capital using marginal weights
• Is the weighted average cost of new / incremental
capital
• Marginal weight refers to the proportion of various
sources of funds to be employed in raising additional
funds
• If the firm uses the same existing proportion,
Marginal cost of capital will be the same as that of
the existing overall cost of capital

31. Calculation
1. Calculate the existing overall cost of capital as
usual
2. Then calculate the new overall cost of
capital(after raising new funds). Take new
ratio or proportion as the weights. Use the
same steps and formula, mentioned above
3. Compare the new overall cost of capital with
the existing one, the difference can be
considered as the MCC

32. Capital Asset Pricing Model (CAPM)
Risk-free – investment is risky – thus, we have to consider
risk involved while calculating cost of capital. CAPM
considers the risk involved in the business while
calculating the cost of capital
CAPM is a model that provides a framework to determine
the required rate of return on asset and indicates the
relationship between return and risk of the asset.
The required rate of return calculated under this method
helps in valuing assets. It can also be used for
determining the cost of equity on the assumption that
the investors expect more on risky investments than
risk free investments

33. Thus, according to this method,
Ke=Rf+(Rm-Rf)ᵝj
Where :-
Rf= Risk free investment
(Rm-Rf)= market risk premium
ᵝ = the systematic risk of an ordinary share
in relation to the market
Risk-free rate is the yield on government securities,
considered as risk-free
Market risk premium is generally taken as the difference
between the long-term arithmetic averages of market
return and the risk-free rate.
The beta of firm’s share is the systematic risk of an
ordinary share in relations to the market.