Explanation of Cost of Capital Theory

1. FINANCIAL MANAGEMENT
COST OF CAPITAL
BY:
SMT.UMA MINAJIGI REUR
HEAD, DEPT. OF COMMERCE & MANAGEMENT
SMT. V G DEGREE COLLEGE FOR WOMEN, KALABURAGI

2. INTRIDUCTION
 Cost: Cost means amount spent in the form of money, material and labour for
production of goods and services.
 Capital : Capital is an important factor of production. Its an amount invested
in both fixed as well as current assets of the firm. Capital has a cost because
interest is paid on capital.

3. COST OF CAPITAL
 The Cost of Capital is the rate of return the firm expects to earn from its
investment in order to increase the value of the firm in the market place.
 In other words, it is the rate of return that the suppliers of capital require as
compensation for their contribution of capital.

4. DEFINITION OF COST OF CAPITAL
According to Ezra Soloman, “the cost of capital is the minimum required rate of earnings or cut-
off rate of capital expenditure.”
According to James ‘C’ Von Horne, “The cost of capital represents a cut-off rate for the
allocations of capital to investment of projects. It is the rate of return on project that will leave
unchanging the market price of the stock.”
From the above definition, it is clear that cost of capital is that the minimum rate of return which
a firm must and is expected to earn on its investments so as to maintain the market value of its
equity shares and earnings per share to equity shareholders.

5. SOURCE OF COST OF CAPITAL
The source of capital employed by the firm is usually in the following form:

6. COMPONENTS OF COST OF CAPITAL
There are three factors to the cost of capital explained below:
 Zero Risk Return
At zero risk return means, the expected rate of return when a project involves no financial or business risks.
 Premium for the Business Risk
Business risk is determined by the capital budgeting decisions that a firm takes for its investment proposals. So, if a
firm selects a project that has more than normal risk, then it is obvious that the providers of capital would require or
demand a higher rate of return than the normal rate.
Thus the premium factor plays an important role here as it increases the Cost of Capital. But how much premium?
it’s up to the firm’s project selection decision which alienates with the firm’s goal and objectives and how badly they want
the project to increase their market value.
 Premium for the Financial Risk
Financial risk is associated with the capital structure pattern of the firm. Here, the
premium finds its way to the picture depending on the volume of debts the firm owes. The
higher the debt capital, the more is the risk compared to a firm that has relatively low
debts.

7. COST OF CAPITAL FORMULA
The three components of cost of capital discussed above can be written in an equation as follows:
K = r0 + b + f
Where,
K = Cost of Capital
r0 = Return at zero risk level
b = Premium for business risk
f = Premium for finance risk

8. CLASSIFICATION / TYPES OF COST OF CAPITAL
1. Marginal Cost of Capital & Average Cost
2. Explicit Cost & Implicit Cost
3. Future Cost & Historical Cost
4. Specific Cost & Combined Cost
5. Spot Cost & Normal Cost

9. MARGINAL COST OF CAPITAL & AVERAGE COST
 Marginal Cost : It is the additional cost of manufacturing an additional unit. Marginal cost is
average cost of new fund required to be raised by the company. So the current rate of interest
on long term debt is treated as the marginal cost of capital. It is the rate of return
that shareholders and debt holders expect before making an investment in a company. The
marginal cost of capital usually goes up as the company raises more capital.
 Average Cost : Average cost is the combined cost of various sources of capital such as
debentures, preference shares and equity shares. It is the weighted average cost of various
sources of finance. Average cost is cost per unit. It is calculated by dividing total cost by
number units produced.

10. EXPLICIT COST & IMPLICIT COST
 Explicit Cost:
1. Explicit Cost arises when funds are raised.
2. It is based on the concept of net present value.
3. Explicit cost involves the payment of fixed charges in the form of interest and dividend. It effects cash
outflows in the form of payment for fixed charges.
 Implicit Cost:
1. Implicit cost arises when funds are used.
2. It is opportunity cost.
3. It will not effect the inflows and outflows of cash. Implicit cost arises when the firm thinks
in terms of different alternative opportunities of investment with the available funds at its
disposal.

11. FUTURE COST & HISTORICAL COST
 Future Cost (Estimated Cost):
1. It refers to the cost of funds intended to finance the expected project.
2. These costs are calculated on the basis of post records.
3. These costs are useful for decision making and designing capital structure of the firm.
 Historical Cost:
1. It is the cost which has already been incurred for financing a particular project.
2. These cost are actual costs that are recorded.
3. These costs are useful for controlling future costs and evaluating the past performance.

12. SPECIFIC COST & COMBINED COST
 Specific Cost:
1. It is a component of capital structure i.e, debentures, preference share & equity shares, etc.
2. It implies the cost of specific source of funds.
3. These costs are useful for decision making and designing capital structure of the firm.
 Combined Cost:
1. It is aggregate of the cost of capital from all sources of funds i.e, debt equity and preference
capital and other loans. It is also called weighted cost or composite cost.
2. It is the average cost of all sources of finance.
3. It is useful decision making.

13. SPOT COST & NORMAL COST
 Spot Costs: Spot costs are those costs prevailing in the market at a certain times.
 Normalised Costs: These are long term costs. It is an estimate of costs by some averaging
process from which cyclical element is removed. These are normally used for taking overall
investment decisions.

14. CALCULATE OF COST OF CAPITAL
In calculating the cost of capital, the following methods can be used:
1. Computation of Specific Cost of Capital
Specific Cost refers to the cost which is associated with the source of capital.
Eg. Cost of equity. Computing specific cost of capital involves summing up of all forms of
capital listed below
• Cost of debt
• Cost of preference shares
• Cost of equity shares
• Cost of retained earnings
2. Computation of Composite Cost of Capital
Composite capital is the combined cost of different sources of capital taken together. It is
also called a Weighted Average Cost of Capital (WACC).

15. COST OF CAPITAL
Thank You
Lets study each cost of capital in next classes.