FM Cost of Capital
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Suraj AgarwalFM Cost of Capital
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Suraj AgarwalSource of long term finance and cost of capital
1) Explain the cost of capital.
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. It is the required rate of return on its investments which belongs to equity, debt
and retained earnings that a firm must earn on its project investments to maintain market value and
attract funds.
2) Explain the factors determining cost of capital.
i) Economic Economic conditions determine the demand for and supply of capital within
Conditions the economy, as well as the level of expected inflation. This economic
variable is reflected in the risk less rate of return. This rate represents the
rate of return on risk- free investments.
ii) Market conditions When investors increase their required rate of return, the cost of capital
rises simultaneously. If a security is readily marketable and its price is
reasonably stable, the investor will require a lower rate of return and the
company’s cost of capital will be lower and vice versa.
iii) Amount of As the financing requirements of the firm become larger, the cost of capital
financing increases. High amount of capital also increases the overall cost of capital
due to issue related costs and the greater risks involved. If the firm uses
lower volume of capital then the suppliers of the fund remain more assured
of their fund and the cost of capital reduces.
3) Explain the importance of cost of capital.
The importance of this concept to modern management is summarized as follows:
i) Designing the Each source of capital involves different cost and different risk. By
Optimal Capital comparing various specific costs of different sources, the financial manager
Structure can select the best and the most economical source of finance.
ii) Helpful in An expansion project will be accepted by the management only when the
Evaluation of marginal return on investment exceeds the cost of its financing
Expansion Projects:
iii) Rational The concept of cost of capital is important for national economy as well
Allocation of National since it provides the basis of optimum allocation of financial resources.
Resources:
iv) Evaluation of Such an evaluation can be done by comparing the actual profitability of the
Financial projects undertaken with the projected overall cost of capital, and an
Performance appraisal of the actual costs incurred in raising the required funds.
Measurement of Cost of Capital
A company has a capital structure with the different components. Each component carries its own
importance as well as burden over the firm. This burden is in term of the cost charged over the firm to
carry such component; therefore it is required to calculate their cost on individual basis. These are as
follows:
i) Cost of debt or borrowing: The debts always carry a fixed rate of interest as a charge for the users
which a firm is ready to pay to maximize its profitability and wealth. This rate of interest is called as
cost of capital.
Debt-capital is of two types:
A) Perpetual or Irredeemable Debt
B) Redeemable Debt
Source of long term finance and cost of capital
A) Perpetual or Irredeemable Debt: These are the debts which are repayable only on the liquidation
of the company. Calculated as:
Cd (or Kd ) = I
------------- x 100
NP
where I = Amount of Annual Interest NP = Net Proceeds
Source of long term finance and cost of capital
B) Redeemable Debt: Mostly debentures are repayable within a stipulated time period. In the
calculation of cost of such debts, time period of their redemption is very important.
Formula:
I + MV – NP
N
Kd = ----------------------------------- X 100
MV+NP
2
where, Cd = cost of debt capital
i = annual interest payment
MV = maturity value
NP = net proceeds
n = number of years to maturity
iii) cost of preference share capital:
A) Cost of Irredeemable Preference Share Capital:
Cost of such preference shares is the ratio of annual dividend burden on each such share to its net
proceeds.
As per formula:
Cp (or Kp) = PD X 100
NP
Where, Kp= Cost of preference capital
PD = Preference dividend amount per share
NP = Net Proceeds per share
B) Cost of redeemable preference share:
Such shares are redeemed after a specified period.
PD + MV-NP
Kp or C = _______n_______ x 100
MV+NP
2
Where, PD = amount of annual preference dividend
MV = amount to be paid on maturity
NP = net proceeds
n = number of years after which the preference shares will be repaid
iii) Cost of Equity: The cost of equity is the return that a company requires to decide if an investment
meets capital return requirements. Firms often use it as a capital budgeting threshold for the required
rate of return.
A) CAPM model
This is a popular approach to estimate the cost of equity. According to the CAPM, the cost of equity
capital is:
Ke = Rf + (Rm - Rf ) β
Where: Ke = Cost of equity
Rf = Risk-free rate
Rm = Equity market required return (expected return on the market portfolio)
β = beta is Systematic Risk Coefficient
B) Dividend Yield Method:
This is also called as Dividend/Price Ratio Method or D/P Ratio Method. This Method is based on the
thinking that when an investor invests his savings in a company, he expects dividend at least at
current rate of return.
Ke (after tax) = DPS X100
MP
Source of long term finance and cost of capital
