Block 2, unit 2

Block 2, unit 2

• 1.
  PREPARED BY :GROUP 4
• 2.
  Group Members: 1. BariyaAsha 2. Patel Mehul 3. Yadav Jyoti 4. Patel Ajit 5. Tiwari Vikash 6. Giri Bhargavi
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  DEFINATION • According toI.M. Pandey “It is simply the rate of return the funds should produce to justify their use within the firm in light of the wealth maximization objective”. • According to Solomon & Pringle “It is the rate of return required by those who supply the capital”.
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  COMPUTATION OF COSTOF CAPITAL • Cost of capital is the combined cost of equity, preference, debt and retained earnings. • To calculate cost of capital we need to calculate cost of different sources of finance.
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  COST OF DEBT •A company’s debt capital may be of short term or long term nature. • For the calculation of cost of debt, the interest on the debt can be considered, but in reality it is not the real cost of debt. • cost of debt is much lower than the rate of interest the company has to pay. • while computing the cost of debts adjustments are to be made for considering tax.
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  TYPES OF COSTOF DEBT • Debt issued at par which are Irredeemable • Debt issued at premium or discount when the debt is perpetual or irredeemable. • Cost of redeemable debt.
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  1. Debt issuedat par which are Irredeemable Kd = I (1 –T) X100 •Where, Kd = Cost of capital •T = Tax rate •I = Interest Rate
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  2. Debt issuedat premium or discount when the debt is perpetual or irredeemable Kd = (I/ S.V.) X (1 –T) X100 Where : I = Annual Interest payment S.V.= Sales Value T = tax rate
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  3. Cost ofredeemable debt • Kd = I + [(RV-SV)/n] x (1-t) x 100 (RV+SV)/2 - where, I = Annual Interest RV = Redemption Value SV = Selling Value n = Number of Years to Maturity t = Tax Rate
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  Floating Cost • Allthe expenditures that company needs to make for issuing its shares or debentures. • Examples are underwriter's fee, promotion cost, advertisement cost etc. • Flotation cost is always deducted form sale value.
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  Cost of TermLoan It is given by the formula : Kt = I (1-t) • Where, I = Interest rate on term loans • t = tax rate
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  Cost of preferenceshares : redeemable • The cost of preference shares is calculated by considering the proceeds received from the preference shares and dividend paid. • Since the amount of divided payable on preference shares is not tax deductable expenditure, no need to adjust for tax benefits. • Kp = D + [(Rv – Sv)/n] (Rv + Sv)/2 • Where, Kp= cost of preference shares • D = Annual Preference dividend • Rv= Redemption Price • Sv = Face valve • n = Maturity Period.
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  Cost of Irredeemablepreference share Capital • Kp = (D /P) x 100 • Where, Kp = Cost of preference capital • D = Dividend • P = Price per share.
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  COST OF EQUITY •The cost of equity capital depends upon the market value of shares, which in turn depends upon the dividends paid and the rate of dividend depends on the degree of financial and business risks. • The various approaches to the computation of cost of equity are as follows: 1. Dividend price approach 2. Dividend Plus Growth Approach 3. Earning Price Ratio or Earning Yield Approach 4. Capital Asset Pricing Model
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  1. Dividend PriceApproach • Cost of Equity is given as Ke = (D/P) x 100 • Where, • D= dividend/share • P = market price /share
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  2. Dividend +growth approach • Cost of Equity is given as Ke = (D/P) + G Where, D = expected Dividend P = market price/share G= growth in dividend
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  3. Earning Priceratio/ Earning yield Approach • Cost of Equity is given as, Ke = (E/P) x 100 • Where, • E = earning/ share • P = market price / share
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  4. Capital AssetPricing Model • Cost of Equity = Yield on long term bond + risk premium = Rf + B (Rm – Rf) Where, Rf = Risk free rate B = Beta(Risk) Rm = market return
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  Sources of LongTerm Finance
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  Weighted Average Costof Capital (WACC)  WACC is the overall cost of capital WACC is calculated by giving Weightage to cost of each source of fund by assigning portion of each source of fund to the total fund.
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  Limitations of WACC •Some Limitations of WACC are as follows: 1. Difficulty in the Determination of Weights 2. Problem with Choosing Capital Structure 3. Other Limitations