UNIT-II

COST OF CAPITAL

Q.GIVE THE MEANING AND CONCEPT OF COST OF CAPITAL.

The cost of capital of a firm is the minimum rate of return expected by its investors. It is the
weighted average cost of various sources of finance used by a firm. The capital used by a firm may be in the
form of debt, preference capital, retained earnings and equity shares.
A decision to invest in a particular project depends upon the cost of capital of the firm or the cut off rate
which is the minimum rate of return expected by the investors. In case a firm is not able to achieve even the cut
off rate, the market value of its shares will fall. In fact, cost of capital is the minimum rate of return expected
by its investors which will maintain the market value of shares at its present level. Hence to achieve the
objective of wealth maximization, a firm must earn a rate of return more than its cost of capital.
Further, optimal capital structure maximized the value of a firm and hence the wealth of its owners and
minimizes the firms cost of capital.
Cost of capital for a firm may be defined as the cost of obtaining funds, ie., the average rate of return
that the investors in a firm would expect for supplying funds to the firm.

CONCEPT OF COST OF CAPITAL

There are three basic aspects of concept of cost of capital.
1) It is not a cost as such-A firm’s cost of capital is really the rate of return that it requires on the projects
available. It is merely a hurdle rate. Of course, such rate may be calculated on the basis of actual cost of
different components of capital.
2) It is the minimum rate of return-A firm’s cost of capital represents the minimum rate of return that will
result in at least maintaining(if not necessary) the value of the equity shares.
3) It comprises of three components-A firm’s cost of capital comprises three components.
a) Return at zero risk level-This refers to the expected rate of return when a project involves no
risk whether business or financial.
b) Premium for business risk-The term business risk refers to the variability in operating profit
(EBIT) due to change in sales. In case a firm selects a project having more than the normal or
average risk, the suppliers of funds for the project will expect a higher rate of return than the
normal rate.
The cost of capital will thus go up. The business risk is generally determined by the capital
budgeting decisions.
c) Premium for financial risk-The term financial risk refers to the risk on account of pattern of
capital structure(or debt-equity mix).in general, it may be aid that a firm having a higher debt
content in its capita structure is more risky as compared to a firm which has a comparatively low
debt content.
This is because in the former case the firm requires higher operating profit to cover periodic interest
payment & repayment of principal at the time of maturity as compared to the latter. Thus, the chances of cash
insolvency are greater in case of such firms. The supplier of funds would therefore expect a higher rate of return
from such firms as compensation for higher risk.
Symbolically cost of capital may be represented as: k= ro + b + F

Where k = cost of capital

ro = normal rate of return at zero risk level

b=premium for business risk

f=premium for financial risk

Q.DEFINE COST OF CAPITAL

“A 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”.
According to Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut off rate of
capital expenditure”.
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Hampton, John J defines cost of capital as, “the rate of return the firm requires from investment in order to
increase the value of the firm in the market place”.

Q.EXPLAIN THE SIGNIFICANCE OF THE COST OF CAPITAL

As an acceptance criterion in capital budgeting:
Capital budgeting decisions can be made by considering the cost of capital. According to the present
value method of capital budgeting, if the present value of expected returns from investment is greater than or
equal to the cost of investment, the project may be accepted; otherwise, the project may be rejected. The
present value of expected returns is calculated by discounting the expected cash inflows as cut off rate (which is
the cost of capital). Hence the concept of cost of capital is very useful in capital budgeting decision.
As a determinant of capital mix in capital structure decisions:
Financing the firm’s assets is a very crucial problem in every business and as a general rule there should
be a proper mix of debt and equity capital in financing a firm’s assets. While designing an optimal capital
structure, the management has to keep in mind the objective of maximizing the value of the firm and
minimizing the cost of capital. Measurement of cost of capital from various sources is very essential in
planning the capital structure of any firm.
As a basis for evaluating the financial performance:
The actual profitability of the project is compared to the projected overall cost of capital and the actual
cost of capital of funds raised to finance the project if the actual profitability of the project is more than the
projected and the actual cost of capital, the performance may be said to be satisfactory.
As a basis for taking other financial decisions:
The cost of capital is also used in making other financial decisions such as dividend policy,
capitalization of profits, making the rights issue and working capital.

Q. DESCRIBE THE VARIOUS CLASSIFICATION OF COST.

Historical cost and future cost:
Future cost refers to the expected cost of funds to finance the project, while historical cost is the cost
which has already been incurred for financing a particular project in financial decision making; the relevant
costs are future costs & not the historical costs. However, historical costs are useful in projecting the future
costs & providing an appraisal of the post performance when compared with standard or predetermined cost.
Specific cost and composite cost:
Specific cost refers to the cost of a specific source of capital while composite cost is combined cost of
various sources of capital. It is the weighted average cost of capital. In case more than one form of capital is
used in the business, it is the composite cost which should be considered for decision making and not the
specific cost. But where only one type of capital is employed the specific cost of that type of capital may be
considered. In capital structure decisions, it is the weighted average cost of capital which should be given
consideration.
Explicit cost and implicit cost:
An explicit cost is the discount rate which equates the present value of cash inflows with the present
value of cash outflows. In other words, it is the internal rate of return. The explicit cost of a specific source of
finance may be determined with the help of the following formula:
n
Ot

O1 O2 On
 
I 0 (1  k ) (1  k )2  .............  =
(1  k ) t 1 (1  k )
n t

Where
I 0 is the net cash inflow at zero point of time,
Ot is the outflow of cash in periods 1, 2 and n.
k is the explicit cost of capital.
Implicit cost also known as the opportunity cost is the cost of the opportunity foregone in order to take up a
particular project. For example, the implicit cost of retained earnings is the rate of return available to
shareholders by investing the funds elsewhere.

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Average cost and marginal cost:
An average cost refers to the combined cost of various sources of capital such as debentures, preference
shares and equity shares. It is the weighted average cost of the costs of various sources of finance. Marginal
cost of capital refers to the average cost of capital which has to be incurred to obtain additional funds required
by a firm. In investment decisions, it is the marginal cost which should be taken into consideration.

Q.DISCUSS THE PROBLEMS IN DETERMINATION OF COST OF CAPITAL.

The major problems concerning the determination of cost of capital are discussed as below:
Conceptual controversies regarding the relationship between the cost of capital and the capital structure:
Different theories have been propounded by different authors explaining the relationship between
capital structure, cost of capital and the value of the firm. This has resulted into various conceptual difficulties.
According to the net income approach and the traditional theories both the cost of capital as well the value of
the firm have a direct relationship with the method and level of financing.
In their opinion, a firm can minimize weighted average cost of capital and increase the value of the firm
by using debt financing. In their opinion, a firm can minimize weighted average cost of capital and increase the
value of the firm by using debt financing.
On the other hand, net operating income and Modigliani and Miller approach prove that the cost of
capital is not affected by changes in the capital structure or say that debt equity mix is irrelevant in
determination of cost of capital and the value of a firm. However, the M and M approach is based upon certain
unrealistic assumptions such as, there is a perfect market or the expected earnings of all the firms have identical
risk characteristic etc.
Historic cost and future cost:
Another problem in the determination of cost of capital arises on account of the difference of opinion as
regards the concept of cost itself. It is argued that historic costs are book costs which are related to the past and
are irrelevant in the decision making process. In their opinion, future estimated costs are more relevant for
decision making. In the same manner, arguments are given in favour of specific cost and composite cost as
well as explicit cost and implicit cost and the marginal cost.
Problem in computation of cost of equity:
The computation of cost of equity depends upon the expected rate of return by its investors. But the
quantification of the expectations of equity shareholders is a very difficult task because there are many factors
which influence their valuation about a firm.
Problems computation of cost of retained earnings:
It is sometimes argued that retained earnings do not involve any cost. But in reality, it is the
opportunity cost of dividends foregone by its shareholders. Since different shareholders may have different
opportunities for investing their dividends, it becomes very difficult to compute the cost of retained earnings.
Problems in assigning weights:
For determining the weighted average cost of capital, weights have to be assigned to the specific cost of
individual sources of finance. The choice of using the book value of the source or the market value of the
source poses another problem in the determination of cost of capital.

Q.EXPLAIN IN DETAIL THE COMPUTATION OF COST OF CAPITAL

Computation of overall cost of capital of a firm involves:
A. Computation of cost of specific source of finance and
B. Computation of weighted average cost of capital.

A. Computation of specific source of finance:

Computation of each specific source of finance, viz, debt, preference share capital, equity share capital
and retained earnings is discussed as below:

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1. COST OF DEBT:
The cost of debt is the rate of interest payable on debt. For example, a company issues Rs.1,00,000
10% debentures at par; the before-tax cost of this debt issue will also be 10%. By way of a formula, before-tax-
cost of debt may be calculated as:
I
(i) K db  P
Where, K db = before tax cost of debt
I = Interest
And P = Principal
In case the debt is raised at premium or discount. We should consider P as the amount of net proceeds
received from the issue and not the face value of securities. The formula may be changed to

I
(ii) K db
 (where, NP=Net Proceeds)
NP
Further, when debt is used as a source of finance, the firm saves a considerable amount in payment of
tax as interest is allowed as deducible expenses in computation of tax. Hence, the effective cost of debts is
reduced. The after-tax cost of the debt may be calculated with the help of following formula:
I
(iii) K da  K db(1  t )  (1  t )
NP
Where, K da = After-tax cost of debt
t = Rate of tax.

COST OF REDEEMABLE DEBT

Usually, the debt is issued to be redeemed after a certain period during the life time of a firm. Such a
debt issue is known as Redeemable debt. The cost of redeemable debt capital may be compared as:
(iv) Before-tax cost of debt
1
1  ( P  NP)
K db  1 n
( P  NP)
2
Where, I = Interest
N = Number of years in which debt is to be redeemed
P = Proceeds at par
NP = Net Proceeds

(v) After-tax cost of debt, K da

 K db(1  t )
1
1  ( P  NP)
Where K db  n
1
( P  NP)
2
COST OF DEBT REDEEMABLE AT PREMIUM.
Sometimes debentures are to be redeemed at a premium, i.e., at more than the face value after the expiry
of a certain period. The cost of such debt redeemable at premium can be computed as below:
(i)Before tax cost of debt,

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 1
1  ( RV  NP)
K db  1 n
( RV  NP)
2
Where I = Interest
n = Number of years in which debt is to be redeemed
RV = Redeemable value of debt
NP = Net Proceeds.
(ii)After-tax cost of debt,
K da  K db(1  t )
Where t = Tax Rate
K db = same as in (i) above.
COST OF EXISTING DEBT:
If a firm wants to compute the current cost of its existing debt, the current market yield of the debt
should be taken into consideration.

COST OF DEBT REDEEMABLE IN INSTALLMENTS

Financial institutions generally require principal to be amortized in installments. A company may also
issue a bond or debenture to be redeemed periodically. In such a case, principal amount is repaid cash period
instead of a lump sum at maturity and hence cash outflows each period include interest and principal.

The amount of interest goes on decreasing each period as it is calculated on the outstanding amount of debt.
The before-tax cost of such a debt can be calculated as below:
I P I P I P
V d  (11 kd 1)1  (12 kd )22  .............  (1n kd )nn
n
I t  Pt
Or, Vd  
t 1 (1  kd )t

Where, V d
= Present value of bond or debt
I1 , I 2 ,...., I n = Annual interest (Rs.) in period 1,2,…. and so on
P1 , P2 ,...., Pn = Periodic payment of principal in period 1,2,…., and so on
n = Number of years to maturity
K d = Cost of debt or required rate of return.
COST OF ZERO COUPON BONDS
Sometimes companies issue bonds or debentures at a discount rate from their eventual maturity value
and having zero interest rate. No interest is payable on such debentures before their redemption and at the time
of redemption the maturity value of the bond is to be paid to the investors. The cost of such debt can be
calculated by finding the present values of cash flows as below:
 Prepare the cash flow table using an arbitrary assumed discount rate to discount the cash flows to the
present value.
 Find out the net present value by deducting the present value of the outflows from the present value of the
inflows.
 If the net present value is positive, apply higher rate of discount
 If the higher discount rate still gives a positive net present value, increase the discount rate further until the
NPV becomes negative
 If the NPV is negative at this higher rate, the cost of debt must be between these two rates.
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FLOATING OR VARIABLE RATE DEBT:
The interest on floating rate debt changes depending upon the market rate of interest payable on gilt
edged securities or the prime lending rate of the bank. For example, suppose a company raises debt from
external sources on the terms of prime lending rate of the bank plus four percent. If the prime lending rate of
the bank is 8% p.a., the company will have to pay interest at the rate of 12% p.a. Further, if the prime lending
rate falls to 6% p.a., the company shall pay interest at only 10% p.a.

COST OF PREFERENCE CAPITAL

The computation of the cost of preference capital poses some conceptual problems. In case of
borrowings, there is a legal obligation on the firm to pay interest at fixed rates while in case of preference
shares, there is no such legal obligation. Hence, some people argue that dividends payable on preference share
capital do not constitute cost. However, this is not true.
This is because, thought it is not legally binding on the company to pay dividends on preference shares,
it is generally paid whenever the company makes sufficient profits. The failure to pay dividend may be a matter
of serious concern from the point of view of equity shareholders. They may even lose control of the company
because of the preference shareholders getting the legal right to participate in the general meetings of the
company with equity shareholders under certain conditions in the event of failure of the company to pay them
their dividends.
Moreover, the accumulation of arrears of preference dividends may adversely affect the right of equity
shareholders to receive dividends. This is because no dividend can be paid to them unless the arrears of
preference dividend are cleared. On account of these reasons the cost of preference capital is also computed on
the same basis as that of debentures. The method of its computation can be put in the form of the following
equation
D
Kp = P
Where K p = Cost of preference capital
D = Annual preference dividend
P = Preference share capital (proceeds)
Further, if preference shares are issued at premium or discount or when cost of flotation are incurred to
issue preference shares, the nominal or par value of preference share capital has to be adjusted to find out the
net proceeds from the issue of preference shares. In such a case, the cost of preference capital can be computed
with the following formula:
D
K p = NP
It may be noted that as dividends are not allowed to be deducted in computation of tax, no adjustment is
required for taxes. Sometimes redeemable preference shares are issued which can be redeemed or cancelled on
maturity date. The cost of redeemable preference share capital can be calculated as:
MV  NP
D
K pr  n
1
( MV  NP)
2
Where,
K pr = Cost of redeemable preference shares
D =Annual preference dividend
MV = Maturity value of preference shares
NP = Net proceeds of preference shares

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Dr. S.Sivasankari, Financial Management
 COST OF EQUITY SHARE CAPITAL
The cost of equity is the ‘minimum rate of return that the company must earn on equity financed portion
of its investments in order to leave unchanged the market price of its stock.’ The cost of equity capital is a
function of the expected return by its investors. The cost of equity is not the out-of-pocket cost of using equity
capital as the equity shareholders are not paid dividend at a fixed rate every year.
Moreover, payment of dividend is not legal binding. It may or may not be paid. But is does not mean
that equity share capital is a cost free capital. Shareholders invest money in equity shares on the expectation of
getting dividend and the company must earn this minimum rate so that the market price of the shares remains
unchanged.
Whenever a company wants to raise additional funds by the issue of new equity shares, the expectations
of the shareholders have to be evaluated.

A)Dividend Yield Method Or Dividend/Price Ratio Method:

According to this method, the cost of equity capital is the ‘discount rate that equates the present value of
expected future dividends per share with the net proceeds (for current market price) of a share’.
D D
Ke = or
NP MP
Where, Ke = Cost of equity capital
D = Expected dividend per share
NP = Net proceeds per share
MP = Market price per share
The basic assumptions underlying this method are that the investors give prime importance to dividends
and risk in the firm remains unchanged. The dividend price ratio method does not seem to consider the growth
in dividend,
 It does not consider future earnings or retained earnings and
 It does not take into account the capital gains.
This method of computing cost of equity capital is suitable only when the company has stable earnings and
stable dividend policy over a period of time.
B)Dividend Yield Plus Growth In Dividend Method:
When the dividends of the firm are expected to grow at a constant rate and the dividend-pay-out ratio is
constant this method may be used to compute the cost of equity capital. According to this method the cost of
equity capital is based on the dividends and the growth rate.
D1 D (1  g )
Ke = G = 0 G
NP NP
Where, Ke = Cost of equity capital
D1 = Expected dividend per shares at the end of the year
NP = Net proceeds per share
G = Rate of growth in dividends
D0 = Previous year’s dividend.
Further, in case cost of existing equity share capital is to be calculated, the NP should be changed with MP
(Market price per share) in the above equation.
D1
Ke = G
MP
Earning Yield Method:
According to this method, the cost of equity capital is the discount rate that equates the present value of
expected future earnings per share with the net proceeds (or, current market price of a share. Symbolically:
Earnings per share
Ke = ----------------------------
Net proceeds

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Dr. S.Sivasankari, Financial Management
 EPS

NP
Where, the cost of existing capital is to be calculated:
Earnings per share
Ke = ------------------------------
Market price per share

EPS

MP

This method of computing cost of equity capital may be employed in the following cases:
 When the earnings per share are expected to remain constant
 When the dividend pay-out-ratio is 100 percent or when the retention ratio is zero, i.e., all the available
profits are distributed as dividends.
 When a firm is expected to earn an amount on new equity shares capital, which is equal to the current
rate of earnings.
 The market price of the share is influenced only by earnings per share.

d) Realized Yield Method:

One of the serious limitations of using dividend yield method or earnings yield method is the problem
of estimating the expectations of the investors regarding future dividends and earnings. It is not possible to
estimate future dividends and earnings correctly; both of these depend upon so many uncertain factors. To
remove this drawback, realized yield method, which takes into account the actual average rate of return realized
in the past may be applied to compute the cost of equity share capital. To calculate the average rate of return
realized, dividend received in the past along with the gain realized at the time of sale of shares should be
considered. The cost of equity capital is said to be the realized rate of return by the shareholders. This method
of computing cost of equity capital is based upon the following assumptions:
 The firm will remain in the same risk class over the period;
 The shareholders expectations are based upon past realized yield;
 The investors get the same rate of return as the realized yield even if they invest elsewhere;
 The market price of the share does not change significantly.

COST OF RETAINED EARNINGS

It is sometime argued that retained earnings do not involve any cost because a firm is not required to
pay dividends on retained earnings. However, the shareholders expect a return on retained profits. Retained
earnings accrue to a firm only because of some sacrifice made by the shareholders in not receiving the
dividends out of the available profits.
The cost of retained earnings may be considered as the rate which the existing shareholder can obtain by
investing the after-tax dividends in alternative opportunity of equal qualities. It is, thus, the opportunity cost of
dividends forgone by the shareholders. Cost of retained earnings can be computed with the help of following
formula:

Kr D
= G
NP
Where, Kr = Cost of equity capital
D = Expected dividend
NP = Net proceeds of share issue
G = Rate of growth

Further, the shareholders usually cannot obtain the entire amount of retained profits by way of
dividends even if there is 100 percent pay out ratio. It is so because the shareholders are required to pay tax on
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their dividend income. So, some adjustment has to be made for tax. However, tax adjustment in determining the
cost of retained earnings is a difficult problem because all shareholders do not fall under the same tax bracket.
Moreover, if the shareholders wish to invest their after –tax dividends income in alternative securities, they may
have to incur some costs of purchasing the securities, such as brokerage.
Hence the effective rate of return realized by the shareholders from the new investment will be
somewhat lesser than their present return from the firm. to make adjustment in the cost of retained earnings for
tax and costs of purchasing new securities, the following formula is adopted:

Kr D 
=  G  x (1-t) x (1-b)
 NP 
or, Kr = Ke (1-t) (1-b)
Where,
Kr = cost of retained earnings
D = Expected dividend
NP = Net proceeds of share issue
G = Rate of growth
t = tax rate
b = cost of purchasing new securities or brokerage costs.’
Ke = Rate of return available to shareholders.

WEIGHTED AVERAGE COST OF CAPITAL

Weighted average cost of capital is the average costs of the costs of various sources of financing.
Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average
cost of capital.
The computation of the weighted average cost of capital involves the following steps:
1. Calculation of the cost of each specific source of funds
2. Assigning weights to specific costs
3. Adding of the weighted cost of all sources of funds to get an overall Weighted average cost of capital
1. Calculation of the cost of each specific source of funds
This involves the determination of the cost of debt, equity capital, and preference capital. Etc. This can
be done either on “before tax basis or after tax basis. However, it will be more appropriate to measure the cost
of capital on after tax basis. This is because the return to the shareholders is an important figure in determining
the cost of capital and they can get dividends only after taxes have been paid.

2. Assigning weights to specific costs

This involves determination of the proportion of each source of funds in the total capital structure of the
company. This may be done according to any of the following methods:
a) Marginal weights method (Marginal cost of capital)-
Sometimes we may be required to calculate the cost of additional funds to be raised, called the marginal
cost of capital. The marginal cost of capital is the weighted average cost of new capital calculated by using the
marginal weights. The marginal weights represent the proportion of various sources of funds to be employed in
raising additional funds. In case, a firm employs the existing proportion of capital structure and the components
costs remain the same the marginal cost of capital shall be equal to the weighted average cost of capital. But in
practice, the proportion and/or the components costs may change for additional funds to be raised. Under this
situation, the marginal cost of capital shall not be equal to the weighted average cost of capital. However ,the
marginal cost of capital concept ignores the long-term implications of the new financing plans and thus,
weighted average cost of capital should be preferred for maximization of shareholder’s wealth in the long-run.
b) Historical weights method-
According to this method the relative proportions of various sources to the existing capital structure are
used to assign weights. Thus, in case of this method the basis of weights is the funds already employed by the

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firm. This is based on the assumption that the firm’s present capital structure is optimum and it should be
maintained in the future also.
Weights under historic system may be either (i) book value or (ii) market value weights. The weighted
average cost of capital will be different, depending upon whether book value weights are used or market value
weights are used.
The use of market value of weights for calculating the cost of capital is theoretically more appealing on
account of the following reasons:
i) The market values of the securities are closely approximate to the actual amount to be received from
the sale of such securities.
ii) The cost of each specific sources of finance which constitutes the capital structure is calculated
according to the prevailing market price.
However, the use of market value as weights is subject to the following practical difficulties:
i) The market values of the securities may fluctuate considerably
ii) Market values are not readily available as compared to the book values. The book values can be
taken from the published records of the firm.
iii) The analysis of the capital structure of the company, in terms of debt-equity ratio, is based on the
book values and not on the market values.
Thus, market value weights are operationally inconvenient as compared to book value weights. However,
market value weights are theoretically consistent and sound; hence they are a better indicator of the firm’s
cost of capital.

3. Adding of the weighted cost of capital of all sources of funds to get an overall weighted cost of
capital.

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