Cost of Capital

Raghavendra
M.B.A, M.Phil, NCFM, (Ph.D)

Senior Asst. Professor Dept. of MBA MITE

Cost of capital

Cost of capital constitutes an integral part of investment decision. It provides a yardstick to measure the worth of investment proposal, and thus performs the role of accept-reject criterion. Also known as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard return and so on.

Definition

It is defined as the minimum rate of return

that a firm must earn on its investments, for the market value of the firm to remain unchanged.

Significance of Cost of Capital

It

is useful as a standard for:

Evaluating Investment Decisions Designing a firms debt policy Appraising the financial performance of top mgt

Components of Cost of capital

Cost of Debt Cost of preference shares Cost of equity capital Cost of retained earnings Weighted Average Cost of Capital

Cost of Debt Kd =

I --------- (1 - T) NP

Where

I = Annual Interest Payment T = Corporate Tax Rate

NP = Net Proceeds from Debts

Cost of Redeemable Debt

(at par, premium or discount)

RV - NP I + --------------n

Kd=

------------------------------- (1 - T) RV + NP ------------2

Where I = RV = NP = n = T =

Annual Interest Payment Redeemable Value on Maturity Net Proceeds from sale No. of years to Maturity Corporate Tax Rate

Cost of Preference Capital Kp =

D --------------NP

Where

D = Preference Dividend NP = Net Proceeds

(Please note: Preference shares may be issued at par, premium or discount, floatation cost may or may not be incurred. Same formula is used.)

Cost of Redeemable Preference Shares:

RV - NP D + --------------n

Kp =

------------------------------RV + NP -----------2 = Annual Dividend Payment = Redeemable Value on Maturity = Net Proceeds from sale = No. of years to Maturity

Where D RV NP n

Cost of Equity
1. Dividend Yield Method 2. Dividend Growth Model 3. Price Earning Method

4. Capital Asset Pricing Model

Cost of Equity
(Dividend Yield Method)

Annual Dividend per Share Cost of Equity = ---------------------------------------Ke Market Price per Share

Cost of Equity
(Dividend Growth Model)
Annual Dividend per Share Cost of Equity = ----------------------------------Ke Market Price per Share Growth + in Dividend

Cost of Equity
(Price Earning Method)
Earning per Share -------------------------------Market price per Share

Cost of Equity =

Ke

Cost of Equity

Capital Asset Pricing Model (CAPM)

Cost of Equity = Rf + B ( Rm - Rf)
Where Rf = Risk free Rate of Return Rm = Expected Market Rate of Return B = Beta Co-efficient of the Investment

Cost of Retained Earnings

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. Cost of retained earnings is the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities.

Kr = Cost of Equity Capital X ( 1 - T )

Where T = Tax Rate of Individuals

Weighted Average Cost of Capital (WACC)

Is the average cost of the costs of various sources of financing. It is also known as composite cost of capital. The weights may be given on the basis of book value or market value weights. Usually market value weights are preferred, because it represent real or true value to the investment.

Practical problems using cost of capital