Concept and Measurement of Cost of Capital

Cost of capital provides a yardstick to measure the worth of

investment proposal and thus performs the role of accept-
reject criterion. It is also referred to as cut-off rate/target
rate/minimum rate of return/standard return etc.
Cost of Capital is an operational criterion fulfils the
objective of Wealth Maximisation. The accept-reject rules
require that a firm should avail of only such investment
opportunities as promise a rate of return higher
than the cost of capital. So Cost of Capital is
important because of its practical utility as an
acceptance-rejection decision criterion
A minimum rate of return that a firm must earn on
its investment for the market value of the firm to
remain unchanged.

In Cost of Capital we have to measure specific Cost

of Capital and Weighted Cost of Capital
 Assumptions
The firm’s business and financial risks are unaffected by
the acceptance and financing of project. Business risk
measures the variability in operating profits
[earnings before interest and taxes (EBIT)] due to
change in sales. If a firm accepts a project that is
considerably more risky than the average, the suppliers
of the funds are quite likely to increase the cost of fund
as there is an increased probability of committing
default on the part of the firm in making payments of
their journey.

The financing decision determines its financial risk. The

greater the proportion of long-term debt in the
capital structure of the firm, the greater is the
financial risk.
Cost of Capital (k) consists of the following three
components:
(i) The riskless cost of the particular type of financing rj

(ii) The business risk premium, b and

(iii) The financial risk premium, f

k = rj + b+f
Explicit and Implicit Cost
 Explicit and Implicit Costs

Explicit Cost of any source of capital is the discount

rate that equates the present value of the cash
inflows that are incremental to taking of financing
opportunity with the present value of its
incremental cash outflows.
CIo = σ𝒏 𝑪𝑶 / (1+C)t
𝒕=𝟏 t
CIo = Initial Cash inflow at time o
If it is received on instalment basis
Cio + CI1/(1+C)1 + = CO1/(1+C)1 +
CI1/(1+C)2 + CO1/(1+C)2 +
CI1/(1+C)3+…………+ CO1/(1+C)3+………
CIn/(1+C)n …+ COn/(1+C)n
Implicit Cost of Capital of funds raised and invested by
the firm may, therefore, be defined as the rate of return
associated with the best investment opportunity
for the firm and its shareholders that would be
foregone, if the projects presently under
consideration by the firm were accepted.
The cost of retained earnings is an opportunity cost
or implicit capital cost, in the sense that it is the rate
of return at which the shareholders could have invested
these funds had they been distributed to them.

Explicit cost arises when funds are raised, whereas

the implicit costs arise when funds are used.
 Measurement of Specific Cost
Cost of Debt
Cost of Preference Share
Cost of Equity
Cost of Retained earning

Computation of Cost of Capital, therefore, involves

two steps:
(i) The computation of the different elements of
the cost in terms of the cost of the different
sources of finance (specific cost)
(ii) The calculation of the overall cost by combining
the specific costs into a composite cost
 Cost of Debt
Data should be gathered on (i) net cash proceeds/inflow
(the issue price of debentures/amount of loan minus
all floatation cost) from specific source of debt (ii)
the net cash outflows in terms of the amount of
periodic interest payment and repayment of
principal in instalments or in lump sum on maturity.
The interest payment made by the firm on debt issues
quality for tax deduction in determining net taxable income.
Therefore, the effective cash outflows is less than the actual
payment of interest made by the firm to the debt holders by
the amount of tax shield on interest payment.
Cost of Perpetual Debt (A bond with no maturity date):
It is the rate of return which the lenders expect. The debt
carries a certain rate of interest. The interest rate on
debt can be said to represent an approximation of the
cost of debt.
ki = I/SV kd = I/SV(1-t)
ki = Before-tax cost of debt
kd = Tax-adjusted cost of debt
I = Annual Interest Payment
SV = Sale Proceeds of the bond/debenture
t = tax rate
 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒅𝒆𝒆𝒎𝒂𝒃𝒍𝒆 𝑫𝒆𝒃𝒕

CIo = COIt /(1+ kd)t + COPn / (1+kd)n

𝒏
𝑪𝑰𝒐 = ෌𝒕=𝟏[𝑪𝑶𝑰t + COPn ] / (1+kd)t
Alternatively,
kd =I(1-t)+(f+d+pr-pi)/Nm
(RV + SV) / 2
I = Annual Interest Payment
RV = Redeemable value of debentures/debt
SV = Net Sales proceeds from the issue of debenture/debt
(face value of debt – issue expenses)
Nm = Term of Debt
f = floatation cost
d = Discount on issue of debentures
pi = Premium on issue on debenture
pr = Premium on redemption of debentures
t = tax rate
 Cost of Preference Share:
Irredeemable: No maturity date is here
kp = Dp / P0 (1-f) or kp = Dp (1+Dt) / P0 (1-f) (with tax)
kp = Cost of Preference capital
Dp = Constant Annual Dividend Payment
P0 = Expected Sales price of preference share
f = Floatation costs as a percentage of sales price
Dt = Tax on preference dividend

Redeemable Preference Capital:

P0 (1-f) = σ𝒏𝒕=𝟏 𝑫𝒑t / (1+kp)t + Pn(1+kp)n
𝑷𝒐 = Expected Sale Price of the preference share
f = Floatation Cost
Dp= Dividend Paid on preference share
Pn = Repayment of preference capital amount
 Cost of Equity Capital
The return to the equity holders solely depends upon the discretion
of the company management. Apart from the absence of any
definite commitment to receive dividend, the equity
shareholders rank at the bottom as claimants on the assets of
the company at the time of its liquidation.
The main objective of financial management is to maximise
shareholder’s wealth and the maximisation of market price of
shares is the operational substitute for wealth maximisation.
When equity holders invest their funds they also expect returns in
the form of dividends. The market value of shares is a function of
the return that the shareholders expect and get. If the company
does not meet the requirements of its shareholders, it will have an
adverse effect on the market price of shares.
The equity shares, thus, involve a return in terms of the
dividend and, therefore, carry a cost.

In fact, the cost of equity capital is relatively the

highest among all the sources of funds. The equity
shares involve the highest degree of financial risk
since they are entitled to receive dividend and
return of principal after all other obligations of the
firm are met.

As a compensation to the higher risk exposure, holders

of such securities expect a higher return and, therefore,
higher cost is associated with them.
Cost of Equity Capital (ke) may be defined as the
minimum rate of return that an equity
shareholder must earn.

Assumptions with respect to the behaviour of investors

and their ability to forecast future values:
 The market value of shares depends upon the
expected dividends,
 Investors can formulate subjective probability
distribution of dividends per share expected to be paid
in various future periods,
 The initial dividend, Do , is greater than zero

 The dividend pay-out ratio is constant

 Investors can accurately measure the riskiness of

the firm.
There are two possible approaches that can be employed to
calculate the cost of equity capital (i) dividend
approach and (ii) Capital Asset Pricing Model.

Dividend Approach
The Cost of Equity Capital (ke) is accordingly defined as the
discount rate that equates the present value of all expected
future dividends per share with the net proceeds of the sale (or
the current market price) of a share. The two elements of the
calculation of ke on the basis of the dividend approach are (i) net
proceeds from the sale of a share/current market price of a share,
and (ii) dividends and capital gains expected on the share.

In dividend there may be growth, uniform, normal rate

perpetually given or may vary so that for a few years it may be at
level higher than in subsequent years after which it will increase at
a normal rate.
 (A) When dividends are expected to grow at a
uniform rate perpetually:

P0 (1-f) = D0 (1+g)1 / (1+ke)1 + D0 (1+g)2 / (1+ke)2 + ……….+

D0 (1+g)n / (1+ke)n

= D1 (1+g)t-1 / (1+ke)t
So it can be written as

P0 = D1/ (ke – g)
Where ke = D1/ P0 + g
D1 = Expected dividend per share
P0 = Net proceeds per share/current market price
g = Growth in expected dividends
(B) Under different growth assumptions of dividends
over the years

𝐏𝐨 = σ𝒏𝒕=𝟏 D0 (1+gh)t-1/ (1+ke)t + Dn(1+gc)t-1/(1+ke)t

gh = Rate of growth in earlier years

gc = Rate growth in the later years
 In case company’s past growth rate has been
abnormally high or low, either due to its own unique
situation or due to general economic fluctuations, historic
growth rate (g) may not be reliable. In such situations,
dividend growth forecasts should be based on factors such
as projected sales, profit margins and competitive factors.
Accordingly,
k = D k/ePwould
e 1 0
be as follows:
+ Growth rate as projected

.
 However, the dividend growth model approach is be
set with a number of practical problems and
drawbacks.

The major ones are (1) it is applicable only to

those corporates which pay dividends. Its results
are really applicable to cases where a reasonably
steady growth is likely to occur, (2) Cost of equity is
very sensitive to the estimated growth. As
explained earlier, it is not easy to estimate its value,
(3) There is no allowance for the degree of risk
associated with the estimated growth rate for
dividends.
 Capital Asset Pricing Model Approach
The CAPM explains the behaviour of security prices and
provides a mechanism whereby investors could assess the
impact of proposed security investment on their overall
portfolio risk and return.

In other words, it formally describes the risk-return

trade-off for securities. It is based on certain
assumptions. The basic assumptions of CAPM are
related to (a) the efficiency of the security markets and
(b) investor preferences.
The efficient market assumption implies that (i) all
investors have the same information about
securities, (ii) there is no restriction on investment,
(iii) there is no tax, (iv) there is no transaction cost,
and (v) no single investor can affect market price
significantly, (vi) all the investors will have
homogeneity or common expectation.

The implication of investors’ preference assumption is

that all investors prefer the security that provides the
highest return for a given level of risk, i.e., the
investors are risk averse.
The risk to which security investment is exposed, falls into
two groups: (i) diversifiable/unsystematic, (ii) non-
diversifiable/systematic.

The first represents that portion of the total risk of an

investment that can be eliminated/minimised through
diversification. The sources of such risks include management
capabilities and decisions, strikes, unique governance
regulations, availability of raw materials, competition,
level of operating and financial leverage of the firm and so
on.

The systematic/non-diversifiable risk is attributable to

factors that affect all firms. The sources of such risks are
interest rate changes, inflation or purchasing power
change, changes in investors capabilities about the overall
performance of the economy and political changes and so on.
 As unsystematic risk can be eliminated by an
investor through diversification, the systematic risk
is the only relevant risk. Therefore, an investor
(firm) should be concerned, according to CAPM,
solely with the non-diversifiable (systematic) risk.

According to CAPM, the non-diversifiable risk of an

investment/security/asset is assessed in terms of beta
coefficient which is a measure of volatility of a
security’s return relative to the returns of a broad-
based market portfolio.
 Beta for the market portfolio as measured by the
broad based market index if equals one, would imply
that the risk of the specified security is equal to the
market.
The interpretation of zero coefficient is that there is
no market-related risk to the investment.

The going required rate of return in the market for a

given amount of systematic risk is called the Security
Market Line (SML).
Ke = Rf + b (km - Rf)
Ke = Cost of Equity
Rf = Risk free rate of return
km = Return on Market Portfolio
b = Beta Coefficient
 σ 𝑴𝑱 − 𝑵 𝑨𝒗 𝒐𝒇 𝑴 ∗ 𝑨𝒗 𝒐𝒇 𝑱
σ 𝑴 ∗ 𝑴 − 𝑵(𝑨𝒗 𝑴 ∗ 𝑨𝒗 𝑴)

M = Excess in Market return

J = Excess in Security return
N = Number of year
 The CAPM approach directly considers the risk,
while dividend policy method does not consider
this.
It rather uses market price. Dividend policy adjusts
with the floatation cost, while CAPM does not take
this. CAPM is generally used in the company without
dividend.

In general dividend policy is adopted due to lack

of adequate data in CAPM.
 Cost of Retained Earnings

Apparently, retrained earnings may appear to carry no cost

since they represent funds which have not been raised
from outside. However, it is not correct.

If earnings were not retained, they would have been paid out
to the ordinary shareholders as dividends. In other words,
retention of earnings implies withholding of
dividends from holders of ordinary shares. When
earnings are, thus, retained, shareholders are forced to
forego dividends.
Therefore, the cost of retained earnings may be
defined as opportunity cost in terms of dividends
foregone by/withheld from the equity shareholders.
The alternative use of retained earnings is based on
external-yield criterion. The firm should estimate
the yield it can earn from external investment
opportunities by investing its retained earnings
there.
It is approximately ke. . The kr here is simply the return on direct
investment by the firm itself. In brief, the cost of retained earnings
represents an opportunity cost in terms of the return on their
investment in another enterprise by the firm whose cost of retained
earnings is being considered.
 Overall Cost of Capital
The term cost of Capital means the overall composite
cost of capital defined as weighted average of the
cost of each specific type of fund. The use of weighted
average considers the fact that the proportions of various
sources of funds in the capital structure of a firm are
different. To be representative, therefore, the overall
cost of capital should take into account the relative
proportions of different sources and hence the
weighted average.
Computation
Assigning the weights to specific cost
Multiplying the cost of each of the sources by the
appropriate weights
Dividing the total weighted cost by the total weight.
 Assignment of Weights:
Marginal weights Vs Historic Weights

Historical weights can be - (a) Book Value weights or (b) Market

Value weights.

Marginal weights Vs Historic Weights

The critical assumption in any weighting system is that the firm
will raise capital in the specified proportions.
Marginal Weights
The use of marginal weights involves weighting the specific costs
by the proportion of each type of fund to the total funds to be
raised. The marginal weights represent the percentage share
of different financing sources the firm intends to raise/employ.
The basis of assigning relative weights is, therefore,
new/additional/incremental issue of funds, and, hence,
marginal weights.
 The Marginal cost of capital is the cost of the new capital to be
raised to finance the current capital expenditure decision. The
combined cost of capital should be calculated by employing
marginal weights.
Since, capital expenditure decisions are long-term investments of the
firm, attention should be given to the long-term implications of any
financing strategy.

The use of Historical Weights is based on the assumption

that the firm’s existing capital structure is optimal and
therefore, should be maintained in the future. That is the
firm should raise additional funds for financing
investments in the same proportion as they are in the
existing capital structure.
 The firms should raise additional funds from different
sources in the same proportion in which they are in the
existing capital structure implies that there are no
constraints on raising funds from these sources. This is
not correct. For instance, the amount of retained earnings
may actually fall short of its required share in financing
new projects because firms cannot have control over the
retained earnings. Similarly, raising funds from the
capital market depends on several factors such as the
state of the economy, requirements of investprs, temper
of the market and so on, over which the firms have
obviously no control. There are thus practical
difficulties in applying historical weights. A choice
has to be made between the book value weights
and market value weights.
 While it is true that firms actually raise funds in
lump sum amounts from one or two sources at a
time instead of all the available sources, the use of
historical weights to calculate the overall weighted
average cost of capital is more consistent with the
firm’s long-term goal of maximising the owner’s
wealth.
Therefore, the use of historical weights is much more
likely to lead to an optimal selection of capital
investment projects in the long run. It is probably for
this reason that historical weights are commonly used to
calculate the weighted cost of capital, and are treated as
superior to marginal weights which as already indicated,
ignore the long-term implications of the firm’s current
financing.
 Book Value and Market Value Weights:
This problem will arise only in the case of historical
weights.
Both these methods have their own merits. In theory, the
use of market value weights for calculating the
cost of capital is more appealing than the use of
book value weights because: (i) market value of
securities closely approximate the actual amount
to be received from their sale, (ii) the costs of the
specific sources of finance which constitute the
capital structure of the firm are calcualted using
prevailing marketing prices.
However, there are practical difficulties in its use as
calculating the market value of securities may present
difficulties, particularly the market values of retained
earnings. Moreover, weights based on market
values are likely to fluctuate widely.
On the other hand, book values are readily available
from the published records of the firm. Also, firm set
their capital structure targets in terms of book values
rather than market values.