Cost of capital refers to the payment that a firm has to make to the suppliers of capital.

This include dividend payment to equity or preference and interest payment to

debentures. The term cost of capital is generally used in the sense of the overall cost of
capital
Ko=kew1+krw2+kpw3+kdw4
Ko=Overall cost of capital
ke = Cost of equity
Kr =cost of retained earning
kp = cost of preference shares
Kd =after tax cost of debt
W1= proportion equity to total capital
W2 = proportion of retained earnings to total capital
 It is important criterion in many decision making areas.
 In investment decisions to decide about profitability of the
proposal
 Leveraging that is equity and debt mix to reduce the average
cost of capital
 In working capital management
 In performance evaluation
 An explicit cost is a cost that occurs, is easily identified, and is
accounted for in business documents or financial statements. It
represents clear, obvious cash outflows that reduce a business's
bottom-line profitability. Examples of explicit costs would be
items such as wage expenses, rent, or lease costs; it is easy to
identify the sources of those cash outflows and the business
activities to which the expenses are attributed.

 Implicit costs can also be called imputed, implied or notional
costs. Businesses don’t necessarily record implicit costs for
accounting purposes because money does not change hands.
These costs represent loss of potential income and not of profits.
A company may choose to include these costs as the cost of
doing business since they represent possible sources of income.
 Difference Between Implicit and Explicit Costs
 Implicit costs are technically not incurred and therefore cannot
be measured accurately for accounting purposes. There are no
cash exchanges in the realization of implicit costs. However, they
are important costs to ascertain because they help managers
make effective decisions on behalf of the company.
 Earnings/price model
 Dividend growth model
 Earnings growth model
 Capital asset pricing model
Ke=E/P

 E= earning per share

 P= current market price per share
Ke =(D/P)+g
 D= dividend per share at the end of a period
 P= current market price
 G=growth rate in dividend
Ke= (E/P)+g

 E= earnings per share

 P= Current market price of shares
 G= Growth rate in earnings
 These are costs of floating shares in the market and includes
brokerage underwriting etc. There fore cost of new equity will be

Ke =(D/P(1-f))+g
 F= floating charges
 On this basis, the most commonly accepted method for calculating cost of
equity comes from the Nobel Prize-winning capital asset pricing
model (CAPM): The cost of equity is expressed formulaically below:

Re = rf + (rm – rf) * β

Where:

Re = the required rate of return on equity

 rf = the risk free rate
 Rm = Expected return on the market as a whole
 rm – rf = the market risk premium
 β = beta coefficient = systematic risk or unavoidable risk
 Rf – Risk-free rate - This is the amount obtained from investing in
securities considered free from credit risk, such as government bonds
from developed countries.
 ß – Beta - This measures how much a company's share price reacts
against the market as a whole. A beta of one, for instance, indicates
that the company moves in line with the market. If the beta is in
excess of one, the share is exaggerating the market's movements; less
than one means the share is more stable. Occasionally, a company
may have a negative beta (e.g. a gold-mining company), which means
the share price moves in the opposite direction to the broader market.
 (Rm – Rf) = Equity Market Risk Premium (EMRP) - The equity
market risk premium (EMRP) represents the returns investors
expect to compensate them for taking extra risk by investing in
the stock market over and above the risk-free rate. In other
words, it is the difference between the risk-free rate and the
market rate. It is a highly contentious figure. Many
commentators argue that it has gone up due to the notion that
holding shares has become more risky.
 The EMRP frequently cited is based on the historical average
annual excess return obtained from investing in the stock market
above the risk-free rate. The average may either be calculated
using an arithmetic mean or a geometric mean. The geometric
mean provides an annually compounded rate of excess return
and will in most cases be lower than the arithmetic mean. Both
methods are popular, but the arithmetic average has gained
widespread acceptance.
 Once the cost of equity is calculated, adjustments can be made to
take account of risk factors specific to the company, which may
increase or decrease a company's risk profile. Such factors
include the size of the company, pending lawsuits, concentration
of customer base and dependence on key employees.
Adjustments are entirely a matter of investor judgment, and they
vary from company to company.
 Opportunity cost involved.
 Dividend foregone by the shareholders
 Two methods for measuring this cost
 Reinvestment assumption
 External yield criterion
Kr=Ke(1-t)(1-C)

 Kr= cost of retained earnings

 Ke = cost of equity share capital

 C= Commission,brokerage

 t= Marginal tax rate

Kr = Ke =(D/P)+g

Kr = Ke= (E/P)+g

Kp =D/I
 D= Annual dividend
 I = Net proceeds of the preference shares
issued
 Preference shares are paid after tax so no
need for adjustment of tax
 When preference shares are issued at a premium or discount and
are redeemable after the expiry of a given perion(n) the
following formula is used:

kp =D+(1/n(P-I))½(P+I)
 D= Annual dividend payable
 P= Face value of preference shares
 I= Issue price of shares
 A domestic company is required to pay tax at 10% on the
amount of dividend paid to its sharholders(both equity and
preference).Accordingly in computing the cost of equity and cost
of preference, ‘D’ should be adjusted by the factor(1+t) where t
represents the rate of dividend tax

Ke =(D(1+t)/P)+g
 Debt issued at par

 Kd = r(1-t)

 r= Interest rate payable

 t= Marginal tax rate of the firm
Kd = (C+(1/n)(P-I))(1-t)/(1/2)(P+1)
c= Fixed interest charges per annum
P=Face value of the debenture
 I= Price at which the debenture or bond
is sold
 t=Marginal tax rate
 Debts may be issued for a perpetuity.or calculating the explicit
cost of debt, the formula for a perpetuity would be as follows:
 Kd = (C/I)(1-t)

 C =Fixed annual interest payable

 I= Net proceeds of the issue
 t= applicable tax rate.
 Computation of overall cost of capital
 Compute specific cost of each of the sources of capital
 Select appropriate weights
 Multiply the cost of each of the sources by the appropriate
weights
 Divide the total coast by total weights
 Book value weights:It is relative proportions of various sources
of capital to the capital structure of the firm
 Market value weights:Proportions of market values of various
sources of capital may be assigned as weights in computing the
overall cost of capital.
 The rationale for using weighted average cost of capital for capital
budgeting decisions is that by accepting projects that will give more
than the cost of capital, the firm is able to increase its share's market
price because the accepted projects are expected to return more on
their equity financed portion than on the cost of equity capital. Once
theses expectations are apparent to the market place , the market
price of shares will tend to increase, all other factors remaining
constant. This is consistent with the value maximization objective of
the firm.
 The weighted average cost of capital can be calculated on the before-
tax or after tax basis. However, the measurement of the overall cost of
capital on an after tax basis is more appropriate.
 The cost of obtaining another rupee of new capital. As in
practice, a firm raises some fixed amount of capital at a point of
time to finance an investment proposal, the marginal cost of
capital generally signifies the cost of additional amount of
capital that may be raised by a firm.