UNIT 2 : COST OF CAPITAL

PREPARED BY : GROUP 4

Group Members:1. Bariya Asha

2. Patel Mehul

3. Yadav Jyoti

4. Patel Ajit

5. Tiwari Vikash

6. Giri Bhargavi

DEFINATION

• According to I.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”.

COMPUTATION OF COST OF 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.

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.

TYPES OF COST OF 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.

1. Debt issued at par which are Irredeemable

Kd = I (1 –T) X100

•Where, Kd = Cost of capital • T = Tax rate • I = Interest Rate

2. Debt issued at 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 ValueT = tax rate

3. Cost of redeemable 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

Floating Cost

• All the 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.

Cost of Term Loan

It is given by the formula :

Kt = I (1-t)

• Where, I = Interest rate on term loans • t = tax rate

Cost of preference shares : 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.

Cost of Irredeemable preference share Capital

• Kp = (D /P) x 100• Where, Kp = Cost of

preference capital • D = Dividend • P = Price per share.

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 approach2. Dividend Plus Growth Approach3. Earning Price Ratio or Earning Yield Approach4. Capital Asset Pricing Model

1. Dividend Price Approach

• Cost of Equity is given as

Ke = (D/P) x 100• Where,• D= dividend/share• P = market price /share

2. Dividend + growth approach

• Cost of Equity is given as

Ke = (D/P) + GWhere,D = expected Dividend P = market price/shareG= growth in dividend

3. Earning Price ratio/ Earning yield Approach

• Cost of Equity is given as,

Ke = (E/P) x 100

• Where,• E = earning/ share• P = market price / share

4. Capital Asset Pricing Model

• Cost of Equity = Yield on long term bond + risk premium

= Rf + B (Rm – Rf)Where,

Rf = Risk free rateB = Beta(Risk)Rm = market return

Sources of Long Term Finance

Weighted Average Cost of 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.

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

THANK YOU