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Cost of Capital

By

Mr. Abhaya Kumar Muduli

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Components of cost of capital

The expected normal rate of return at zero risklevel

The premium for business risk

The premium for financial risk on account ofpattern of capital structure

Where = Cost of capital

= Normal rate of return at zero risk level

b = Premium for business riskf = premium for financial risk

4

=

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Types of cost

Specific cost and Composite cost Specific cost

refers to the cost of a specific source of capitalwhile composite cost of capital is the combined costof various sources of capital

Explicit Cost and Implicit cost An explicit cost

is the discount rate which equates the presentvalue of cash inflows with the present value of cashoutflows. In other words, it is the internal rate ofreturn. Implicit cost is the opportunity cost ofinvestors. So the cost of retained earning is

implicit cost

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Types of cost

Average cost and Marginal cost An averagecost refers to the combined cost of varioussources of capital such as debentures, preferenceshares and equity shares. It is the weightedaverage cost of the costs of various sources of

finance. Marginal cost of capital refers to theaverage cost of capital which has to be incurredto obtain additional funds required by a firm. Ininvestment decision, it is the marginal cost which

should be taken in to consideration

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General Formula for the OpportunityCost of Capital

Opportunity cost of capital is given by the followingformula:

where Io is the capital supplied by investors inperiod 0 (it represents a net cash inflow to thefirm), Ct are returns expected by investors (theyrepresent cash outflows to the firm) and k is therequired rate of return or the cost of capital.

The opportunity cost of retained earnings is the

rate of return, which the ordinary shareholderswould have earned on these funds if they had beendistributed as dividends to them.

1 2

0 2(1 ) (1 ) (1 )

n

n

CC CI

k k k

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Weighted Average Cost of Capital Vs.Specific Costs of Capital

The cost of capital of each source of capital is

known as component,orspecific, cost of capital. The overall cost is also called the weighted

average cost of capital (WACC). Relevant cost in the investment decisions is the

future cost or the marginal cost. Marginal cost is the new or the incremental cost

that the firm incurs if it were to raise capital now,or in the near future.

The historical cost that was incurred in the pastin raising capital is not relevant in financialdecision-making.

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Cost of Debt

Debt Issued at Par

Debt Issued at Discount or Premium

Tax adjustment

0

INT

dk iB

01

INT

(1 ) (1 )

nt n

t nt d d

BB

k k

After-tax cost of debt (1 )dk T

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Cost of perpetual debt

(a) X ltd. issues Rs. 50,000 8% debentures at par.The tax rate applicable to the company is 50%.Compute the cost of debt capital

(b) Y ltd. issues Rs. 50,000 8% debentures at apremium of 10%. The tax rate applicable to thecompany is 60%. Compute the cost of debt capital

(c) A ltd. issues Rs 50,000 8% debentures at adiscount of 5%.The tax rate is 50%, compute thecost of debt capital.

(d) B ltd. issues Rs 1,00,00 9% debentures at a

premium of 10%. The cost of floatation are 2%. Thetax rate applicable is 60%. Compute the cost

of debt.

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Cost of debt Redeemable ininstallments

A company is proposing to issue a 5 year debentureof Rs. 1000 at 14% rate of interest per annum. Thedebenture amount will be amortized equally over itslife. If the present value of the debenture for aninvestor is Rs. 1046.59, calculate the minimum

required rate of return or the cost of debt.

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Cost of Preference Capital

Irredeemable Preference Share

Redeemable Preference Share

0

PDIV

pkP

01

PDIV= +

(1 ) (1 )

nt n

t nt

p p

PP

k k

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Cost of Equity Capital

Cost of External Equity: The DividendGrowthModel

EarningsPrice Ratio and the Cost of Equity

1

0

DIVek g

P

1

0

1

0

EPS (1 )( )

EPS( 0)

e

bk br g br

P

bP

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Thank You

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