1. Cost of Capital
 the main objective of a business firm is to maximize the
wealth of its shareholders in the long run , the management
should invest only in those projects which give a return in
excess of cost of funds invested in the projects of the business.
 the difficulty will arise in determination of cost of funds , if it
is raised from different sources & different quantum's
The various sources are in the form of equity and debt
The cost of capital is the rate of return the company has to
pay to various suppliers of funds in the company.
The cost of capital is used as the discount rate or as the target
rate of return for comparing with a projects Internal rate of
return
 cost of capital is defined as “ The minimum rate of return that
a firm must earn on its investments so that the market value
per share remains unchanged”

2. Cost of Capital
 cost of capital is to be determined to help in managerial decision
making like acceptance of capital investment proposals, appraisal of
profitability and viability of sub-units, restructuring of capital, raising of
additional finances etc
 Cost of capital is the minimum rate of return which consists of risk free
rate + premium for risk associated with the particular business [The
risk of the business can be categorized into (a) Business Risk (b)
Financial Risk]
 Therefore , the business and financial risk associated with a particular
firm calls for payment of additional return to the providers of capital
and debt called as risk premium.
 The long term requirements of the firm is generally met from the
following sources :-
1. Equity share capital
2. Preference Share capital
3. Retained Earnings
4. Debentures & Bonds
5. Term Loans from Banks & Financial Institutions

3. Cost of Capital
 The cost would be differing for different sources
 It depends on :-
1. Rights and obligations of the firm
2. Rights of providers of long term funds
3. Risk associated with each source of finance
4. The expectations of the investors
5. Market rate of return of different sources of finance
6. Participation in management
7. Stability and growth of the firm
8. Firms ability to meet out financial obligations
9. Personal taxation of investors
10. Opportunity cost of funds

4. Cost of Capital
 The project’s cost of capital is the minimum required
rate of return on funds committed to the project, which
depends on the riskiness of its cash flows.
 The firm’s cost of capital will be the overall, or average,
required rate of return on the aggregate of investment
projects.
 Significance of the Cost of Capital
1. Evaluating investment decisions,
2. Designing a firm’s debt policy, and
3. Appraising the financial performance of top management.

5. The Concept of the Opportunity
Cost of Capital
 The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable risk.
OCC
.Equity shares
Risk
.Preference shares
.Corporate bonds
.Government bonds
.Risk-free security

6. Cost of Capital
 The cost of capital consists of the following elements:-
1. Cost Of Equity Capital ( Ke)
2. Cost Of Retained Earnings ( Kr)
3. Cost Of Preference Share capital ( Kp)
4. Cost Of Debt, included both debentures, bonds and term
loans ( Kd)

7. Cost of Equity Capital
 Dividend Yield Method :- As per this method , the cost of equity is
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”.
 This method is based on the assumption that the market value of
equity shares is directly related to the future dividends on those shares
, Another assumption is that the future dividend per equity share is
expected to be constant and the company is expected to earn at least
this yield to keep the equity share holder content.
 Ke = D1/ P0
 Where Ke= Cost Of Equity Capital ( After Tax)
 D1= Annual dividend on equity capital in period 1
 P0 = Current market Price of the equity.
 This method emphasis on future expected dividend to be constant. It
does not allow for any growth rate. But in reality, a shareholder expects
the return to grow over time. this approach has no relevance for the
company

8. Cost of Equity Capital
 Dividend Growth Model:-
 Equity share holders will normally expect dividend to increase year
after year and not to remain constant in perpetuity
 In this method an allowance for future growth in dividend is added to
the current yield.
 It is recognized that the current market price of a share reflects
expected future dividends
 This method is also called the “Gordon’s growth model”
 KE= D1/P0+ g
 Where D1= expected dividend per equity share
 P0 = Current market price per equity share
 g = growth rate in the dividend
 criticism :-
1. Future growth pattern is impossible to predict because it will be
inconsistent and uneven
2. Historic growth rate is used for predicting future growth
3. Calculating cost of equity ignoring the cost of other funds may not be
valid
4. The dividend growth rate depends on the earnings of the company
which is difficult to forecast.
P0P0

9. Cost of Equity Capital
 Sometimes the dividend growth rate model formula for
calculation of cost of equity share capital is also written as
follows, if the last declared dividend is known as :-
KE = D0 (1+g)/P0 +g
D0 =recent dividend paid per equity share
P0 =current market price per share
g = constant annual growth rate of dividends

10. Cost of Equity Capital
 Price Earning Method :-
 This method takes into consideration the earning per share (EPS) and
the market price of the share
 This is based on the assumption that the investor capitalizes the stream
of future earnings of the share and the earnings of the company need
not be uniform on the nature of dividend and also it need not be
disbursed to the shareholders
 It is based on the argument that even if the earnings are not disbursed
as dividend , it is kept in the retained earnings and it causes future
growth in the earnings of the company as well as increase in the
market price of the share
 KE = E/M
 WHERE E= Current Earning Per share
 M= market price per share
 The growth rate model as in the case of dividend also apply on the
model

11. Cost of Equity Capital
 Capital Asset Pricing Model (CAPM)
 The capital asset pricing model divides the cost of equity
into two components, the near risk free return available on
investing in government bonds and an additional risk
premium for investing in particular share or investment.
Putting this all together the CAPM assesses the cost of
equity capital for investment as follows:-
 K E = RF + B I (RM – RF)
 WHERE RF =risk free rate
 B I =beta of the investment
 RM = average market return/ return on the market potfolio.

12. Cost of Retained Capital
 The retained earnings are the distributable profits available
for equity shareholders kept with the company without
distributing them in the form of dividend.
 Some argue that the retained earnings are cost free funds
available with the company , on which no returns are payable
 If the retained earnings are distributed among the equity
shareholders ,the amount would have been reinvested to
earn return on it.
 Therefore , the cost of retained earning may be considered
equivalent to the return foregone by the equity shareholders
and it is the opportunity cost of funds not available for
investment by the individual shareholder
 In other words the retained earnings has a cost equivalent to
the opportunity rate of earnings foregone by the equity
shareholder. Hence the cost of equity includes the retained
earnings

13. Cost of Retained Capital
 The retained earnings are the distributable profits available
for equity shareholders kept with the company without
distributing them in the form of dividend.
 Some argue that the retained earnings are cost free funds
available with the company , on which no returns are payable
 If the retained earnings are distributed among the equity
shareholders ,the amount would have been reinvested to
earn return on it.
 Therefore , the cost of retained earning may be considered
equivalent to the return foregone by the equity shareholders
and it is the opportunity cost of funds not available for
investment by the individual shareholder
 In other words the retained earnings has a cost equivalent to
the opportunity rate of earnings foregone by the equity
shareholder. Hence the cost of equity includes the retained
earnings

14. Cost of Retained Capital
 Opportunity cost approach:- the cost of retained earnings is
basically an opportunity cost of such funds to them. It is
equal to the income that they would have earned by placing
these funds in alternative investment.
 If the retained earnings are distributed to the equity
shareholders , they attract personal taxation of individual
shareholder and therefore cost of retained earnings is
calculated as follows:-
 KR = D ( 1-t)
 KR = Cost of retained earnings
 D= Dividend rate
 T= Individual tax rate

15. Cost of Retained Capital
Right Offer Approach :- according to this approach the shareholder is
entitled to profits retained .
 Suppose if the company distributed the retained profits in the form of
dividend to the equity shareholders and again calls back the money by
right offer, the dividend paid by the company to the shareholder attract
tax liability and the shareholder are in a position to invest only to the
extent of dividend received from the company.
 If the retained earnings are kept within the company , the prices of
shares will increase to the extent of retained earnings which will attract
capital gain tax on individual shareholders.
 Therefore , it will not change the position of the shareholder whether
profits are retained or distributed to shareholder.
 The following formula can be used according to this approach to
calculate cost of retained earnings
 Kr = D ( 1- Ti)/ P(1-Tc)
 Where D= Dividend rate
 Ti= marginal tax rate on individual shareholder
 Tc= Capital Gain tax

16. Cost of Preference Share Capital
 Cost Of Irredeemable Preference Shares :
 KP = Dp/ NP
 Where Dp = Preference Dividend
 NP= Net proceeds received from issue of preference shares
after meeting issue expenses
 Cost Of Redeemable Preference Shares:-
 KP = D + ( Rv- Sv)/N
(Rv+Sv)/2
Where D= Preference dividend
Rv = Redeemable value of preference share at time of redemption
Sv= Sale value of preference share less discount & floatation cost
N= Number of years of redemption

17. Cost of Debt
 The capital structure of a firm normally includes the debt component
also. Debt may be in the form of debentures , bonds , term loans from
financial institutions and banks etc. The debt carries a fixed rate of
interest payable to them ,irrespective of the profitability of the
company.
 Then after the payment of fixed interest charge more surplus is
available for equity shareholders and hence EPS will increase.
 Therefore , any payment towards interest will reduce the profit and
ultimately the company's tax liability would decrease. This
phenomenon is called “tax shield”. The tax shield is viewed as benefit
accruing to a company which is geared. To gain the full tax shield , the
following conditions apply:-
1. The company must be able to show a taxable profit every year to take
full advantage of the tax shield
2. If the company makes loss , the tax shield goes down and cost of
borrowing increases.
 Nominal & Real Cost Of Debt :- The real cost of debt will be less
than the nominal cost as investors are not compensated for the real
drop in value of their funds.
 Real Cost of Debt = Nominal Cost Of Debt / Inflation Rate

18. Cost of Debt
 Cost Of Perpetual Debt / Irredeemable Debt
 K D = Interest / NP
 K D = Cost of Debt
 I= Annual Interest Payment
 NP = Net Proceeds of issue of bond, debenture & term loan
Cost Of Redeemable Debt
K D = Interest+ ( Rv- Sv)/N
( Rv + Sv)/2
Rv= Redeemable value at the time of maturity
Sv= Sale value – Flotation Cost & Discount
N= Period Of Redemption
Both the formula will give the KD ( Before Tax)
For Converting into after tax cost we shall use :-
KD ( After Tax) = KD ( Before Tax) * ( 1-t)

19. Weighted Average Cost of Capital Vs. Specific Costs
of Capital
 The cost of capital of each source of capital is known as
component, or specific, 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 past in raising
capital is not relevant in financial decision-making.

20. The Weighted Average Cost of Capital
 The following steps are involved for calculating the firm’s
WACC:
 Calculate the cost of specific sources of funds
 Multiply the cost of each source by its proportion in the
capital structure.
 Add the weighted component costs to get the WACC.
 WACC is in fact the weighted marginal cost of capital
(WMCC); that is, the weighted average cost of new capital
given the firm’s target capital structure.
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o d d d e
o d e
k k T w k w
D E
k k T k
D E D E
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21. Book Value Versus Market Value
Weights
 Managers prefer the book value weights
for calculating WACC:
 Firms in practice set their target capital structure
in terms of book values.
 The book value information can be easily
derived from the published sources.
 The book value debt—equity ratios are analysed
by investors to evaluate the risk of the firms in
practice.

22. Book Value Versus Market
Value Weights
 The use of the book-value weights can be seriously
questioned on theoretical grounds:
 First, the component costs are opportunity rates
and are determined in the capital markets. The
weights should also be market-determined.
 Second, the book-value weights are based on
arbitrary accounting policies that are used to
calculate retained earnings and value of assets.
Thus, they do not reflect economic values.

23. Book Value Versus Market
Value Weights
 Market-value weights are theoretically
superior to book-value weights:
 They reflect economic values and are not
influenced by accounting policies.
 They are also consistent with the market-
determined component costs.
 The difficulty in using market-value
weights:
 The market prices of securities fluctuate widely and
frequently.
 A market value based target capital structure means
that the amounts of debt and equity are
continuously adjusted as the value of the firm
changes.

24. Flotation Costs, Cost of Capital and
Investment Analysis
 A new issue of debt or shares will invariably involve
flotation costs in the form of legal fees, administrative
expenses, brokerage or underwriting commission.
 One approach is to adjust the flotation costs in the calculation
of the cost of capital. This is not a correct procedure.
Flotation costs are not annual costs; they are one-time costs
incurred when the investment project is undertaken and
financed. If the cost of capital is adjusted for the flotation
costs and used as the discount rate, the effect of the flotation
costs will be compounded over the life of the project.
 The correct procedure is to adjust the investment project’s
cash flows for the flotation costs and use the weighted
average cost of capital, unadjusted for the flotation costs, as
the discount rate.

25. The Cost of Capital for Projects
 A simple practical approach to incorporate
risk differences in projects is to adjust the
firm’s WACC (upwards or downwards), and
use the adjusted WACC to evaluate the
investment project.
 Companies in practice may develop policy
guidelines for incorporating the project risk
differences. One approach is to divide
projects into broad risk classes, and use
different discount rates based on the
decision-maker’s experience.

26. The Cost of Capital for Projects
 For example, projects may be classified
as:
 Low risk projects
discount rate < the firm’s WACC
 Medium risk projects
discount rate = the firm’s WACC
 High risk projects
discount rate > the firm’s WACC