PROF.

PARVEEN SULTANA

Cost of capital refers to the discount rate that is used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. It defined as the minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged.

This cost of capital composed of several elements these elements are the cost of each component of capital . The term component means the different sources from which funds are raised by a firm sources of funds' or each component of capital has it cost. This cost is called specific cost of capital when this specific cost is combined to arrive at over all cost of capital, it is referred to weighted cost of capital or cost of capital or composite cost of capital and combined cost of capital The cost of capital is mainly focus on the valuation of the firm. The riskless cost of the The business risk Cost of capital = particular type of financing + premium (b)

( j)
+ the financing risk premium (f)

K = rj + b + f

The cost of capital can be either Explicit cost of capital:- The explicit cost of any source of capital is the discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows. cot Cio = nE--------t=0 (1+c)t Implicit cost of capital:- The implicit cost of capital defines 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.

Computation of the cost capital:1. The computation of the different elements of the cost in terms of the cost of the different sources of finance (specific cost). 2. Calculation of the overall cost by combining the specific costs into a composite cost. 3. Specific costs have to be calculated for (1) long term debt (including debentures) (2) retained earning.(3) preference shares. (4) equity capital

The calculation of the cost of debt is relatively easy. The cost of the funds raised through debt in the form of debt, in the form of debentures or loan cost of debt is formulated through , 1. The net cash proceeds /inflows ( the issue price of debentures / amount of loan minus all flotation costs) from specific source of debt. 2.The net cash out flows in term of the amount of periodic interest payment and repayment of principal in installment or in lump sum on maturity

The interest payments 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 firms to the debt holders by the amount of tax shield on interest payment

Cost of perpetual debt Cost of redeemable or irredeemable debt

The measurement of the cost of perpetual debt is conceptually relatively easy. It is a rate of return which a lender expect . The debt carries a certain rate of interest which is known as coupon. Debt are issued either in bonds or debentures in the following : At par At discount At premium

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 1 1 Ki =--------------- , kd =------------------ ( 1- t) sv sv

In the case of calculation of cost of redeemable debt account has to be taken in addition to interest payments, of the repayment of the principal . When the amount of principal is repaid in one lump sum at the time of maturity the repayments are in a number of installment coit cop Cio =e --------------- + ------------t=1 ( 1+kd)t (1+k )n
n
n

coit cop Cio =e --------------- + ------------t=1 ( 1+kd)t (1+k )n Where coit= net cash proceeds from issue of debentures or from raising debt. Cot1------cotn= cash outflow on interest payments in time period 12n and so on up to the year of materity after adjusting tax savings on interest payments. Copn= principal repayment in the year of materity Kd = cost of debt If the repayment of debt is in a number of installment instead of lump sum payment :coit+ cop1 Cio=en---------------------t=1 (1=kd)t
n
n

Preference shares are entitled to the preference dividend and the holders of such shares have a preferential right as regards payments of the dividends as well as return of principal as compared to ordinary share holders or equity share holders. Types of cost of preference shares: 1. Irredeemable /perpetual 2. redeemable

This category is a kind of perpetual security in that the principal is not to be returned for a long- time or is likely to be available till the life of the company the redeemable preference shares are issued with a materity date so that the principal will be repaid at some future date

Cost of P.shares which has no specific maturity date. d d(1+ dt) Kp=------------------ kp =--------------po (1-f) po(1-f) Where kp=cost of preference capital, D = constant annual dividend payment Po = expected sales price of preference shares. F =flotation cost as a percentage of sale price. Dt = tax on preference dividend

The explicit cost of preference shares in such a situation is the discount rate that equates the net proceeds of the sale of preference shares with the present value of future dividends and principal repayments.