COST OF CAPITAL

PRESENTED BY PRADEEP PANDEY

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COST OF CAPITAL
The Cost of capital is a minimum rate of return which a firm requires as a condition for undertaking an investment. The Cost of capital is the minimum rate of return or cutoff rate for capital expenditures. The rate of return the firm requires from investment in order to increase the value of the firm in the market place.

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IMPORTANCE OF COC
Capital Budgeting Decision: Cost of capital may be used as the
measuring rod for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing It measures the financial performance and determines the acceptability of all investment opportunities.

Designing the Corporate Financial Structure: The

cost of capital is significant in designing the firm's capital structure. The cost of capital is influenced by the changes in capital structure

Deciding about the Method of Financing: A capable

financial executive must have knowledge of the fluctuations in the capital market and should analyze the rate of interest on loans and normal dividend rates in the market from time to time
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Performance of Top Management: The cost of

capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitability's of the projects and taken with the projected overall cost of capital.

Other areas of decisions making: The concept

of cost of capital is also important in many others areas of decision making, such as dividend decisions, working capital policy etc.

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FACTORS DETERMINING THE COC

General economic conditions : An increase in riskless
rate increases the COC. The riskless rate is determined by: the demand and supply of capital within the economy. Market conditions : The COC increases due to an increase in the market risk as investors demand a higher risk premium. The market risk could increase due to decrease in the liquidity of the security.

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Firms Operating and Financing Decisions

Risk also results from the decisions made within the company. The risk can be divided into two classes: Business Risk: Refers to the variability in returns on assets and is affected by the companys investment decisions. Financial Risk: Refers to the increased variability in returns to the common stockholders as a result of using debt and preferred stock

Amount of Financing
An increase in the amount of financing increases the COC as a result of increase in flotation costs. The risk premium may be a non-linear function of amount of funds

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CALCULATION OF INDIVIDUAL COST OF FUNDS

Short-Term Debt Long Term Debt Irredeemable Debt Redeemable Debt Preference Shares Equity Shares Retained Earnings

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COST OF SHORT-TERM DEBT

FORMULA:
Kd = R(1-T)

Where, Kd = Cost of Debt R = Rate of Interest T = Tax Rate

Example : Ramu

& co. raise Rs 2,00,000 by the issue of 2,000 share ,10% debenture of Rs 100 each payable at per after 10 year . If the rate of company tax is say 50%, what is the cost of debt of the firm ? Solution r = 20,000/2,00,000 =0.10 Kd = 0.10 (1-0.5) =0.05 %

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COST OF LONG-TERM DEBT FORMULA: Kd = R/SP (1-T)

Where, R= Rate of Interest SP= Sale Proceeds of Debt T= Tax Rate

Examples:

Sail co. ltd issued 2,00,000 debenture 10%,rate and got a tax benefit of 50%, calculate cost of capital ? Solution 10% of 2,00,000 = 20,000 Kd= 20,000/2,00,000 (1-0.5) = 0.05

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COST OF REDEEMABLE DEBT

Formula kd
= R +(RV-SP) /n (1-T) ( RV+SP) /2

Where. R= Annual Interest Payment in Rs. SP= Sale Proceeds from RV= Redeemable Value N= Term of Debt Example : A company issued Rs 8,00,000 ,5% redeemable debenture to the public in which they have specified the length of period is 5years. They have changed the flotation cost 30,000 at the time of issue of debenture and they decide to redeem the debenture with 5% ,premium . The company consider the tax rate 40% .compute cost of debenture income of after tax and before tax ?

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Solution :After tax 5% of 8,00,000 =40,000 (R) sales proceeds =8,00,000-30,000 =7,70,000 40,000+(8,40,000-7,70,000)/5 _________________________ X (1-0.4) (8,40,000+7,70,000)/2

40,000+14,000 ________________ X 0.6 8,05,000 =4.02

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COST OF PREFERENCE SHARES

Formula kp =DPS *100
MPS
Where , DPS = dividend per share MPS = Market pries per share Example : Abcl issue a share with a value of Rs 10, and allowed 2% discount at the time of issue to the public . The company also declared dividend of 20%, on the share value . Calculate the cost of share ?

Solution : 2% of 10 =0.2 10-0.2 =9.8 (MPS) 2 ___________ X100 = 20.40 9.8

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COST OF EQUITY SHARES

Dividend approach

Formula :

DPS
Ke = ______ X 100 MPS

Where , DPS = Dividend Per Share MPS = Market Price Per Share Examples: abc company ltd issued shared with a value of Rs 100, and declared a dividend of 20% to shareholders. The market value of the share is Rs 120 calculate the cost of share ? Solution 20 _____ X100 = 16.66% 120
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DPS Ke = ------------ + g MPS (1-F) Where,

DPS = Dividend Per Share MPS = Market Price g = Growth Rate F = Floatation Cost

Examples: mnc company ltd issued shared with the value of Rs

5,00 & declared a dividend of Rs 80 & consider a growth rate of 8% as per market situation the company also considered the flotation cost of 5% calculate the cost of capital ? Solution : 80 ______ + 8 = 24.85 % 500 (1-0.05)

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Cost of retained earnings

formula:

K Re =ke(1-t) (1-b)

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