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INTRODUCTION
1.3 Background
There are three things that make the cost of capital the most important material for discussion.
First, capital budgeting decisions have a large impact on the company while proper budgeting
requires an estimate of the cost of capital. Second, the financial structure affects the level of
risk and the size of the income stream. Knowledge of capital costs and how these costs are
affected by financial leverage, will change in making decisions in the field of capital structure.
Third, a number of decisions such as leasing, refinancing, bonds and working capital policy, all
require estimates of capital costs.
In addition, capital costs are an important concept in investment analysis because they can
indicate the minimum level of investment profit that must be obtained from the investment. If
the investment cannot generate investment returns at least as much as the costs incurred, the
investment does not need to be done. Easier, the cost of capital is the average cost of funds to
be collected to make an investment. It can also be interpreted that the cost of capital of a
company is a part (rate of interest) that the company must spend to satisfy its investors at a
certain level of risk.
1.3 Purpose
- To find out the meaning of Cost of Capital.
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CHAPTER II
DISCUSSION
2.1 Explanation Cost Of Capital
The cost of capital is the company's cost of using funds provided by creditors and
shareholders. A company's cost of capital is the cost of its long-term sources of funds: debt,
preferred equity, and common equity. And the cost of each source reflects the risk of the
assets the company invests in. A company that invests in assets having little risk in
producing income will be able to bear lower costs of capital than a company that invests in
assets having a higher risk of producing income.
2.2 Types of Cost of Capital
Cost of capital can be classified as follows:
i) Historical Cost and future Cost
Historical costs are book costs relating to the past, while future costs are estimated costs act as
guide for estimation of future costs.
ii) Specific Costs and Composite Costs
Specific accost is the cost if a specific source of capital, while composite cost is combined cost
of various sources of capital. Com- posite cost, also known as the weighted average cost of
capital, should be consid- ered in capital and capital budgeting decisions.
iii) Explicit and Implicit Cost
Explicit cost of any source of finance is the discount rate which equates the present value of
cash inflows with the present value of cash outflows. It is the internal rate of return and is
calculated with the following formula.
iv) Average Cost and Marginal Cost
An average cost is the combined cost or weighted average cost of various sources of capital.
Marginal cost of refers to the average cost of capital of new or additional funds required by a
firm. It is the marginal cost which should be taken into consideration in investment decisions.
A. Cost of Debt
The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose
you borrow one dollar and promise to repay it in one year, plus pay $0.10 to compensate the
lender for the use of her money. Since Congress allows you to deduct from you income the
interest you paid, how much does this dollar of debt really cost you? It depends on your
marginal tax rate -- the tax rate on your next dollar of taxable income.
B. Cost of Preferred Equity
The cost associated with raising one more dollar of capital by issuing shares of preferred
stock. Preferred stock is a perpetual security it never matures. Consider the typical preferred
stock with a fixed dividend rate,where the dividend is expressed as a percentage of the par
value of a share.
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C. Cost of Common Equity
The cost of common equity is the cost of raising one more dollar of common equity capital,
either internally -- from earnings retained in the company -- or externally -- by issuing new
shares of common stock. There are costs associated with both internally and externally
generated capita
The cost of issuing common stock is difficult to estimate because of the nature of the cash
flow streams to common shareholders. Common shareholders receive their return (on their
investment in the stock) in the form of dividends and the change in the price of the shares
they own. The dividend stream is not fixed, as in the case of preferred stock. How often and
how much is paid as dividends is at the discretion of the board of directors. Therefore, this
stream is unknown so it is difficult to determine its value.
However, while calculating cost of retained earnings, two adjustments should be made:
Income-tax adjustment as the shareholders are to pay some income tax out of dividends, and
adjustment for brokerage cost as the shareholders should incur some brokerage cost while
investment dividend income. Therefore, after these adjustments, cost of retained earn- ings is
calculated as:
Kr = Ke (1-t)(1-b)
Where, Kr = cost of retained earnings; Ke = Cost of equity ; t = rate of tax
b = cost of purchasing new securities or brokerage cost.
E. Cost of Rights Issue
Rights issue is an invitation to the existing shareholders to subscribe for further shares to be
issued by a company. A right simply means an option to buy certain shares at a privileged
price which is considerably below the market price. It is generally felt that the cost of issue
would be different from the cost of direct issue. But for two reasons, the real cost of rights issue
would be the same as the cost of direct issue of share to the public.
i) The shareholder who is not interested in the rights issue, sells his rights and obtain
cash. Then he has the old share plus the money obtained from selling the rights.
ii) Otherwise, the shareholder exercise his rights and acquires the share the new share, in
addition to the old shares.
Thus, the present wealth of the shareholders in both the cases remains the same.
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share is known as “conversion price”. This conversion price is declares at the time of the issue
of debentures itself.
When the bondholder exercises his option of conversion, he enjoys two benefits-interest on
bonds till the date of conversion and increased market value share a at the time of conversion.
Hence, the cost of convertible securities is taken to be that rate of discount swhich equates the
after-tax interest and the expected market value of the share at the end option period, with the
current market value of bond.
This is calculated with the help of following formula:
Po =
Where,
Po = Current market value of debenture
I = Interest
T = tax rate
Ko = Rate of discount or cost of convertible security.
n = no. of years at the end of which conversion takes place.
CR = conversion or the no. of share the bond – holder gets on conversion
Problem
Consider the Plum Computer Company once again. Suppose Plum will raise capital in the following proportions: Debt: 40
percent; Preferred stock: 10 percent; Common stock: 50 percent. What is Plum's weighted average cost of capital if its cost
of debt is 3.6 percent, its cost of preferred stock is 8 percent, and its cost of common stock is 12 percent?
Solution
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FACTORS AFFECTING COST OF CAPITAL
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RELATIONSHIP OF COST OF CAPITAL WITH CAPITAL BUDGETING
Multinational companies evaluate projects by using capital budgeting, which compares the benefits
of a project with its costs. Capital budgeting is intended to separate projects that are feasible to
implement and projects that are not feasible. Multinational capital budgeting usually involves the
same process. However, the specific characteristics of projects that affect future cash flows or
discounted interest rates used to discount cash flows make budgeting for multinational capital more
complicated.
Capital shows that the fixed assets used for production and budget are a detailed plan that projects
cash inflows and outflows of cash for several periods in the future. Capital budgeting is an outline
of the plan for issuing fixed assets and is a comprehensive process of analyzing the project and
determining which are included in the capital budget.
Capital budgeting is the process by which financial managers are faced with the decision whether to
invest in a particular project or on a particular asset. Capital budgeting needs to pay attention to
several things, namely (1) what projects are profitable for the company, (2) from a series of project
choices, what assets are needed to support the project, and (3) how much investment must be spent
to obtain the assets. Capital budgeting is carried out by agencies that have long-term projects that
they want to run. This long-term project can be an expansion of a division of a subsidiary to
establish a new subsidiary. Capital budgeting decisions will affect the long term so that the
company loses its flexibility.
The capital budgeting phase includes (1) project costs must be determined, (2) management must
estimate the expected cash flow from the project, including the asset's final value, (3) the risk from
the project cash flow must be estimated using a cash flow probability distribution, (4) with know
the risks of the project, management must determine the cost of capital (discount of capital) is
appropriate for discounting the cash flow of the project, (5) using the time value of money,
expected cash inflows used to estimate asset value, (6) present value of flow expected cash
compared to the cost. Effective capital budgeting will increase the timeliness and quality of adding
assets and capital expenditures is very important to study.
Capital budgeting decisions have a large influence on the company and good capital budgeting will
require a forecast of the right cost of capital.
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CHAPTER III
CONCLUSION
Cost of capital is the real cost that must be incurred by the company to obtain funds both debt,
preferred stock, ordinary shares, and retained earnings to fund a company's investment. Cost of
Capital is the cost that must be paid or paid by the company to obtain capital used for company
investment.
There are several types cost of capital : historical cost and future cost , specific cost and composite
cost , explicit cost and implicit cost , average cost and marginal cost
1. Factors that the Company Cannot Control : Interest Rate , Tax Rates.
2. Factors That Can Be Controlled by Companies : Capital Structure Policy, Dividend policy
Investment Policy.
So the cost of capital is very influential for the company to run company activities due to capital
costs can be used as a benchmark for the company find out whether the company is getting a high
profit or not. Capital budgeting decisions have a big influence on the company and good capital
budgeting will require a forecast of the right cost of capital.
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REFERENCE