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CHAPTER I

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.

1.2 Problem Formulation


- What is the Cost of Capital ?

- What are the types of Cost of Capital ?

- What are the factors that affect the Cost of Capital ?

1.3 Purpose
- To find out the meaning of Cost of Capital.

- To find out the types of Cost of Capital.

- To find out the factors that affect the 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.

D. Cost of Retained Earnings (Kr)


Retained earnings refer to undistributed profits of a firm. Out of the total earnings, firms
generally distribute only past of them in the form of dividends and the rest will be retained
within the firms. Since no dividend is required to paid on retained earnings, it is stated that
‘retained earnings carry no cost’. But this approach is not appropriate. Retained earnings has
the opportunity cost of dividends in alternative investment becomes cost if retained earnings.
Hence, shareholders expect a return on retained earnings at least equity.
Kr = Ke = D/NP+g

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.

F. Cost of Convertible Securities


Convertible securities or debentures are another type of instruments for mobilization of debt
capital. In this case the debenture holder is entitled to gull pr a part of the value of the deben-
ture being converted into equity shares. The price at whch the debenture is convertible into

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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

Weighted Average Cost of Capital (WACC)


The cost of capital is the average of the cost of each source, weighted by its proportion of the
total capital it represents. Hence, it is also referred to as the weighted average cost of
capital (WACC) or the weighted cost of capital (WCC). The weighted average cost of
capital is:

WACC = wdr d* + wprp + were


where

wd is the proportion of debt in the capital structure;


wp is the proportion of preferred stock in the capital structure; and we is the proportion of
common stock in the capital structure. As you raise more and more money, the cost of each
additional dollar of new capital may increase. This may be due to a couple of factors: the
flotation costs and the demand for the security representing the capital to be raised.

Example Calculating the WACC

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

WACC = 0.40 (0.036) + 0.10 (0.08) + 0.50 (0.12)

WACC = 0.0144 + 0.008 + 0.06

WACC = 0.0824 or 8.24%

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FACTORS AFFECTING COST OF CAPITAL

1. Factors that the Company Cannot Control.


a. Interest Rate : If interest rates in the economy increase, the cost of debt will also increase because
companies must pay bondholders with higher interest rates to obtain debt capital.
b. Tax rates : Tax rates are used in the calculation of debt costs used in the WACC, and there are
other ways that are less tangible where tax policies affect the cost of capital.
2. Factors That Can Be Controlled by Companies.
a. Capital Structure Policy. The WACC calculation is based on the interest rate of each capital
component with the composition of its capital structure. So if the capital structure changes, the
capital costs will change.
b. Dividend Policy. Decreasing the ratio of dividend payments may cause the cost of own capital to
increase, so that the MACC rises.
c. Investment policy. The impact of investment policies will have a risky impact. The size of this
risk will affect the cost of capital.
3. Important variables that affect capital costs include:
a. General economic conditions. This factor determines the level of risk free or riskless yield level.
b. Selling power of a company's stock. If the stock's selling power increases, the minimum yield
level of investors will decrease and the company's capital costs will be low.
c. Operational decisions and financing made by management. If management agrees to invest in
high risk or utilize extensively special debt and shares, the level of risk of the company increases.
Investors then ask for a higher level so that the company's capital costs increase too.
d. The amount of financing needed. Large amounts of capital demand will increase the company's
capital costs.
4. Assumptions in the capital cost model include:
a. Business risk is constant. Business risk is the potential level of change in return on an investment.
The level of business risk in a company is determined by investment management policies. Capital
costs are an investment criterion that is only appropriate for an investment that has the same
business risk as existing assets.
b. Financial risk is constant. Financial risk is defined as an increase in the variation of returns on
common shares due to the increased use of sources of debt financing and special shares. The cost of
capital from individual sources is a function of the current financial structure.
c. Dividend policy is constant.This assumption is needed in estimating the capital costs related to
the company's dividend policy. This assumption states that the ratio of dividend payments
(dividends / net income) is also constant.

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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

Cost of Capital factors in the company include:

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

Brigham and Houston. Fundamentals of Financial Management. Tenth Edition


Jordan, Ross Westerfield. Fundamentals of Corporate Finance. Sixth Edition
http://dl4a.org/uploads/pdf/Financial%20Management-final.pdf
http://chettinadtech.ac.in/coursenotes/CostofCapital-I.pdf
http://educ.jmu.edu/~drakepp/principles/module7/coc.pdf
https://www.docsity.com/documents/download/id/167580/lang/en/
https://s3.amazonaws.com/academia.edu.documents/36330054/COST_OF_CAPITAL.docx?AWS
AccessKeyId=AKIAIWOWYYGZ2Y53UL3A&Expires=1544069708&Signature=tINKLptDBc48
BPFXBaGSoXcfWIU%3D&response-content-
disposition=attachment%3B%20filename%3DMakalah_Cost_Of_Capital.docx
https://www.csus.edu/indiv/k/kuhlej/QUIZ3.ppt
https://www.kau.edu.sa/GetFile.aspx?id=215764&fn=Chap014.ppt
https://www.rose-hulman.edu/~bremmer/EMGT/ppt/Chapter%2010.ppt

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