K.

J SOMAIYA OF SCIENCE & COMMERCE

NAME-AAYUSHI.PATEL
ROLL NO-28
SEAT NO - 18-7528
CLASS-SYBFM
SUBJECT-CORPORATE FINANCE

COST OF CAPITAL
What is cost of capital ?
Cost of capital refers to the
opportunity cost of making a
specific investment. It is the
rate of return that could have
been earned by putting the
same money into different
investments with equal risk.
The factors which determine the
cost of capital are:
·0 Source of finance
·1 Corresponding payment for using
finance.
On raising funds from the market,from
various sources ,the firm has to pay some
additional amount.
CLASSIFICATION OF COST OF
CAPITAL
1.Explicit cost of capital- It is the cost of
capital in which firm's cashoutflow is
oriented towards utilisation of capital which
is evident , such aspayment of dividend to
the shareholders,interest to the debenture
holders.
2.Implicit cost of capital- It does not involve
any cash outflow but it denotes the
oppurtunity foregone while opting for
another alternative oppurtinity.

IMPORTANCE OF COST OF CAPITAL

·2 It helps in evaluating the investment
options by converting the future cash
flows of the investment avenues into
present value by discounting it.
·3 It is helpful in capital budgeting decisions
regarding the sources of finance used by
the company.
·4 It is vital in designing the optimal capital
structure of the firm.
 ·5 It can also be used to appraise the
performance of specific projects by
comparing the performfance against cost
of capital.
·6 It is useful in framing optimum credit
policy.

COMPONENTS OF COST OF
CAPITAL The
components of cost of capital are as follows :
A) Cost of Debt
B) Cost of equity share capital
C) Cost of retained earnings
D) Cost of preference share capital
E) Cost of borrowing
F) cost of fund index ( COFI)
A) Cost
of debt - The cost of funds raised in the form
of debentures or borrowings from financial
institutions. It may be perpetual or
redeemable debt. It is also a part of capital
structure of a company. Besides the cost of
debt is also helpful in providing the investors
with an idea about company's riskiness as
compared to others.

B) Cost of equity share capital- The equity

shareholders are the owner of the firm. The
cost of equity is the return a firm pays to its
investors , i.e, shareholders to compensate
for the risk they undertake by investing their
capital.Firms need to acquire capital from
others to operate and grow. Individuals &
organizations who are willing to provide their
funds to others naturally desire to be
rewarded.
C) Cost
of retained earnings - The cost of retained
earnings is the earnings forgone by the
shareholders. Retained earnings represent a
business firm's cumulative earnings since its
inception , that is not paid out as dividends
to common shareholders. Retained earnings
belong to the shareholders since they are
efectively owners of the company. If put back
into the company retained earnings serve as
a further investment in the firm on behalf of
the shareholders.

D) Cost of preference share capital - The

preference share capital is different from
equity share capital.The preference share are
entitled to receive dividends at a fixed rate.
In case of liquidation of the company the
preference shareholders will get the capital
repayment in priority over the distribution
among the equity shareholders.Therefore ,
without paying the dividend to preference
shares, they cannot pay anything to equity
shares.In that scenario management
normally tries to pay a regular dividend to
the preference shareholders. Cost of
preference share is used to calculate cost of
capital and are the fixed cost bearing
securities.Preference shareholders also
typically do not hold any voting rights but
common shareholders do.

e)Cost of borrowing- Borrowing cost can be

defined as interest and other costs incurred
by an enterprise in relation to the borrowing
of funds. Cost of borrowing refers to the total
amount a debtor pays to secure a loan and
use funds , including financing costs, account
maintenance , loan and other loan related
expenses. "cost of borrowing" sums appear
as amounts, in currency units such as
dollars,pounds or euro.The borrowing cost
for a business tends to go up when prevailing
market interest rates are rising during times
of economic expansion and increased
inflation.

f)Cost of fund index- A Cost of funds index

(COFI) refers to an established cost of funds
rate for a region.

BREAKING DOWN COST OF

CAPITAL
Cost of capital is widely used in economics
and accounting. Another way to describe cost
of capital is the opportunity cost of making
an investment in business.Wise company
management will invest in initiatives and
projects that will provide returns that exceed
cost of capital.
Cost of capital,from perspective on investor is
the return expected by whomever is
providing the capital for business.

WEIGHTED AVERAGE COST OF

CAPITAL ( WACC)
The weighted average cost of capital (WACC)
is the rate that a company is expected to pay
on average to all its security holders to
finance its assets. The WACC is commonly
referred as firm's cost of capital. Impotantly it
is dictated by the external market not by
management. The WACC represents the
minimum return that a company must earn
on an existing asset base to satisfy its
creditors, owners,and other providers of
capital.
Companies raise money from a number of
sources : common stock, preferred stock,
straight debt, convertible debt, warrants,
options, pension liabilities. The WACC is
calculated taking into account the relative
weights of each component of the capital
structure , the more laborious it is to
calculate the WACC. Companies can use
WACC to see if the investment projects
available to them are worhwile to undertake.
Debt and equity make up the capital
structure of the firm, along with other
accounts of right - hand side of firm's balance
sheet such as preferred stock.
OMPONENTS OF COST