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Meaning
The Cost of capital to a firm is the minimum
return, which the suppliers of capital require.
It is a price of obtaining capital and it is a
compensation for time and risk.
Long-term debt
Preferred stock
Common equity
Capital Components
Capital
on
funds
Risk
Computation of Cost of
Capital
(A) Specific source of finance
(B) Weighted Average cost of capital (WACC)
Cost of Debt
(i) Debenture at Par: (before tax)
i
Kdb = --------P
where, Kdb = before cost of debt
i = Interest
P = Principle
(ii) Debt raised at Premium or Discount:
i
Kdb = --------NP
NP = Net proceeds
Cost of Debt
(iii) After tax cost of debt:
i
Kda = ------ (1-t) OR Kda = Kdb(1-t)
NP
where, Kda = After tax cost of debt
(iv) Cost of Redeemable debt (at par): The
debt is issued and redeemed after a
certain period at par during the life time of
a firm.
i + (P NP)/n
Kdb = ------------------(P + NP) / 2
P = proceeds at par NP = Net proceeds
I + (RV NP)/n
= ----------------------(RV + NP) / 2
RV = redeemable
NP = Net proceeds
n = no. of years debt is redeem
Cost of debt after Tax:
Kda = Kdb(1-t)
(iii) Redeemable PS :
D + (MV NP)/n
Kps = ------------------(MV + NP) / 2
MV = Maturity Value
NP = Net proceeds
(3) Cost of Equity Share Capital:
Is the
maximum rate of return that the company must
earn as equity financed portion of its investments
in order to leave unchanged the market price of
its stock
D
= --------NP or MP
CAPM .
and
Return
are
the
two
important
CAPM .
CAPM .
Systematic risk (Undiversifiable / Market) risk:
Risk of a stock represents that portion of its
risk which is attributable to economy-wide
factors like growth rate of GDP, interest rate,
inflation
rate,
currency
exchange,
natural
requires
the
rate of risks.
value of 1.
CAPM .
Risk premium =
i ( Market return of a diversified portfolio risk
free return )
OR
i (Rm Rf)
Cost of equity, acc. to CAPM will ;
Ke = Rf + i (Rm Rf)
Where,
Ke
Rf
i
Rm
=
=
=
=
portfolio
portfolio
Example:
D
Kr = ------ + G
NP
Kr = Cost of retained earnings
D = Expected dividend
NP = Net proceeds of share value
G = Rate of growth
To make adjustment in the cost of retained
earning for tax and costs of purchasing new
securities, the following formulae may be
adopted;
proportion of finance
Steps..
2. Identify the levels of total new financing at which
the cost of the new components would change,
given the capital structure policy of the firm. These
levels, called breaking points,
TFj
BPj = ------Wj
Where BPj = breaking point on account of
financing source j
TFj = total new financing from source j
at the breaking point
Wj = proportion of financing source j in the
capital structure
Steps.