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COST OF CAPITAL

Cost of capital is the rate return


the firm requires from investment
in order to increase the value of the
firm in the market place
Components of cost of
capital

• Return at zero risk level


1
1. return at zero risk level
2.Business risk premium
• Business
3.financial risk riskprmium
premium
2

3 • Financial risk premium


COST OF DIFFERENT
SOURCES OF CAPITAL
1. Cost of Debt
2. Cost of Preference Share
Capital
3. Cost of Equity Share Capital
4. Cost of Retained Earnings
Cost of Debt
• When companies borrow funds from outside
lenders, the interest paid on these funds is
called the cost of debt.
Debt may either be:
1. Irredeemable
2. Redeemable
Cost of Redeemable debt
 A company issues a debt which is redeemable after
a certain period during its life time.
Formal:

Cost of redeemable debt =

I = Interest
RV = Redeemable value of debenture
NP = Net proceeds
Example :
A company issue RS. 5,00,000 , 10% redeemable debenture
redeemable after 5 years. The cost of floating amount to 4% of face
value.
Solution : I = 10% of 5,00,000 =RS. 50,000
No. of years = 5 yrs.
RV = RS. 5,00,000
NP = RS. 5,00,000-4%of RS. 5,00,000(cost of floating)=
RS.4,80,000

Cost of redeemable debt =

= 50,000 + 4,000 × 100


4,90,000
= 11.02%
Cost of Irredeemable Debt
Irredeemable debt is that debt which is not
required to be repaid during the lifetime of the
company.
Cost of Irredeemable Debt (Kdb )= Interest
×100
NP

After tax (Kda) = Kdb × (1 - t)


Example:

 A company issued 12% debentures at par for Rs 2, 00,000.


Compute .
Solution:
I= Interest,. 2,00,000×12/100=₹24,000
NP= Net proceed, is = ₹2,00,000
t = Tax is 30%
Cost of debenture= Interest × 100
NP
= 24,0000 ×100 = 12%
2,00,000
Cost of Preference Share
Capital
Preference shareholders are entitled
to get a fixed rate of dividend if the
company earns profit.
Preference Share are two types:
1. Redeemable Preference Share
2. Irredeemable Preference Share
Cost of Redeemable
Preference Share
 Redeemable preference shares are those that are
repaid after a specific period of time.
 Redeemable preference shares may also be issued at
par, discount or at a premium.
Formula:
Cost of Redeemable Preference Share =

Dividend+ ( RV - NP )
No. of years ×100
(RV + NP)
2
Example:

 Baibhav Ltd., issued 100 ,12% preference shares of Rs 1


each at a premium of 6% ; the floatation cost being 2.5%
on issue price. The shares are to be redeemed after 5
years at a premium of 5%. Compute the cost of
preference share capital.
Solution:
Cost of Irredeemable
Preference Share
 Irredeemable preference share is not
required to be repaid during the lifetime
of the company.
 These shares may be issued at par, at
premium or at a discount.
Cost of Irredeemable Preference Share=
Dividend ×100
NP
Example:

A company issued 100, 12% irredeemable preference shares


of Rs 1each. Find out the cost of the preference share
capital.
Solution: