COST OF CAPITAL

Submitted by:
SIDDHARTH NAYAK
PGDM 1st YEAR(A)
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The projects cost of capital is the
minimum required rate of return on funds
committed to the project, which depends on
the riskiness of its cash flows.

The firms cost of capital will be the
overall, or average, required rate of return
on the aggregate of investment projects

DEFINITION:
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Evaluating investment decisions

Designing a firms debt policy

Appraising the financial performance of top
management

SIGNIFICANCE OF THE COST OF CAPITAL
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COST OF
CAPITAL
COST OF DEBT
COST OF
PERPETUAL
DEBT
COST OF
REDEEMABLE
DEBT
COST OF
PREFERENCE
SHARES
COST OF
PERPETUAL
PREF. SHARES
COST OF
REDEEMABLE
PREF. SHARES
COST OF
EQUITY
COST OF
RETAINED
EARNINGS
WACC
STRUCTURE OF COST OF CAPITAL
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The effective rate that a company pays on its
current debt is the cost of debt. This can be
measured in either before- or after-tax returns.


COST OF DEBT
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Cost of perpetual debt






Cost of redeemable debt


100 ) ( =
NP
R
bef oretax k
d
100
2
) (
(

+
(

+
=
NP MV
n
NP MV
R
beforetax kd
COST OF DEBT
) 1 ( ) ( ) ( t beforetax k aftertax k
d d
=
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Cost of preference share capital is that part of
cost of capital in which we calculate the
amount which is payable to preference
shareholder in the form of dividend with fixed
rate.
COST OF PREFERENCE SHARE
CAPITAL
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o Irredeemable Preference Share



o Redeemable Preference Share

100 ) ( =
NP
DPS
aftertax k
p
COST OF PREFERENCE CAPITAL
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2
100
) (
NP MV
n
NP MV
PD
af tertax k
p
+

|
.
|

\
|

+
=
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Cost of equity is the return that stockholders require for
a company. A firm's cost of equity represents the
compensation that the market demands in exchange for
owning the asset and bearing the risk of ownership.
COST OF EQUITY SHARE CAPITAL
Dividend yield method


Earning yield method



Dividend yield growth in dividend method

100 =
MP
DPS
k
e
100 =
MP
EPS
k
e
COST OF EQUITY SHARE CAPITAL
G
MP
DPS
k
e
+
(
(

= 100
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11
The percentage of net earnings not paid out as
dividends, but retained by the company to be
reinvested in its core business or to pay debt. It is
recorded under shareholders' equity on the balance
sheet.
COST OF RETAINED EARNINGS
100
) 1 )( 1 (
100
) 1 )( 1 (
) 1 )( 1 (

=
=
MP
B T EPS
k
or
MP
B T DPS
k
or
B T k k
d
r
d
r
d e r
COST OF RETAINED EARNINGS
Where: T
d
=Tax rate on income distributed in dividend

B = Brokerage
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13
A calculation of a firm's cost of capital in which each category of
capital is proportionately weighted. All capital sources - common
stock, preferred stock, bonds and any other long-term debt - are
included in a WACC calculation. All else equal, the WACC of a
firm increases as the beta and rate of return on equity increases,
as an increase in WACC notes a decrease in valuation and a
higher risk.
WEIGHTED AVERAGE COST OF CAPITAL
THE WEIGHTED AVERAGE COST OF
CAPITAL

The following steps are involved for calculating the
firms WACC:
Calculate the cost of specific sources of funds
Multiply the cost of each source by its proportion in
the capital structure.
Add the weighted component costs to get the WACC.



WACC is in fact the weighted marginal cost of capital
(WMCC); that is, the weighted average cost of new
capital given the firms target capital structure.

E D
E
k
E D
D
) T 1 ( k k
w k w ) T 1 ( k k
e d o
e d d d o
+
+
+
=
+ =
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THANK YOU
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