2.2.3 Concept of Cost of Capital including Types.pptx

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1. INSTITUTE-USB DEPARTMENT-BBA Bachelor of Business Administration FINANCIAL MANAGEMENT ( 22BAT-154 ) Faculty name – Ms. Anmol Preet (Assistant Professor) CONCEPT OF COST OF CAPITAL INCULDING TYPES DISCOVER . LEARN . EMPOWER

2. CONCEPT OF COST OF CAPITAL INCULDING TYPES COURSE OUTCOME CO NUMBER TITLE LEVEL CO1 To understand the functions of financial management and the role of the finance manager in business organization. Understanding CO2 To demonstrate the concept of time value of money and its importance in taking business decisions. Understanding CO3 To analyze various sources of capital and dividend policies and their structure on the basis of leverage and cost of capital. Analyze CO4 To evaluate long term investment decisions by applying investment appraisal techniques. Evaluating CO5 To validate the risk and return associated with financial assets and their effect on cost of capital and dividend policy. Creating

3. INTRODUCTION TO COST OF CAPITAL The cost of capital of an investor in financial management is equal to the return an investor can fetch from the next best alternative investment. In simple words, it is the opportunity cost of investing the same money in a different investment having similar risks and other characteristics. From a financing angle, it is simply the cost paid for using the capital. Alternatively, a percentage return on investment that convinces an investor to invest in a particular project or company is the appropriate cost of capital for that investor.

4. CHARACTERISTICS OF COST OF CAPITAL The following are the basic characteristics of cost of capital : Cost of capital is a rate of return, It is not a cost as such. This return, however, is calculated on the basis of actual cost of different components of capital. A firm's cost of capital represents minimum rate of return that will result in at least maintaining the value of its equity shares. It is related to long term capital funds.

5. v ) Cost of capital consists of three components : Return at Zero Risk Level. (r0) Premium for Business Risk (b) Premium for Financial Risk (f) vi) The cost of capital may be put in the form of the following equation : Where, K = Cost of Capital ro = Return at Zero Risk Level b = Premium for Business Risk f = Premium for Financial Risk K = ro + b + f

6. TYPES OF COST OF CAPITAL We can classify the cost of capital into the following broad classifications- Cost of Equity The cost of equity is the cost of using the money of equity shareholders in the operations. We incur this in the form of dividends and capital appreciation (increase in stock price). F ormula - Cost of Equity Capital = Risk-Free Rate + Beta * (Market Risk Premium – Risk-Free Rate)

7. 2. Cost of Debt The cost of debt capital is the cost of using a bank’s or financial institution’s money in the business. The banks get their compensation in the form of interest on their capital. The formula for calculating the cost of debt is as follows- Cost of Debt Capital = Interest Rate * (1 – Tax Rate)

8. 3. Weighted Average Cost of Capital (WACC) WACC is also used in place of the cost of capital because of its frequent and vast utilization, especially when evaluating existing or new projects. WACC is the weighted average of all types of capital present in the capital structure of a company. Assuming these two types of capital in the capital structure, i.e., equity and debt, we can calculate the WACC using the following formula: WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt

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