Cost of capital

This PPT describes the concept of cost of capital and the method of calculation

1. COST OF CAPITAL Dr.BELLARMIN DIANA Assistant Professor Department of Management Studies Bon Secours College for Women, Thanjavur .

2. Cost of capital INTRODUCTION Finance is defined as the provision of money at the time it is needed. Finance function may be defined as the procurement of funds and their effective utilization. FINANCIAL REQUIREMENTS OF BUSINESS SHORT TERM FINANCIAL REQUIREMENTS LONG TERM FINANCIAL REQUIREMENTS

3. Short term funds required for meeting working capital needs. They are usually required for a period up to one year. The requirement of these funds is usually met by taking short term loans or getting the bill discounted from the commercial banks. FINANCIAL REQUIREMENTS long term funds required to a great extend for meeting the fixed capital requirements of the business. They are required for a period exceeding one year. These funds are raised by business by business from sources which provide, in an uninterrupted way, the use of fund for a long period, viz., shares, debentures, loans from specialized financial institution SHORT TERM FINANCIAL REQUIREMENTS LONG TERM FINANCIAL REQUIREMENTS

4. SOURCES OF FINANCING

5. MEANING COST OF CAPITAL Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders. Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.

6. Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place John J. Hampton COST OF CAPITAL DEFINITION A cut-off rate for The allocation of capital to investment of projects. It is the rate of return on a project that Will leave unchanged the market price of the stock C. Van Horne

7. Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts : Assumptions of Cost of Capital 1 . It is not a cost as such. It is merely a hurdle rate. 2. It is the minimum rate of return. 3. It consist of three important risks such as zero risk level, business risk and financial risk.

8. COMPONENTS OF COST CAPITAL

9. RETURN AT ZERO RISK LEVEL The expected rate of return when a project involves no risk whether business or financial. PREMIUM FOR BUSINESS RISK PREMIUM FOR FINANCIAL RISK Financial risk refers to the risk on account of pattern of capital structure (debt-equity mix). A firm having higher a higher debt content in its capital structure is more risky compared to a firm which has low debt content. Therefore the suppliers of fund would therefore expect a higher rate of return from such a fund Business Risk refers to the variability in operating profit(EBIT) due to change in sales. When the business risk is more than normal, the suppliers of fund will expect higher rate of return. K =Ro + b + f K – cost of capital Ro – return at zero risk level b - premium for business risk F – premium for financial risk

10. Classification of cost of capital

11. Explicit cost – The internal rate return the firm pays for financing. This cost arises when the funds are raised. IMPLICIT COST - Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently under consideration by the firm were accepted. Specific and Combine Cost The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of capital. The composite or combined cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. CLASSIFICATION OF COST OF CAPITAL

12. Historical and Future Cost Historical cost is the cost which as already been incurred for financing a particular project. It is based on the actual cost incurred in the previous project. Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of previous experience. CLASSIFICATION OF COST OF CAPITAL AVERAGE AND MARGINAL COST Average cost of capital is the weighted average cost of each component of capital employed by the company. It considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc. Marginal cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when the company goes for further raising of finance.

13. IMPORTANCE OF COST OF CAPITAL

14. Computation of cost of capital COST OF DEBT DEBT ISSUED AT PAR Kd = (1 – T) R Kd = Cost of debt T = Tax rate R = debenture interest rate COST OF DEBT IRREDEEMABLE DEBT

15. Computation of cost of capital COST OF DEBT DEBT ISSUED AT PREMIUM I Kd = ________ (1-T) NP Kd = Cost of debt I= Annual interest payment NP =Net proceeds T = Tax rate NP = Face value + premium

16. Computation of cost of capital COST OF DEBT DEBT ISSUED AT DISCOUNT I Kd = _______ (1-T) NP Kd = Cost of debt I= Annual interest payment NP =Net proceeds T = Tax rate NP = Face value - Discount

17. Computation of cost of capital COST OF REDEEMABLE DEBT I +(P-NP)/n _____________ Kd (before tax) = (P+NP)/2 Kd (after tax) = Kd(before tax) x (1-T) I = Annual interest payment P = Par value of debenture NP = Net proceeds n = Number of years to maturity

18. Computation of cost of capital COST OF IRREDEEMABLE PREFERENCE SHARES Dp Kp = _______ Np Kp = cost of preference share capital Dp = fixed preference dividend Np = Net proceeds of preference shares

19. Computation of cost of capital COST OF REDEEMABLE PREFERENCE SHARES Dp + (RV-Np)/n Kp = _______ (RV+ Np)/2 Kp = cost of preference share capital Dp = fixed preference dividend Np = Net proceeds of preference shares RV = Redemption value n = Number of years to redemption

20. Computation of cost of capital COST OF EQUITY CAPITAL APPROACHES Dividend price (D/P) approach Dividend price plus growth (D/P + g) approach Earning price (E/P) approach Realized yield approach.

21. Computation of cost of capital COST OF EQUITY CAPITAL Dividend price (D/P) approach D Ke = ______ NP Ke = Cost of equity capital D = Dividend per share Np = Net proceeds of an equity share D Ke = ______ MP Ke = Cost of equity capital D = Dividend per share MP = Market price of an equity share COST OF EQUITY ON THE BASIS OF MARKET PRICE

22. Computation of cost of capital COST OF EQUITY CAPITAL Dividend price plus growth (D/P + g) approach D Ke = ______+g NP Ke = Cost of equity capital D = Expected Dividend per share Np = Net proceeds of an equity share g= Growth in expected dividend

23. Computation of cost of capital COST OF EQUITY CAPITAL Earning price (E/P) approach E Ke = ______ NP Ke = Cost of equity capital E = Earnings per share Np = Net proceeds of an equity share

24. Computation of cost of capital COST OF EQUITY CAPITAL Realized yield approach Ke = PVf xD Ke = Cost of equity capital PVf = Present value of discount factor D= Dividend per share

25. Computation of cost of capital COST OF RETAINED EARNINGS Kr = Ke (1-t) (1-b) Kr= Cost of retained earnings Ke = Cost of equity t = Tax rate b= Brokerage cost

26. Computation of cost of capital WEIGHTED AVERAGE COST OF CAPITAL XW Kw = __________ W Kw = Weighted average cost of capital X= Cost of specific sources of finance W= Weight, proportion of specific sources of finance

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