Copy (3) of Mani Finance

7/30/2019 Copy (3) of Mani Finance

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Submitted By:

Mani SharmaMBA 2nd Semester

Submitted To:

Sunil BhardwajAssistant Professor


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contents Definition

3 basic aspects of cost of capital

Classification of costs Computation of cost of capital


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DEFINITIONCost of a capital of a firm is the minimum

rate of return expected by its investors. It is

the weighted average cost of various sourcesof finance used by a firm. A decision toinvest in a particular project depends upon

the cost of capital of a firm or cut off ratewhich is minimum rate of return expectedby the investors.


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3 BASIC ASPECTS OF COST OF

CAPITAL Cost of capital is not a cost as such. In fact, it is the rate

of return that a firm requires to earn from its earnings.

It is the minimum rate of return. Cost of capital of a firmis the minimum rate of return which will at least maintain

the market value of the shares. It comprises ofthree components. As there is always some

business & financial risk in investing funds in a firm, costof capital comprises of components:-

a) the expected normal rate of return at 0 risk level, say therate of interest allowed by bank;

b) the premium for business risk ; and

c) the premium for financial risk on a/c of pattern of

capital structure.


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Symbolically, cost of capital may be

represented as :K= r0+b+f

WHERE,

K= Cost of capital;

r0=Normal rate of return at zero risk levelb =Premium for business risk;

f =Premium for financial risk.


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CLASSIFICATION OF COST

Historical cost & future cost

Specific cost & composite cost

Explicit cost & implicit cost

Average cost & marginal costs

Computation of overall cost of capital of a firm involves :-

A. Computation of cost of specific source of financeB. Computation of weighted average cost of capital

C


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a. Computat on o spec c source o

financeCOST OF DEBT :- It is the rate of interest payable on debt.

(a) Before-tax-cost of debt may be calculated as:Kdb= I ; Kdb = before tax cost of debt,

P I =interest, P= Principal

(b) Incase the debt is raised at premium or discount,

Kdb= I ; NP= Net proceedsNP

(c) The After-tax-cost of debt may be calculated as:

Kda= Kdb (1-t) = I (1-t) ; Kda=After tax cost of debtNP t= rate of taxCost of Redeemable Debt:-

Before tax: Kdb= I + 1/n(P-NP)

(P+NP)After tax: Kda = Kdb(1-t)


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COST OF PREFERENCE CAPITAL :- The costof preference capital is a function of dividend expected by itsinvestors. It can be calculated as:

Kp=D/P or D/NP ; WHEREKp= Cost of preference capital,

D= Annual preference dividend,

P= Preference share capital,NP=Net proceeds of preference shares

The cost of redeemable preference share capital can be

calculated as:Kpr= D+(MV-NP)/n ; WHERE

(MV+NP) MV=Maturity Value ofPreference Shares


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COST OF EQUITY SHARE CAPITAL:- It is

the maximum rate of return that the company must earn onequity financed portion of its investments in order to leaveunchanged the market price of its stock. It can be computedin 3 ways:

1.Dividend yield method:- In this cost of equitycapital is the discount rate that equates the present value ofexpected future dividends per share with the net proceeds.

Ke = D/NP or D/MP ; WHERE,

Ke =Cost of Equity Capital,

D = Expected dividend per share,

NP= Net proceeds per share,

MP= Market price per share.


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2. Dividend yield plus growth individend method:- When the dividends of thefirm are expected to grow at a constant rate & the dividendpay-out ratio is constant this method may be used tocompute the cost of equity capital.

Ke= D1 +G = D0(1+g) +GNP NP

3. Earning-Yield Method:- In this method, thecost of equity capital is the discount rate that equates the

present values of expected future earnings per share with thenet proceeds of a share.

Ke = Earnings per share = EPS

Net Proceeds NP


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b. COMPUTATION OF WEIGHTED AVERAGE

COST OF CAPITAL

Weighted average cost of capital is the average cost of the costs ofvarious sources of financing. Weighted average cost of capital is alsoknown as composite cost of capital, overall cost of capital oraverage cost of capital. Once the specific cost of individual sources offinance is determined, we can compute the weighted average cost of

capital by putting weights to the specific costs of capital in proportion ofthe various sources of funds to the total.

Kw = WX ; WHERE,W

Kw =weighted average cost of capitalX = Cost of specific source of financeW= Weight


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Marginal cost of capitalThe marginal cost of capital is theweighted average cost of new capital

calculated by using marginal weights.The marginal weights represent theproportion of various sources of funds

to be employed in raising additionalfunds


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