Cost of Capital

Cost of CapitalDefinitionThe cost of capital is the minimum required rate of earning or cut-off rate of capital expenditure.MeaningIt represents the minimum rate of return required or expected by the investors on their investment which will maintain the market value of shares at particular level.ImportanceCapital decisions

Designing o capital structure

Evaluation of Financial Performance

Knowledge of firms expected income & risk .Specific cost of CapitalCost of Debt

Cost of Preference capital

Cost of Equity share capitalCost of DebtSimple to calculateRate of interest payable on debtDebt capital is obtained through issue of DebenturesIssue of Debentures involves floating charges for e.g printing of prospectus, advertisement, etc

Formula Kd = I/PWhereas Kd = Cost of Debt before taxI = Interest P = PrincipalIn case the issue of Debentures is at discount or at premium ,the net proceeds should be considered as the value of PKd = I / NP where NP is net proceedsContd.When debt is a source of finance, the firm saves tax as interest on debt is deductible for taxation purpose.After tax cost of Debt = Kd (1-t)Where t is tax rate.Debt is redeemable after such period.Before tax cost of debt:K db = I + 1/n (P NP)/ (P + NP )Where I = Interest , N = No. of yrs in which debt is to be redeemedP = Proceeds at parNP = Net proceedsAfter tax cost of DebtKda = Kdb (1-t )Cost of Preference capitalCarries dividend at fixed rateCost of preference share capital is the function of dividend expected by the investorsIn case dividends are not paid capacity of firm to raise funds is affectedFormula = Kp = D/PWhere Kp is cost of preference capital, D is annual preference dividend, P is preference share capital (proceeds )Contd.When preference shares are issued at premium or discount Kp = D/NP *100In case of redeemable preference sharesKpr = D + MV NP/n/ (MV + NP) *100Where Kpr = cost of redeemable preference shares, D = Annual preference dividend, MV= Maturity value of preference shares & NP = Net Proceeds Cost of Equity share capitalRate of dividend is not fixed therefore some financial experts draw the conclusion that there is no cost of equity capital.

Share holders invest money with a view to earn some returnWeighted average cost of capitalIs the average cost of various source of financeAlso known as overall cost of capital Formula