Cost of Capital

Cost of CapitalIntroduction Thecost ofcapitalis the cost of a company's funds (bothdebtandequity)or,from an investor's point of view "the expected return on a portfolio of all the company's existing securities".It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. Definition The cost of capital is the minimum required rate of earnings or the cut-off rate of expenditure -Solomon Ezra

The cost of capital represents a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock. -James C. Van HorneWhat does cost of capital mean?The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk.

Cost of capital includes the cost of debt and the cost of equityImportance of Cost of Capital The concept of cost of capital is crucial in financial management. Like any other source of finance has a cost and cannot, therefore, be used in the most effective manner unless that cost can be accurately determined and taken into account.

TYPES OF COST OF CAPITAL1)COST OF EQUITY (Ke)

2)COST OF DEBT (Kd)

3)COST OF PREFRENCE SHARES (Kp)

4)COST OF RETAINED EARNINGS

Cost of EquityThe annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of equity.It is denoted by Ke. Formula- Ke = D X 100 P

Cost of DebtCost of debt capital is associated with the amount of interest that is paid on currently outstanding debts. It is denoted by Kd.

Formula-Cost of Debt = I (1 - TAX) I = Interest

Cost of Preference sharesThe preference share capital is different from equity share capital on account of two basic features :1)the preference shares are entitled to receive dividends at a fixed rate in priority over equity shares.2)in case of liquidation of the company ,the preference shareholders will get the capital repayment in priority over the distribution among the equity share holders.It is denoted by Kp.

Cost of Retained EarningsIn accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends.Weighted Average Cost of Capital A calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

Formula-WACC = TOTAL WEIGHTED COST X 100 TOTAL CAPITAL

Capital Structure Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities.Debt financing Debt financing is basically money that you borrow to run your business. Types-Long term debt financing .Short term debt financing.Capital Budgeting Capital budgeting is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.Pay back periodThe length of time required to recover the cost of an investment.

Formula-

Return On New Invested CapitalA calculation used,eitherbya firm orinvestors, to determine the amount of return that a firm couldearn on additional contributed capital. RiskThe chance that an investment's actual returnwill bedifferentthan expected. This includes the possibility of losing some or all of the original investment.Weighted Average Cost of EquityA way to calculate the cost of a company's equitythat gives different weight to different aspects of the equities.Case study on nike

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