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COST OF CAPITALCOST OF CAPITAL

The required return necessary to make a

capital budgeting project worthwhile.

Include the cost of debt and the cost of

equity

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COST OF EQUITYCOST OF EQUITY

The minimum rate of return that a firm must

earn on equity financed portion of its

investment in order to leave unchangedthe market price of its stock

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Methods of computing cost ofMethods of computing cost of

equity capitalequity capital

Dividend Yield method or Dividend /Price Ratiomethod

Dividend Yield plus growth in Dividend method

Earning Yield method

Realised Yield method

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Dividend Yield method or Dividend /Price Ratio method

Cost of capital is the discount rate that equates the presentvalue of expected future dividends per share with the netproceeds / current market price of a share.

D

Ke =

NP

DKe =

MP

Ke = Cost of equity capitalD= Expected dividend per share

NP = Net proceeds per share

MP = Market price per share

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Dividend Yield plus growth in Dividend

method

Cost of equity is based on dividends &

growth rate

( Dividend pay out ratio is constant &

dividends of the firm are expected to growat a constant rate)

D

Ke = + g

NP / MP

G = Rate of rowth in dividends

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Earning Yield method

Cost of equity is discount rate that equates thepresent value of expected future earnings per

share with the net proceeds/current market

price of a share.

EPS

ke =

NP

EPS = Earnings per share

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Realised Yield method

Takes into account the actual average rateof return realised in the past for

computing the cost of equity capital

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cost of debtcost of debt

It is nothing but the required return of lenders.

Since cost of capital is on after-tax basis the

cost of debt should be adjusted to reflect the

taxation effects.

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COST OF DEBTCOST OF DEBT

Rate of interest payable on debt

Before tax cost

IKd =

P

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Pre-tax debt cost has to be adjusted to arrive at the post

tax cost of debt

kd* = kd (1-t)

kd* is the post-tax cost of debt

kd is the pre-tax cost of debt

t is the marginal tax rate

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COST OF REDEEMABLECOST OF REDEEMABLE

DEBENTURESDEBENTURES

P - NP

Int +

n

Kd (Before tax)=

P + NP2

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COST OF REDEEMABLECOST OF REDEEMABLE

DEBENTURESDEBENTURES

P - NP

Int + (1- t )

n

Kd( After tax)=

P + NP2

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Twenty ye

a

r 12.5% debentures ofa

firm

are sold at a rate ofRS. 75. The face

value of each debenture is Rs. 100 and

the rate of tax is 50%. Calculate the

before and after taxcost of debt capital.

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COST OF PREFERENCE CAPITALCOST OF PREFERENCE CAPITAL

Dp

kp =

NP

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COST OF REDEEMABLECOST OF REDEEMABLE

PREFERENCE SHARESPREFERENCE SHARES

P - NP

Dp +

n

Kp =

P + NP2

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The cost of capital is the of cost of each source, weights

equal to the proportion in the total capital it represents.

Hence, it is also referred to as the weighted average cost

of capital (WACC).

WACC = wd kd + wp kp + we ke

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Marginal Cost of CapitalMarginal Cost of Capital

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Computation ofMarginal Cost of Capitalinvolves

--calculating the cost of different

types of additional capital required.--Marginal weight is assigned to each

of them ( based on the proportion of

different types of additional capital

required

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Marginal cost of capital may be equal to theaverage cost of capital to the extent

the proportion of additional capital doesnot change

The cost the components remainsconstant