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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.
8/6/2019 Unit Iiiccc
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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
8/6/2019 Unit Iiiccc
13/19
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