Meaning Of Cost of Capital

Minimum required Rate Of Return

Which A Project MUST earn.

a) The Minimum Earning by a firmb) In order to satisfyc) The Expectations of Those Personsd) Who have invested their funds in the firm.

DEFINITION

Cost Of Capital also known as:

TARGET RATE

HURDLE RATE

CUT-OFF RATE

What If a firm fails to earn returns at expected rate…..

M.V. of shares REDUCE

Overall Wealth of Shareholders REDUCE

Value of The Firm REDUCE

No. of Prospective Investors REDUCE

Moreover,Acceptance Or Rejection

Of an Investment depends onThe Cost Of Capital

ADDITIONAL POINT :-

Importance of Cost Of Capital

For Capital Budgeting Decisions

For Capital Structure Decisions

For Working Capital Policy Decisions

For Comparative Analysis of various sources of Finance

For Evaluation of Fin. Efficiency of TOP MGMT.

Equity share Holders

Pref. share Holders

Debenture Holders

INVESTMENT in the Company

EARNINGS

If Fulfills the Expectations of The Investors

If doesn’t Fulfills the Expectations of The Investors

Value of Firm DecreaseValue of Firm Increase

ADVERSECONDITION

FAVOURABLECONDITION

Cost of RETAINED EARNINGSThe earnings FORGONE by the ShareholdersThe earnings FORGONE by the Shareholders

Part of Profits, Retained for Future Expansion of BusinessPart of Profits, Retained for Future Expansion of Business

NOT FREE of COST i.e. Involve Cost

AsPart of the Shareholders’ Funds which is blocked as Reserves

If it is Invested Anywhere else,

It will produce someExtra Earnings

OpportunityCost

FORMULA-KRE = D1 / MP + g

Or

D / MP

Equity Share Holders

Investment inThe Company

Blocked in Two Ways

SHARE CAPITAL

RETAINED EARNINGS

Weighted Avg. Cost of CapitalAlso Known As :- Combined Cost of Capital

Composite Cost of Capital

Overall Cost of CapitalCombination of

Component Costsi.e.

Kd, Kp, Ke, Kre

According to theWeights of each

Component Capital

Meaning:-

Weights are AssignedAs per

The Proportion of eachComponent capital

In the Capital Structure

Any Fin. DecisionShould be taken with reference to

‘WACC’& Not with reference to

Cost of Component Capital

Main Objective :-

Formula of W.A.C.C.

(D / T.F. * Kd) + (P / T.F. * Kp) + (E / T.F. * Ke)

Kp Ke

Composition according to the respective weights

WACC

Kd

Explicit Cost

The Discount Rate whichEquates

The PV of Cash Inflows&

The PV of Cash Outflows

It ArisesWhen

The FundsAre

Raised

Implicit Cost

The Rate of ReturnWhich will be

ForgoneIf the project presentlyUnder consideration

Is accepted

It ArisesWhen

The FundsAre

Used

AlsoKnown as

OpportunityCost

Assignment of Weights

Book Value Weights

Simple Computations

Wrong Estimates

No Fluctuations

Operationally convenient

Readily Available

Market Value Weights

Difficult To Compute

Good Estimates

Fluctuate Widely

Theoretically consistent

Difficult to calculate

Which Weights Should be used in the calculationof WACC ?

Market Value weightsShould ALWAYS

Be givenPreference

As these provideA Good Estimate of

Cost of Capital

In Case,M.V. Weights

Are not readily avlbl.Then,

Book Value WeightsCan be Used.

Economic Value Added (EVA)Profits Over And Above the Cost of Capital

ROCE > Ko

A Test of Profit Adequacy

A Measure of Corporate Growth

Formula

Actual Earnings – Earnings at Ko

Marginal Cost of CapitalCost of Raising ADDITIONAL Funds

Marginal Weightsare used

i.e. The Proportion of Funds,The firm intends to Employ

The Problem of choosingb/w. B.V. and M.V.

Doesn’t arise inThe case of

WMACC, Why ?

Because WMACC usesMarginal Weights

Which represents theProportion of funds,

The firm intends to employ.

Why should a firm periodically re-examine its Cost of Capital before determining Annual Capital Budget ?

REASONS :-

Firm’s Internal Structure

Capital Market Conditions

Supply and Demand for Funds

Subtle change in Capital Structure