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    Copy (3) of Mani Finance

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    The document defines cost of capital as the minimum rate of return expected by investors in a firm. It discusses the three basic aspects and components of cost of capital, and provides formulas to compute the cost of different sources of capital including debt, preference shares, and equity shares. The document also explains how to calculate the weighted average cost of capital by assigning weights to the costs of different sources of financing in proportion to their usage.

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    Copy (3) of Mani Finance

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    The document defines cost of capital as the minimum rate of return expected by investors in a firm. It discusses the three basic aspects and components of cost of capital, and provides formulas to compute the cost of different sources of capital including debt, preference shares, and equity shares. The document also explains how to calculate the weighted average cost of capital by assigning weights to the costs of different sources of financing in proportion to their usage.

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    The document defines cost of capital as the minimum rate of return expected by investors in a firm. It discusses the three basic aspects and components of cost of capital, and provides formulas to compute the cost of different sources of capital including debt, preference shares, and equity shares. The document also explains how to calculate the weighted average cost of capital by assigning weights to the costs of different sources of financing in proportion to their usage.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    43 views13 pages

    Copy (3) of Mani Finance

    Uploaded by

    tapasyaferia
    The document defines cost of capital as the minimum rate of return expected by investors in a firm. It discusses the three basic aspects and components of cost of capital, and provides formulas to compute the cost of different sources of capital including debt, preference shares, and equity shares. The document also explains how to calculate the weighted average cost of capital by assigning weights to the costs of different sources of financing in proportion to their usage.

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    of 13

    Cost of capital

    Submitted By: Mani Sharma MBA 2nd Semester

    Submitted To: Sunil Bhardwaj Assistant Professor

    contents
    Definition
    3 basic aspects of cost of capital Classification of costs

    Computation of cost of capital

    DEFINITION
    Cost of a capital of a firm is the minimum

    rate of return expected by its investors. It is the weighted average cost of various sources of finance used by a firm. A decision to invest in a particular project depends upon the cost of capital of a firm or cut off rate which is minimum rate of return expected by the investors.

    3 BASIC ASPECTS OF COST OF CAPITAL


    Cost of capital is not a cost as such. In fact, it is the rate

    of return that a firm requires to earn from its earnings. It is the minimum rate of return. Cost of capital of a firm is the minimum rate of return which will at least maintain the market value of the shares. It comprises of three components. As there is always some business & financial risk in investing funds in a firm, cost of capital comprises of components:a) the expected normal rate of return at 0 risk level, say the rate of interest allowed by bank; b) the premium for business risk ; and c) the premium for financial risk on a/c of pattern of capital structure.

    Symbolically, cost of capital may be represented as : K= r0+b+f


    WHERE, K= Cost of capital;

    r0=Normal rate of return at zero risk level


    b =Premium for business risk; f =Premium for financial risk.

    CLASSIFICATION OF COST
    Historical cost & future cost

    Specific cost & composite cost


    Explicit cost & implicit cost Average cost & marginal costs

    Computation of overall cost of capital of a firm involves :A. Computation of cost of specific source of finance B. Computation of weighted average cost of capital

    a. Computation of specific source of finance


    COST OF DEBT :- It is the rate of interest payable on debt.

    (a) Before-tax-cost of debt may be calculated as: Kdb= I ; Kdb = before tax cost of debt, P I =interest, P= Principal (b) Incase the debt is raised at premium or discount, Kdb= I ; NP= Net proceeds NP (c) The After-tax-cost of

    debt may be calculated as:

    Kda= Kdb (1-t) = I (1-t) ; Kda=After tax cost of debt NP t= rate of tax Cost of Redeemable Debt:Before tax: Kdb= I + 1/n(P-NP) (P+NP) After tax: Kda = Kdb(1-t)

    COST OF PREFERENCE CAPITAL :- The cost


    of preference capital is a function of dividend expected by its investors. It can be calculated as: Kp=D/P or D/NP ; WHERE

    Kp= Cost of preference capital, D= Annual preference dividend, P= Preference share capital, NP=Net proceeds of preference shares The cost of redeemable preference share capital can be calculated as:

    Kpr= D+(MV-NP)/n ; WHERE


    (MV+NP) Preference Shares MV=Maturity Value of

    COST OF EQUITY SHARE CAPITAL:- It is


    the maximum rate of return that the company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock. It can be computed in 3 ways: 1.Dividend yield method:- In this cost of equity capital is the discount rate that equates the present value of expected future dividends per share with the net proceeds. Ke = D/NP or D/MP ; WHERE, Ke =Cost of Equity Capital, D = Expected dividend per share, NP= Net proceeds per share, MP= Market price per share.

    2. Dividend

    yield plus growth in dividend method:- When the dividends of the


    firm are expected to grow at a constant rate & the dividend pay-out ratio is constant this method may be used to compute the cost of equity capital.

    Ke= D1 +G = D0(1+g) +G
    NP NP 3. Earning-Yield Method:- In this method, the cost of equity capital is the discount rate that equates the present values of expected future earnings per share with the net proceeds of a share.

    Ke = Earnings per share = EPS


    Net Proceeds NP

    b. COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL


    Weighted average cost of capital is the average cost of the costs of

    various sources of financing. Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion of the various sources of funds to the total.

    Kw = WX
    W

    ; WHERE,

    Kw = weighted average cost of capital


    X = Cost of specific source of finance W= Weight

    Marginal cost of capital


    The marginal cost of capital is the

    weighted average cost of new capital calculated by using marginal weights. The marginal weights represent the proportion of various sources of funds to be employed in raising additional funds

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