The Cost of Capital

JITHIN K THOMAS

BIMS

Cost of Capital

• The cost of capital to a firm is the minimum required rate of return, which the suppliers of capital require.

• It is the price of obtaining capital.

• It is the compensation for time and risk.

SIGNIFICANCE OF THE COST OF CAPITAL

• Evaluating investment decisions

• Designing a firm’s debt policy

• Appraising the financial performance of top management

3

Source of Capital

• A firm obtain capital for investment in the form of equity and debt.

• A firms cost of capital will the Weighted Average Cost of debt and equity.

Debt

• Debt includes all interest bearing borrowings.

• Its cost is return (yield), which lender expects from their investment.

• Coupon Rate – annual contracted rate

• Interest charges are tax deductable for a firm

• Cost of debt should be calculated after adjusting for tax shield

COST OF DEBT

• Debt Issued at Par

• Debt Issued at Discount or Premium

• Tax adjustment

0d

B

INTik

nd

n

td

tn

1t0

)k1(

B

)k1(

INTB

)T1(kdebt ofcost tax After d

6

Cost of Debt

• Debt Issued at Par

• Debt Issued at Discount or Premium

• kd (1-T)• Where kd is the before tax cost of debt and T is the tax rate

Equity

• Equity includes paid – up capital and reserves and surplus.

• Equity has no explicit cost as payment of dividend is not obligatory.

• It involves an opportunity cost

Opportunity Cost

• The Opportunity cost of equity is the rate of return required by shareholders on securities of comparable risk

• It is the price which the company must pay to attract capital from shareholders.

Cost of Equity

• Shareholders expect to receive dividends and capital gain

• where DIV1 is expected dividend per share P0 is the market pricetoday and g is the expected growth.

• When a company issues new share capital, it has tooffer shares at a price, which much less than theprevailing market price. Therefore the cost ofretained earnings will be less than the cost of newissue of equity.

Calculation of WACC

• Calculate cost of Equity and Debt

• Weights is assigned according to the capital structure

• Product of component costs and weight is summed to determine WACC