COST of CAPITAL

INTRODUCTION
basic concept of cost of capital
The cost of capital is an important factor while planning
the capital structure of an organization. The cost of
capital is concerned with what a firm has to pay for the
capital it uses to finance new investments. The capital
may be in the form of debt, retained earnings,
preference shares and equity shares. Every firm, for its
survival and growth, has to earn a sufficient return to
cover its costs of capital and also to have surplus for its
growth. If a firm’s rate of return on its investment
exceeds its cost of capital, the wealth of equity
stockholders is enhanced. It is, because, the firm’s rate of
return on its investments is greater than its cost of
capital, the rate of return earned on equity capital (after
nearing the costs of other forms of financing) will exceed
the rate of return required by equity stockholders.
Hence, the wealth of equity stockholders will increase.
Meaning and Definitions of Cost of Capital
‘Cost of Capital’ is a concept having manifold meanings. Cost of capital, for an
investor is the measurement of disutility of funds in the present as compared to the
return expected in the future. From the firm’s point of view, its meaning is somewhat
different. From its point of view, cost of capital is the required rate of return needed
to justify the use of capital. This very idea has been subscribed by the following
authorities also:
“The cost of capital is the minimum required rate of earnings or the cut off rate for
capital expenditure”. Solomon Ezra
“The cost of capital is the rate of return a company must earn on an investment to
maintain the value of the company”. M.J. Gorden
‘’Cost of capital is the rate of return, the firm requires from investment in order to
increase the value of the firm in the market rate”. John J. H.
“The cost of capital is the minimum rate of return which a firm requires as a condition
for undertaking an investment”. Milton H. Spencer
“The cost of capital represents a cut off rate for the allocation of capital to investment
of projects. It is the rate of return on a project that will leave unchanged the market
price of the stock”. James C. Van Home
Conclusion : Thus, it is clear from the above that the cost of capital is the minimum
rate of return which a company is expected to earn from a proposed project so as to
make no reduction in the earning per share of equity shareholders and Its market
price. It is the combined coal of each type of source by which a firm raises the funds.
Classification of Cost of Capital
1. Historical Cost and Future Cost: Historical cost are those which are calculated on the
basis of existing capital structure. Future cost relates to the cost of funds intended to
finance the expected project, historical costs are useful for analyzing the existing capital
structures. Future costs are widely used in capital budgeting and capital structure designing
decisions.
2. Specific Cost and Composite Cost: The cost of individual source of capital is referred to as
the specific cost and the cost of capital of all the sources combined is termed as composite
cost. It is, thus the weighted cost of capital.
3. Average Cost and Marginal Cost: The average cost is the average of the various specific
costs of the different components of capital structure at a given time. The average cost is
relevant for overall investment decision as on enterprise employs a mix of different sources.
The marginal cost of capital is that average cost which is concerned with the additional
funds raised by the firm. It is very important in capital budgeting decisions. Marginal cost
tends to increase proportionately as the amount of debt increases.
4. Explicit Cost and Implicit Cost: An explicit cost is the discount rate which equates the
present value of cash inflows with the present value of cash outflows. In other words, it is
the internal rate of return of cash flows.
Implicit cost is also known as opportunity cost. It may be defined as the rate of return
associated with the best investment opportunity for the firm. It is generally said that cost of
retained earnings is an opportunity cost in the sense that it is the rate of return at which the
shareholders could have invested these funds and they had been distributed among them.
Cost of Different Sources of Capital
In making investment decisions, cost of different types of capital is measured and
compared. The source, which is the cheapest is chosen and than capital is raised. It
is necessary to determine the specific cost of each source in order to determine the
minimum obligation on a company. (Generally, the following are the sources of
capital:
Specific cost of different sources of raising funds are calculated In the following
manner :
funds in
shares with the expectation of getting dividend from the company. Thus, equity shares involve
a return in
terms of dividend expected by the equity shareholders.
Methods of Computing Cost of Equity Share Capital:
The following methods are used for computing cost of equity share capital :
(i) Dividend Yield Method
(ii) Earnings Yield Method
(iii) Dividend Yield and Growth in Dividend Method
(iv) Realized Yield Method.
(i) Dividend Yield Method: It is also known as dividend price ratio method. According to this
method, the cost of equity share capital is calculated on the basis of a required rate of return in
terms of future dividends to be paid on equity shares for maintaining their present market
price. This method is based on the assumptions that the investors give prime importance to
dividends and risk in the form remains unchanged. This method does not seem to consider the
growth in dividend. The following formula is used for computation of cost of existing equity
shares :
Ce (after tax) = ×100

Ce = Cost of Equity Share Capital

DPS = Dividend Per Share
MPS = Market Price per Share
Illustration 10: Varsha Ltd. issued 10,000 Equity Shares of Rs. 100 each at
par. The company has been paying 20% dividend to equity shareholders for
the past five years and expects to maintain the same in the future also.
Market price of equity share is Rs. 160. Calculate the cost of equity share
capital.
Solution:
Ce (after tax) = ×100

Ce =×100

= 12.5%
(ii) Earnings Yield Method: This is also called ‘Earnings Price Ratio’ method.
According to this approach, the earning per share determines the market price
of equity shares. Under this method, the cost of equity share capital is equal to
the rate which must be earned on incremental issues of equity shares so as to
maintain the present value of investment. The following formula is used for
computation of cost of equity share capital:

Ce = ×100

Ce = Cost of Equity Share Capital

EPS = Earnings Per Share
MPS = Market Price per Share
This method of computing cost of equity capital may be employed in the
following cases : (i)
When the earnings per share are expected to remain constant.
(ii) When all earnings are distributed to the shareholders in the form of
dividends.
(iii) The market price of the share is influenced only by earnings per share.
ILLUSTRATION : Jain Tubes Ltd. has issued 10,000 equity shares of Rs 100 each fully paid. It
has earned profit after tax R| 1,80,000. The market price per share is Rs. 200. Calculate the
cost of equity share capital on the basis of earning yield method assuming that all earnings
has among shareholders.

Solution:
EPS
Ce = 100
MPS
Rs.18
= 100  9%
Rs.200
Profit After Tax
EPS = No. of Equity Share

= = 18
(iii) Dividend Yield and Growth in Dividend Method: According to this method, the
cost of equity is determined on the basis of the expected dividend rate plus the rate
of growth in dividend.
The rate of growth in dividend is determined on the basis of amount of dividends
paid by the company for the last few years. According to this approach the cost of
equity share capital may be determined by using the following formula :

Ce = ×100+G

Ce = Cost of Equity Capital

DPS = Dividend Per Share
MPS = Market Price Per Share
G = Growth rate in dividend
Illustration : Mahadev Ltd. has issued 20,000 equity shares of Rs. 100 each ige rate
of dividend paid by the company is 21%. The earnings of the company have
recorded a growth rate of 5% per annum. The current market price of an equity
share of company is Rs. 150.
Find out cost of equity share capital.

Solution:

Ce =×100+G

= 100+ 5%
= 14% + 5% = 19%
(iv) Realised Yield Method: According to this method, the rate of return
actually realised by shareholders forms the basis for determining the cost
of equity capital. The advocate of this approach argue that the rate of
earnings as well as the market price of shares are always subject to
fluctuations on account of so many factors. Therefore the return actually
realised is a true indicator of the return
expected by the shareholders. The realised return is discounted al the
present value factor and then compared with the value of investment.
This approach is based on the following assumptions :
(i) The risks of the company remain same.
(ii) The shareholders continue to expect the same rate of return for
bearing the given risk.
(iii) The reinvestment opportunity rate of the shareholders is equal to the
realised yield.