Cost of Capital

Definition
An essential input for several corporate finance decision as it serves it as benchmark.
This is because as a finance manager is whether or not make use of opportunities offered by
the technological advancements, market development, or economic development of the
society.
Economy continuously offers business opportunities that need to be examined and evaluated by
business enterprises.
in any kind of a situation, one needs a standard against which the comparison or assessment is made.
In context of financial management, a benchmark is needed for the purpose of
evaluation of business opportunities
Returns of business opportunities
This benchmark against which business opportunities are compared is called discount rate or
hurdle rate. In most cases this hurdle rate is considered as cost of capital.
Origination of Cost of Capital
Investor always in favor different ways of using the fund, based on underlying economics of
Time value of Money
Opportunity costs

The opportunity cost is not as simple as individual investing.

Simple because of one investor and one capital

Extension of opportunity cost of capital to multiple investors causes difficulty to calculate the hurdle
rate.
investment pooled by different investors.
they have different expectation for their return.
Questions
If different investors have different expectations of returns, what would be
Opportunity costs
Hurdle rate

Should we change according to each investor? What would happen

Some investors would accept
Some investors would reject

However, expectation must converge towards common goal. What is it?

For that opportunity cost must be as same as hurdle rate. Why?

Hurdle rate or discount rate is that rate equated to opportunity cost that market must afford.
Parameter
Market determined opportunity cost of capital
Cost of Capital = Hurdle
Rate ???
Capital is necessary factor of Production
It has its own cost
This cost is equal to marginal investor’s required return on the security.

With the objective of the firm, and companies can increase the
shareholders value by
Investing on those projects, that can earn more than cost of capital.

Where is the hurdle? Cost or return or both? Explain for 2

minutes.
What are the other names of cost of capital.
Points to be noted
Hurdle rate should indicate returns of investment along with risk associated with investment. The
opportunity cost must compare the investment of the same risk class.
This implies opportunity cost must compare with the investment of the same risk class.
Opportunity cost of a bank fixed deposits cannot be used to evaluating the investment in equity shares.

Existence of loans can affects hurdle rate in

Cost of funds for the firm as interest cost is tax-deductible
Modify the expectations of equity investors
Claim of debt holder is prior than equity holders claims.
Claims of debt holder are fixed,
irrespective of profit or loss
Increases the risk of equity holders.
Hurdle rate become dependent upon proportion of debt.
Besides costs
Purpose of cost of Capital
The project cost of capital,
minimum required rate of funds committed to the project which depends upon riskiness of cash
flows
The firm’s cost of Capital
Overall, or average, required rate of return on the aggregate of investment projects.
Significance
Evaluating investment decisions
Designing a firm’s debt policy
Appraising the financial performance of top management
Other Purposes of Cost of
Capital
It is the key input used to calculate firm’s or division economic value added (EVA).

Managers estimate and use the cost of capital when deciding if they should
Purchase the asset
Lease the asset

In regulating monopoly. Why?

One firm can supply at service at lower cost than two or more firms.
It would exploit the customers, investors, creditors, government if they are unregulated
For regulator it is a boon
To have an information of cost that capital investors and other stakeholders have provided to monopoly firm
And then set rates designed to permit the company to earn cost of capital, no more than that and no less than that
A situation
With different type of sources of funding the expectation
of return, should evaluation of investment proposals be
done against the specific sources of funding the
investment?
Incorporate business risks:- Manager tend to offset risks of cash flows by raising the qualifying
bar, i.e., to revise upwards the discount rate while appropriate way would be risk adjusted
discount rate approach.
Incorporate financial Risk:- The variability of cash flows pertains the business risk where market
environment other related factors causing uncertainty of cash flows.
Capital structure
Basic terms
The items on the right side of balance sheet—various type of debt, preferred stock, and common
equity called capital components.
The cost of each component is called the component cost.
Types
cost of debt, 
Cost of preferred stock, 
Cost of common equity, 
After tax cost of debt, , where  is marginal tax rate.
Basic Assumption
Business risk—the risk to the firm of being unable to cover operating costs—is assumed to
unchanged. This assumption means that the firm’s acceptance of given project does not affect its
ability to meet operating costs.

Financial risk–the risk to the firm of being unable to cover required financial obligations
(interest, lease payments, preferred stock dividends)—is assumed to be unchanged. This
assumption means that project are financed in such a way that projects are financed in such a way
that firm’s ability to meet required costs unchanged.

After-tax cost are considered relevant. In other words, the cost of capital is measured on an
after tax basis. This assumption is consistent with after tax framework used to make capital
budgeting decisions.

Why we assume that risk of the firm is subject to unchanged?

Why cost of capital is calculated on after-tax basis?
Opportunities, values and
claims.
Creditors have a priority claim over the firm’s assets and cash flows.

The firm is under a legal obligation to pay interest and repay principal. There is a probability that it
may default on its obligation to pay interest and principal. Corporate bonds are riskier than
government bonds since it is very unlikely that the government will default in its obligation to pay
interest and principal

In an all-equity financed firm, the equity capital of ordinary shareholders is the only source to finance
investment projects, the firm’s cost of capital is equal to the opportunity cost of equity capital, which
will depend only on the business risk of the firm.
Basic Concept
It reflects the expected average cost of funds over the long run.
Cost of capital should reflect the interrelatedness of financing activities.
In order to make optimal capital structure.

We need to look overall cost of capital rather than cost of the specific source of funds. Why and
how?

Cost of capital is calculated on finding the costs of specific sources of capital and combining them to
determine the weighted average cost of capital.
Where would we find the
sources of capital

Sources of long-term funds

Formula of opportunity cost of
capital

Where,
)
 (they represent cash outflows from the firm)


Correlate with one of the formula that we have gone through with this
subject. If yes, what is it? If not why?

However, investors required rate of should be adjusted for taxes. In practice for calculating of specific
cost of capital.
Cost of Long Term Debt
Assumption:- Bonds pay annual interest.
Net proceeds:- Most of the corporate long term debts are incurred through sell of bonds.
The net proceeds from sale of bond, or any security, are funds that are actually received
from sales.
Floatation Cost:- the total cost issuing and selling the a security- reduce net proceeds from
the sales.
Components of floatation cost:-
(1) Underwriting Cost:- compensation earned by investment bankers for selling the security.
(2) administrative cost:- issuer expenses such as legal, accounting, printing, and other
expenses.
How to obtain the Before Tax
cost of debt
Using cost quotations
When net proceeds from sales of a bond equal its par value, the before tax cost just equals the coupon interest rate.
By calculation
Calculating IRR from financial calculator or spreadsheet software like, Microsoft Office Excel, etc.
By approximation through regression.
Implicit cost
Our ultimate objective of firm to maximize the shareholders’ wealth.
Cost of retained earning technically equivalent to the opportunity cost.
The implicit cost of capital of funds raised and invested, therefore, be defined as ‘The rate of
return associated with the best investment opportunity of the firm and its shareholders that
would be forgone, if the projects under the consideration by the firm were accepted.
The opportunity cost of retained earnings is an opportunity cost or implicit opportunity cost,
in the sense that it rate of return at which the shareholders could have invested these funds
they had been distributed to them.
WACC (Weighted Average Cost
of Capital)
Component cost of capital or specific cost of capital are cost of capital of
each individual source of capital.

The combined cost of capital of each source is called average cost of capital.
When component cost are combined according to the weight of each
component to obtain average cost of capital. Thus, overall cost of capital is
also called weighted average cost of capital.
What are wrong with specific costs of
capital and average cost of capital.
The various source of capital are related to each other. The firm decision to use debt in a given period
reduces the future of debt capacity as well as increase the risk of shareholders.
The shareholders will require higher rate of return to compensate for increased risk.
Similarly firm’s decision to reduce equity capital would enlarge its potential in burrowing the future.
Over the long run, the firm is expected to maintain a balance between debt and equity.

Because of the connection between sources of capital and the firm’s desire to have the target capital
structure. In long run, cost of capital should be used in composite, overall sense.  we consider
weighted average cost of capital.
Formula for Weighted Average
cost of Capital
For Company, Cost of capital = 
Where,




V = Total value of the firm
Important Points to be noted for
calculating CAPM
For computational convenience, it is best to convert the weights into decimal form and leave the
specific costs in percentage terms.
The sum of weights must be equal 1.0. Simply stated, all capital strucfture componenets must be
accounted for.
Weighing schemes
Book value versus Market Value
Book value weighs use accounting values to measure the proportion of each type capital in the firm’s
financial structure.
Market value weights measure the proportion of each type of capital at its market value.

However market value clearly prefer over book value

weights. Why?
Second type of Weighing
Scheme
Historical cost can be either book or market value weights based on actual capital structure
proportions. For example, past or current book value proportions would constitute a form of
historical weighing.

Target weights, which can also be based on either book or market values, reflect the firm’s desired
capital structure proportions. It is type through which firm capital

However we use to prefer target weighing

scheme for WACC. Why?
Group Discussion
Why weighted average cost capital is used to calculate cost of capital?
What type weight signifies here?
Is cost capital provides IRR or MIRR?
Should we go for debt financing or equity financing or mixed? Justify your point from the purview
1. Real estate
2. Aviation
3. FMCG
4. Renewable energies
5. Startups (either biotech or app-based fintech)
6. Cellular communication technology like, 5G, 6G, 7G
Remember Noteworthily
Relevant cost = Future cost or marginal cost.
Marginal cost is the new or incremental cost that firm incurs if it where to raise capital now or near future.

Historical cost that were incurred in the past in raising the capital is not relevant in financial decision
making.
Historical cost may significant in
They help to predicting the future costs
Providing the information of past performance when compared with the standard, or predetermined, costs.
Cost of Debt (introduction)
A company may raise debt in various ways. It may burrow funds from financial institution or
public either in the debentures for a specified period of time at a certain rate of interest.

A debenture or bond may be issued at par or at discount or premium as compared to face

value.

The contractual rate of interest or coupon rate form the basis for the calculation of cost
of debt.
Debt Issued at Par

Where,  is before-tax cost of debt,
 is coupon rate of interest
 is the issue price of the bond (debt)
Debt Issued at Discount or
Premium

Where,
= the repayment of debt on maturity and other variables as defined earlier.
This equation will help to coats of debt at par, at premium, and at discount
When, 
Cost of Preference Shares
The preference share may be treated as a perpetual security if is redeemable.

Where
= cost of preference shares
= expected preference dividend
= is the issue price of preference share.
Cost of preference share

Where, 
= Dividend of preference share

State which formula you use for calculation, state which way cost of preference is easy to
obtain.
Redeemable preference share

Does Cost of Debt to adjusted
for tax?
Cost of Equity Capital
From earnings retained by the firm, internally
Alternatively, they could distribute entire earnings by issuing the new shares.
Therefore, the equity shareholders’ would be same as whether they supply by purchasing new shares
or forgoing dividend, which would have to be distributed to them.
The firm may have to issue new shares less than the current market price. Also, it may have to incur
floatation costs.
Cost of equity (internal)
The retained earnings consists of the retained earnings.
The opportunity cost of the retained earnings is the rate of return foregone by shareholders.
The shareholder generally expect dividend and long-term capital gain.
Normal growth:- where dividend expected to grow at a constant rate of g is as follows:
  , where 
Super Normal growth:-

Cost of External Equity
Dividend Growth model

One exception, cost of equity of no growth firm

Factors that affect the cost of
capital
Factors that firm cannot control
- The level of interest rates
- Tax rates

Factors the firm can control

- Capital Structure Policy
- Dividend policy
- Investment Policy
Reference:-
Brigham, E. F., & Houston, J. F. (2004). Fundamentals of Financial Management. Ohio:
Thompson South Western.
Srivastava, R., & Misra, A. (2011). Financial Management. New Delhi: Oxford University Press.
Gitman, L.J. (2008). Principles of Managerial Finance. New Delhi: Pearson
Pandey, I.M. (2011), Financial Management. Noida: Vikas Publishing House