Concept and Measurement of Cost of Capital

Concept And Measurement Of  Cost Of Capital

The cost of 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 the firm. The capital used may be debt, preference shares, retained earnings and equity shares.

^v   The decision to invest in particular project depends on cost of capital or cut off rate of the firm,.

^v   To achieve the objective of wealth maximization, a firm must earn a rate of return more than its cost of capital.

^v   Higher the risk involved in the firm, higher is the cost of capital.

Factors Affecting The Cost Of Capital Of A Firm

1) Risk Free Interest Rate:

The risk free interest rate, I_f , is the interest rate on the risk free and default- free securities. Theoretically speaking, the risk free interest rate depends upon the supply and demand consideration in financial market for long term funds. The market sources of demand and supply determines the I_f , which is consisting of two components:

a)  Real interest Rate:

The real interest rate is the interest rate payable to the lender for supplying the funds or in other words, for surrendering the funds for a particular period.

b)       Purchasing power risk premium:

Investors, in general, like to maintain their purchasing power and therefore, like to be compensated for the loss in purchasing power over the period of lending or supply of funds. So, over and above the real interest rate, the purchasing power risk premium is added to find out the risk free interest rate. Higher the expected rate of inflation, greater would be the purchasing power risk premium and consequently higher would be the risk free interest rate.

2) Business Risk:

Another factor affecting the cost of capital is the risk associated with the firm‘s promise to pay interest and dividends to its investors. The business risk is related to the response of the firm‘s Earnings Before Interest and Taxes, EBIT, to change in sa les revenue. Every project has its effect on the business risk of the firm. If a firm accepts a proposal which is more risky than average present risk, the investors will probably raise the cost of funds so as to be compensated for the increased risk. This premium is added for the business risk compensation is also known as Business Risk Premium.

3) Financial Risk:

The financial risk is a type of risk which can affect the cost of capital of the firm. The particular composition and mixing of different sources of finance, known as the financial plan or the capital structure, can affect the return available to the investors. The financial risk is affected by the capital structure or the financial plan of the firm. Higher the proportion of fixed cost securities in the overall capital structure, greater would be the financial risk.

4) Other Consideration:

The investors may also like to add a premium with reference to other factors. One such factor may be the liquidity or marketability of the investment. Higher the liquidity available with an investment, lower would be the premium demanded by the investor. If the investment is not easily marketable, then the investors may add a premium for this also and consequently demand a higher rate of return.

1 Computation Of Cost Of Capital

A.               Computation of cost of specific source of finance

B.               Computation of cost of weighted average cost of capital

2Computation of specific source of finance

(i)       Cost of debt

It is the rate of interest payable on debt.

Debenture before tax

^Ø     Issued at par

^Ø     Issued at premium or discount

Debenture after tax

(ii) Cost of redeemable debt

The debt is to be redeemed after a certain period during the life time of the firm. Such debt issued is known as redeemable debt.

^Ø     Before tax cost of redeemable debt

^Ø     After tax cost of redeemable debt

(iii) Cost of preference capital

A fixed rate of dividend is payable on preference shares. Dividend is payable at the discretion of the board of directors and there is no legal binding to pay dividend. In case dividend are not paid, it will affect the fund raising capacity of the firm. Hence dividends are paid regularly except when there is no profit

^Ø     Issued at par

^Ø     Issued at premium or discount

Cost of redeemable preference shares

Redeemable preference shares are issued which can be redeemed or cancelled on maturity date.

(iv) Cost of equity share capital

The cost of equity is the maximum rate of return that the company must earn on equity financed position of its investments in order to leave or unchanged the market price of its stock.It may or may not be paid. Shareholders invest money in equity shares on the expectation of getting dividend and the company must earn this minimum rate so that the market price of the shares remains unchanged.

(a)    Dividend yield method or dividend / price ratio method

(b)    Dividend yield plus growth in dividend method

(c)     Earnings yield method

(v) Cost of retained earnings

The retained earnings do not involve any cost because a firm is not required to pay dividend on retained earnings. But shareholder expects return o n retained earnings.

Computation Of Cost Of Capital

Co mputation of cost of capital consists  of two  important parts:

1.      Measureme nt of specific costs

2.      Measureme nt of overall cost of capital

3Measurement of Cost of Capital

It refers  to the cost of each specific sources  of finance like:

•       Cost of equity

•       Cost of debt

• Cost of prefere nce share

• Cost of retained earnings

Cost of Equity

Cost of equity capital is the rate at which investors discount the expected dividends of the firm to deter mine its share value.

 Conceptually the cost of equity capital (Ke) defined as the ―Minimum rate of

retur n that a firm must earn on the equity financed portion of an investme nt project in order to leave unc hanged the market price of the shares‖.

Cost of equity can be calculated from the following approach:

• Dividend price (D/P) approach

• Dividend price plus growth (D/P + g) approach

• Earning price (E/P) approach

• Realized yield approach.

Dividend Price Approach

The  cost of equity         capital  will be that  rate  of expected  dividend  which will  ma inta in the present market         price of equity shares.   

Dividend  price approach  can be measured with  the  help of the following       formula:

Ke=D/Np

Where,

Ke = Cost of equity  capital

D = Dividend per equity  share

Np = Net proceeds  of an equity  share