Assumption of Cost of Capital

It is documented in theoretical studies that cost of capital is based on some

assumptions which are directly related while calculating and measuring the cost
of capital. There are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and financial
risk.

Cost of capital can be measured with the following equation:

Where,
K= Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.

Importance of Cost of Capital

Computation of cost of capital is significant part of the financial management to

decide the capital structure of the business concern.
Importance to Capital Budgeting Decision: Capital budget decision mainly
depends on the cost of capital of each source. According to net present value
method, present value of cash inflow must be more than the present value of
cash outflow. Therefore, cost of capital is used for capital budgeting decision.
Importance to Structure Decision: Capital structure is the mix or proportion of
the different types of long term securities. Company uses particular type of
sources if the cost of capital is suitable. Therefore, cost of capital supports to
take decision regarding structure.
Importance to Evolution of Financial Performance: Cost of capital is imperative
to determine which affects the capital budgeting, capital structure and value of
the firm. It helps to estimate the financial performance of the firm.
Importance to Other Financial Decisions: Cost of capital is also used in some
other areas such as, market value of share, earning capacity of securities etc.
hence, it plays a major part in the financial management.

Computation of cost of capital:

Computation of cost of capital has two important parts:

1. Measurement of specific costs

2. Measurement of overall cost of capital
Measurement of Cost of Capital:

It refers to the cost of each specific sources of finance such as:

• Cost of equity
• Cost of debt
• Cost of preference 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 determine its share value. Theoretically, the
cost of equity capital is described as the "Minimum rate of return that a firm
must earn on the equity financed portion of an investment project in order to
leave unchanged 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 maintain the present market price of equity
shares.
Dividend price approach can be measured with the following formula:

Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Dividend Price Plus Growth Approach: The cost of equity is calculated on the
basis of the expected dividend rate per share plus growth in dividend (R M
Srivastava, 2008).
It can be measured by the following formula:

Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
Earning Price Approach: Cost of equity regulates the market price of the shares.
It is based on the future earnings forecasts of the equity (R M Srivastava, 2008).
The formula for calculating the cost of equity according to this approach is as
follows.

Where,
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share
Realized Yield Approach: It is simple method to compute cost of equity capital
(R M Srivastava, 2008). Under this method, cost of equity is calculated by

Where,
Ke = Cost of equity capital.
PVf = Present value of discount factor.
D = Dividend per share.
II. Cost of Debt: Cost of debt is the after tax cost of long-term funds through
borrowing. Debt may be issued at par, at premium or at discount and also it may
be perpetual or redeemable.
Debt Issued at Par: Debt issued at par means, debt is issued at the face value of
the debt. It may be calculated with the following formula

Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount: If the debt is issued at premium or
discount, the cost of debt is calculated with the following formula.

Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Cost of Perpetual Debt and Redeemable Debt: It is the rate of return which the
lenders expect. The debt carries a certain rate of interest.

Where,
I = Annual interest payable
P = Par value of debt
Np = Net proceeds of the debenture
n = Number of years to maturity
Kdb = Cost of debt before tax
Cost of debt after tax can be calculated with the following formula:

Where,
Kda = Cost of debt after tax
Kdb = Cost of debt before tax
t = Tax rate
III. Cost of Preference Share Capital: Cost of preference share capital is the
annual preference share dividend by the net proceeds from the sale of
preference share. There are two types of preference shares irredeemable and
redeemable.
Following formula is used to calculate the cost of redeemable preference share
capital:

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
Cost of irredeemable preference share is calculated with the following formula:
Where,
Kp = Cost of preference share
Dp = Fixed preference share
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.
IV. Cost of Retained Earnings: Retained earnings is one of the sources of
finance for investment proposal. It is dissimilar from other sources like debt,
equity and preference shares. Cost of retained earnings is the same as the cost of
an equivalent fully subscripted issue of additional shares, which is measured by
the cost of equity capital.
Cost of retained earnings can be calculated with the following formula:

Where,
Kr = Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b = Brokerage cost
Measurement of Overall Cost of Capital:
It is also known as weighted average cost of capital and composite cost of
capital. Weighted average cost of capital is the expected average future cost of
funds over the long run found by weighting the cost of each specific type of
capital by its proportion in the firm's capital structure.
The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the following formula;

Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following formula also:

Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.
To, summarize, cost of return is defined as the return the firm's investors could
expect to earn if they invested in securities with comparable degrees of risk. The
cost of capital signifies the overall cost of financing to the firm. It is normally
the relevant discount rate to use in evaluating an investment. Cost of capital is
important because it is used to assess new project of company and permits the
calculations to be easy so that it has minimum return that investor expect for
providing investment to the company.