Cost of Capital

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This MBA Seminar topic on Cost of Capital, discuss about source of long term capital like Equity and Preference capital, Debts, Average cost of capital and cost of a specific source of income.

Firms need finance mainly for two purposes – to fund capital expenditure decisions and to meet working capital requirements. Capital expenditure decisions are met by long-term sources of funds. The source of long-term capital for firms are equity (common stocks), preference capital, and debt (debenture, term loans etc.)

Equity (common stocks)

Equity holders are owners of business. They enjoy residual profits of the company after having paid the preference shareholders and other creditors of the company. Their liability is restricted to the amount of share capital they contributed to the company. Equity capital provides the issuing firm the advantage of not having any fixed obligation for dividend payment but offers permanent capital with limited liability for repayment. However, cost of equity capital is higher than other capital.

Preference Capital

The preference shareholders have preference over equity shareholders to the post-tax earnings in the form of dividends; and assets in event of liquidation.

Debt

Debenture capital

A debenture is a marketable legal contract whereby the company promises to pay its owner, a specified rate of interest for a defined period of time and to repay the principal at the specified date of maturity. Debentures are usually secured by a charge on the immovable properties of the company.

Term loans

Term loans constitute one of the major sources of debt finance for a long-term project. It is offered by financial institutions. The interest rate fixed after financial institution appraises the project and assesses the credit risk.

 CASE ACASE B
EBIT 100 100
INTEREST - 60
EBT 100 40
TAX(T) @ @ ASSUMING 60% 60 24
EAT 40 16

Interest payment of 60 in case b, bring a tax shield of 60 x 0.60 (tax rate) = 36. This implies that the post-tax cost of an interest payment of 60 is only 24.

After familiarizing with different sources of long-term finance, let us find out what it costs the company to raise these various types of finance. The cost of capital to a company is the minimum rate of return that it must earn on its investment in order to satisfy various categories of investors who have made investments in the form of shares, debentures, term loans.

Concept Of Average Cost Of Capital

A Firm’s Cost Of Capital Is The Weighted Arithmetic Average Of The Cost Of Various Sources Of Long-term Finance Used By It.

Cost Of Capital = (proportion Of Equity X Cost Of Equity) + (proportion Of Debt X Cost Of Debt)

For Calculating Cost Of Capital Of The Firm, We have to first define the cost of various sources of finance used by it.

Cost Of A Specific Source Of Finance

It is measured as rate of discount which equates present value of expected payments to that source of finance with net funds received from that source of finance. It is the value of r, in equation



Where; p = net funds received from the source and
Ct = expected payment to the source at the end of year t.

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