UNIT-2

COST OF CAPITAL
Cost of capital
The concept of cost of capital budgeting is
concerned with cost of capital . The concept of
cost of capital is significant not only for capital
budgeting it is also indispensable in other areas
of financial management.
In operational terms the cost of capital is the
rate of return of a firm must earn on its
investments so that market value of the concern
remain unchanged.

DEFINITION
Cost of capital is the minimum required
rate of earning or the cut off rate for
capital expenditure.
Soloman Ezra
Importance of the concept of cost of
capital
(i) Designing the optimal Capital structure
(ii) Assisting in investment decisions
(iii) Helpful in evaluation of expansion
projects
(iv) Rational allocation of national resources
MEASUREMENT OF COST OF
CAPITAL OR COMPONENT
1. Debts
2. Preference share capital
3. Equity Share capital
4. Retained earning
5. Depreciation fund
6. Short term credit
Cost of debts
A company obtains debts generally by
issue of debentures . Usually rate of
interest payable on debenture is related as
its cost but it is not correct .
types
1. Irredeemable
2. Redeemable


after tax= Before tax ( 1- tax rate)
Example
Monika ltd issued 10000,14% debentures of
Rs 100 each at a discount of 5%. The
debenture are irredeemable . Cost of issue
is 2% and the rate of tax is 50%
.Calculation of cost of capital before tax.
example
A company issued 10000 ten years 8%
debentures of Rs 100 each at 4% discount
. Under the terms trust, these debentures
are to be redeemed after 10 years at 5%
premium . The cost of issue is 2%.
Assuming tax rate at 50% . Calculate the
cost of capital.
Cost of equity
The calculation of cost of equity share
capital is relatively difficult task because
alike preference share capital there is
neither any pre fixed rate of dividend
payable on these shares nor there is any
legal obligation to pay dividend on them.
Types
1.Dividend yield method
2. Earning yield method
3.Dividend yield + growth in dividend
method

DIVIDEND YEILD
Ce (after tax)= DPS x100
MP
dividend per share=
divisible profit x payout ratio
no of equity shares