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Defination
According to Soloman
Ezracost of capital is the
minimum required rate of
earnings or the cut-off rate
of capital expenditure.
Importance /
significance of the
cost capital
(1)Optimum capital structure decision.
(2)Helpful in taking decision.
(3)For evaluating the financial
performance.
(4)For deciding about the method of
financing.
(5)For taking financial decision.
Classification of cost
Marginal cost-
*Future cost-
*Specific cost-
*Opportunity cost-
regarding the
cost of capital
(a) Traditional ApproachAccording to this approach , a
companys cost of capital depends
upon the method and level of
financing or its capital structure .
It means that a company can
change its overall cost of capital
by changing its capital structure.
Measurement of
cost of capital
capital
(3)Equity share capital
Perpetual or
irredeemable debt
Perpetual or irredeemable debt provides
permanent funds to the firm, because the funds
will remain in the firm till liquidation. For
calculating the cost of perpetual or
irredeemable debt, amount of interest payable
on it is dividend by the net proceeds from its
issue. It can be calculate in two ways viz.
* Cost of irredeemable debt before tax.
* Cost of irredeemable debt after tax.
Cost of
irredeemable debt
before tax
Kdp = I np 100
I =interest
NP=net proceed
Net proceeds which will be as under.
1.When debenture are issued at par
NP= par value floatation charges
pr/n 100
Pr = premium on redemption on
debenture
Kpt = Pd 100 NP
pd = dividend payment
* When preference share are issued at par.
NP = Par value floatation charge
* When preference share are issued at discount.
NP = par value discount floatation cost
*When preference share are issued at premium.
NP = Par value floatation + premium.
(After tax)
= kpt ( 1- t )
Cost of redeemable
preference share
NOTE Cost of
redeemable preference
share are calculate as
same as redeemable
debenture
Ke = E 100 P
Ke = cost of equity share capital
E = earning per share
P = market price per share
Cost of retained
earnings
Based on a sound policy , a successful company does
not distribute the entire profit earned by it ; a
portion of earned profit is retained in the business
for future expansion of the business. This is known
as retained earnings . Thus the formula is
Kr = AD/RE 100
AD = earning from alternatives investment
* When brokerage & tax on dividend are taken into
account
Kr = (1-Td) (1-B) / RE 100
When brokerage , dividend tax and capital gains
tax are taken into account.