COST OF CAPITAL

Dr.Bharath V

bharath.v@kristujayanti.com
 2

Introduction and Meaning of CC

• According to Professor I.M.Pandy “Cost of Capital is the
discount rate used in evaluating the desirability of the
investment project”. The cost of capital is the minimum
rate of return required for investment project.

• The cost of capital is the minimum rate of return which will

maintain the market value per share at its current level. If
the firm earns more than the cost of capital, the market
value per share is expected to increase.
 3

Importance of the Cost of Capital

• Capital budgeting decisions

• Capital structure decisions

• Evaluation of final Performance

• Other financial decisions

 4

Sources of Finance

• Long-term financial needs

• Medium-term financial needs

• Short-term financial needs

 5

Classification of Financial Sources

Equtity shares
Share Captial
Preference
shares
External
Sources Debentures

Sources of Loan from

Debt or
Finance Financial
Borrowed
Instutuions
Mainly
Internal
retained Others
Sources
earnings
 6

Owners Capital or Equity Capital

• A public limited company may raise funds from promoters
or from the investing public by way of owner’s capital or
equity capital by issuing ordinary equity shares.
• It is a source of permanent capital.
• owners of the company as they undertake the highest
risk.
• Entitled to dividends
• In the event of winding up, ordinary shareholders can
exercise their claim on assets after the claims of the other
suppliers of capital have been met.
 7

Advantages
• It is a permanent source of finance. Since such shares
are not redeemable, the company has no liability for cash
outflows associated with its redemption.
• Equity capital increases the company’s financial base and
thus helps further the borrowing powers of the company.
• The company is not obliged legally to pay dividends.
Hence in times of uncertainties or when the company is
not performing well, dividend payments can be reduced or
even suspended.
• The company can make further issue of share capital by
making a right issue.
 8

Disadvantages

• The cost of ordinary shares is higher because dividends

are not tax deductible and also the floatation costs of such
issues are higher.
• Investors find ordinary shares riskier because of uncertain
dividend payments and capital gains.
• The issue of new equity shares reduces the earning per
share of the existing shareholders until and unless the
profits are proportionately increased.
• The issue of new equity shares can also reduce the
ownership and control of the existing shareholders.
 9

Preference Share Capital

• Preference share capital refers to the funds raised by a
company through the issuance of preference shares,
which have preferential rights over equity shares in terms
of:
• Receiving dividends (at a fixed rate) before equity shareholders.
• Repayment of capital in case of liquidation of the company.

• Preference shareholders do not usually have voting

rights, except in certain circumstances (e.g., non-payment
of dividends). They are considered a hybrid between
equity and debt due to their fixed return but limited
ownership control.
 10

Advantages
• No Obligation to Repay Capital

• Fixed Dividend Obligation:

• No Voting Rights

• Attracts Conservative Investors

• Priority in Capital Repayment

• Less Risky than Equity Shares

 11

Disadvantages
• Fixed Dividend Commitment

• Higher Cost of Capital

• Limited Flexibility

• Repayment Obligation for Redeemable Shares

• No Voting Rights

• Limited Returns

• Lower Priority than Debt

 12

Retained Earnings
• Retained earnings refer to the portion of a company's net
profits that are not distributed as dividends to shareholders
but are instead reinvested into the business or reserved for
future use.

• These earnings are recorded in the equity section of the

balance sheet under "Retained Earnings.“

• Business Expansion, Debt Repayment, Reserve for

Unforeseen Expenses, Enhancing Shareholder Value
 13

Advantages

• Cost-Effective Source of Finance

• Improves Financial Stability

• Control and Independence

• Enhances Investor Confidence

 14

Disadvantages
• Limited Availability

• Opportunity Cost

• Risk of Mismanagement

• No Tax Advantage
 15

Debentures
• Debentures are a type of long-term debt instrument
issued by companies to raise funds.

• They are a form of loan taken by the company from the

public or institutions, with a promise to pay a fixed rate of
interest at regular intervals and repay the principal
amount at maturity.

• Debenture holders are creditors of the company and do

not have ownership rights.
 16

Key Features of Debentures

• Fixed Interest: Debentures carry a pre-determined
interest rate, paid periodically.
• Maturity Period: Debentures are issued for a specific
term, at the end of which the principal is repaid.
• No Voting Rights: Debenture holders do not have voting
rights or control over the company.
• Secured or Unsecured: Debentures can be secured
(backed by the company's assets) or unsecured (no
backing but based on creditworthiness).
• Tradable: Debentures can often be traded in the stock
market, providing liquidity to investors.
 17

Types of Debentures
• On the Basis of Security:
• Secured Debentures: Backed by specific assets of the company.
• Unsecured Debentures: Not backed by any collateral.

• On the Basis of Convertibility:

• Convertible Debentures: Can be converted into equity shares after
a specified period.
• Non-Convertible Debentures (NCDs): Cannot be converted into
equity and must be repaid in cash.
 18

• On the Basis of Repayment:

• Redeemable Debentures: Repaid at the end of a specific period.
• Irredeemable (Perpetual) Debentures: Not repaid during the lifetime
of the company, but interest is paid indefinitely.

• On the Basis of Registration:

• Registered Debentures: Issued in the name of specific holders, and
their transfer requires formal registration.
• Bearer Debentures: No formal registration; the holder of the
physical certificate is considered the owner.
 19

Advantages
• Fixed Income for Investors

• Lower Risk for Investors

• No Ownership Dilution

• Tax Deductible for the Company

• Attractive to Conservative Investors

 20

Disadvantages
• Fixed Obligation

• No Growth Opportunity for Investors

• Risk for Unsecured Debentures

• Negative Impact on Cash Flow

• Priority to Debenture Holders

 21

BONDS
• A bond is a fixed-income financial instrument that
represents a loan made by an investor to a borrower
(typically a corporation, government, or municipality).

• In return for the loan, the borrower agrees to pay periodic

interest (known as a coupon) and repay the principal (the
face value of the bond) at a predetermined maturity date.

• Bonds are a common way for entities to raise capital while

offering investors a relatively low-risk investment option.
 22

Key Features of Bonds

• Face Value (Principal): The amount of money the
bondholder will receive back at the bond's maturity.
• Coupon Rate: The fixed interest rate that the bond issuer
pays to the bondholder, typically expressed as a
percentage of the face value.
• Maturity Date: The date on which the issuer repays the
principal amount to the bondholder.
• Issuer: Bonds can be issued by corporations,
governments, or municipalities.
• Market Price: Bonds can be traded in secondary
markets, and their price may fluctuate based on market
interest rates and creditworthiness.
 23

Types of Bonds
• Based on Issuer:
• Government Bonds: Issued by national governments (e.g.,
Treasury Bonds in the US).
• Corporate Bonds: Issued by companies to fund operations or
expansion.
• Municipal Bonds: Issued by local governments or municipalities.

• Based on Interest Payments:

• Fixed-Rate Bonds: Pay a fixed interest rate over the bond’s term.
• Floating-Rate Bonds: The interest rate changes based on market
conditions.
 24

• Based on Convertibility:
• Convertible Bonds: Can be converted into a predetermined number
of company shares.
• Non-Convertible Bonds: Cannot be converted into shares.

• Zero-Coupon Bonds:
• These bonds do not pay periodic interest but are issued at a
discount and redeemed at face value upon maturity.

• Secured and Unsecured Bonds:

• Secured Bonds: Backed by specific assets of the issuer.
• Unsecured Bonds (Debentures): Not backed by collateral; rely on
the creditworthiness of the issuer.
 25

Advantages
• Regular Income

• Lower Risk

• Diverse Investment Options

• Priority in Repayment

• Tax Benefits
 26

Disadvantages
• Lower Returns

• Interest Rate Risk

• Inflation Risk

• Credit Risk

• Liquidity Risk
 27

Computation of Cost of Capital

Cost of
Capital

Cost of Cost of Combination

Cost of Cost of Long of Cost and
Preference Cost of Debt Retained
Equity term loan Weight of
shre Earning
each source
of capital

Weighted
Average
Cost of
Capital
(WACC)