PPT: Cost of Capital | Financial Management & Strategic Management for CA Intermediate PDF Download

 Page 1


COST OF CAPITAL
Cost of capital is the rate return the firm requires
from investment in order to increase the value of the
firm in the market place.
Hampton
? The sources of capital of a firm must be in the form of
preference shares, equity shares, debt and retained earnings.
? In simple cost of capital of a firm is the weighted average
cost of their different sources of financing.
Page 2


COST OF CAPITAL
Cost of capital is the rate return the firm requires
from investment in order to increase the value of the
firm in the market place.
Hampton
? The sources of capital of a firm must be in the form of
preference shares, equity shares, debt and retained earnings.
? In simple cost of capital of a firm is the weighted average
cost of their different sources of financing.
Components Of Cost Of Capital
A firm’s cost of capital include 3 components :
1) Return at zero risk level :- It relates to the expected
rate of return when a project involves no financial
or business risk.
2) Business risk premium :- Generally business risk
premium is determined by the capital budgeting
decisions for investment proposals. If the firm
selects a project which has more than the normal
risk, the suppliers of the funds for the project will
naturally expect a higher rate of return than the
normal rate. Thus the cost of capital increases.
Page 3


COST OF CAPITAL
Cost of capital is the rate return the firm requires
from investment in order to increase the value of the
firm in the market place.
Hampton
? The sources of capital of a firm must be in the form of
preference shares, equity shares, debt and retained earnings.
? In simple cost of capital of a firm is the weighted average
cost of their different sources of financing.
Components Of Cost Of Capital
A firm’s cost of capital include 3 components :
1) Return at zero risk level :- It relates to the expected
rate of return when a project involves no financial
or business risk.
2) Business risk premium :- Generally business risk
premium is determined by the capital budgeting
decisions for investment proposals. If the firm
selects a project which has more than the normal
risk, the suppliers of the funds for the project will
naturally expect a higher rate of return than the
normal rate. Thus the cost of capital increases.
3) Financial risk premium :- Financial risk relates to
the pattern of capital structure of the firm. A firm
which has higher debt content in its capital
structure should have more risk than a firm which
has comparatively low debt content.
Page 4


COST OF CAPITAL
Cost of capital is the rate return the firm requires
from investment in order to increase the value of the
firm in the market place.
Hampton
? The sources of capital of a firm must be in the form of
preference shares, equity shares, debt and retained earnings.
? In simple cost of capital of a firm is the weighted average
cost of their different sources of financing.
Components Of Cost Of Capital
A firm’s cost of capital include 3 components :
1) Return at zero risk level :- It relates to the expected
rate of return when a project involves no financial
or business risk.
2) Business risk premium :- Generally business risk
premium is determined by the capital budgeting
decisions for investment proposals. If the firm
selects a project which has more than the normal
risk, the suppliers of the funds for the project will
naturally expect a higher rate of return than the
normal rate. Thus the cost of capital increases.
3) Financial risk premium :- Financial risk relates to
the pattern of capital structure of the firm. A firm
which has higher debt content in its capital
structure should have more risk than a firm which
has comparatively low debt content.
The above 3 components of cost of capital may be
written in the form of the following equation.
K=r0+ b + f
Where,
K= cost of capital
r0 = return at 0 risk level
b= business risk premium
f= financial risk premium
Page 5


COST OF CAPITAL
Cost of capital is the rate return the firm requires
from investment in order to increase the value of the
firm in the market place.
Hampton
? The sources of capital of a firm must be in the form of
preference shares, equity shares, debt and retained earnings.
? In simple cost of capital of a firm is the weighted average
cost of their different sources of financing.
Components Of Cost Of Capital
A firm’s cost of capital include 3 components :
1) Return at zero risk level :- It relates to the expected
rate of return when a project involves no financial
or business risk.
2) Business risk premium :- Generally business risk
premium is determined by the capital budgeting
decisions for investment proposals. If the firm
selects a project which has more than the normal
risk, the suppliers of the funds for the project will
naturally expect a higher rate of return than the
normal rate. Thus the cost of capital increases.
3) Financial risk premium :- Financial risk relates to
the pattern of capital structure of the firm. A firm
which has higher debt content in its capital
structure should have more risk than a firm which
has comparatively low debt content.
The above 3 components of cost of capital may be
written in the form of the following equation.
K=r0+ b + f
Where,
K= cost of capital
r0 = return at 0 risk level
b= business risk premium
f= financial risk premium
Classification Of Cost Of Capital
1) Historical cost and Future cost
2) Specific cost and Composite cost
3) Average cost and Marginal cost
4) Explicit cost and Implicit cost
Historical cost and Future cost :-
Historical cost are the costs which are incurred for
the procurement of funds based upon the existing
capital structure of the firm. It is a book cost.