Cost of Capital | Accountancy and Financial Management - B Com PDF Download

 Page 1


COST OF CAPITAL
Presented by : Nirmal.PR
Page 2


COST OF CAPITAL
Presented by : Nirmal.PR
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 3


COST OF CAPITAL
Presented by : Nirmal.PR
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 4


COST OF CAPITAL
Presented by : Nirmal.PR
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 5


COST OF CAPITAL
Presented by : Nirmal.PR
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