Cost of capital and methods of calculating cost of capital

Cost of capital is the minimum rate of investment which a company has to earn for getting fund .
When any company investor invests his money , he sees the rate of return . So , company has to mention , what will company pay , if investors provide their money to company . That average cost on the investment is called cost of capital . We calculate it with following way :-

Cost of capital = interest rate at zero level risk + premium for business risk + premium for financial risk


If a company has not power to earn , cost of capital , then this company can not get fund from public .

Importance of cost of capital


1. Basis of capital budgeting decisions:-


A company wants to invest his money in different project. Then it will compare their cost of capital and company will never invest his money in that project whose cost of capital is less than other project .


2. Basis of redesigning of capital structure :-


Cost of capital affects capital structure designing. Capital structure is just mixed of debt and equity sources which company wants to get from investors. At that time company selects that mixture of debt and equity in which cost of capital will be become minimum. With this company can increase the value of shares.


3. Basis of other decisions:-


There are large number decision & like dividend policy, interest policy which is depend on correct calculation of cost capital.

Method of calculation cost of capital:-


1. cost of debt



company wants to get debt from public, then calculating the cost of debt is the rate which calculated by dividing value of interest on loan with amount of principal.


a) cost of debt before tax adjustment



if company issues debentures on premium or discount , then for calculating cost of debt , principal amount will be adjusted with these amount . After adjust amount will be net proceed




b) Cost of debt after tax adjustment












2. Cost of pref. share capital


Cost of pref. share capital is rate which should company earn for paying dividend to pref. share holders because , it effects also the value of shares . With following formula we can calculate cost of pref. share capital





3. Cost of equity


Cost of equity is calculated with dividend yield method , or dividend yield plus growth rate method or earning yield method or realised yield method .



I) Dividend yield method :-


Under this method , company can calculate cost of equity on the basis of following formula





for example if the dividend per share is 10 and company issue 100 shares at Rs. 100 plus premium 10% then cost of equity


Ke= 10 / 110 X 100 = 9.9%


II) Dividend yield plus growth rate of dividend method :-









C) Earning yield method





4. Weighted average cost of capital


if we multiply all cost of capital with proportion of capital structure and divides with the total of proportion of capital structure % . After this what we receive is called weighted average of cost of capital .




Practical example of calculating weighted average of cost of capital :-





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Accounting Education: Cost of capital and methods of calculating cost of capital
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