GTU MBA II Sem Financial management

Chapter Objectives
 Cost of Debt
Chapter - 9
 Cost of Preference Capital
The Cost of Capital
 Cost of Equity Capital

 WACC

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Cost of Capital FUND

 Discount rate
 Target rate
 Hurdle rate
 Opportunity cost of capital
 Minimum required rate of return
 Cut-off rate

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Sources of funds
 Equity shareholders
 Preference shareholders  To procure funds, the firm must pay
 Debt holders this return to the investor.

 These investors provide funds to the firm  So, the proposal must earn at least
 They expect a minimum return from the firm. that much, which is sufficient to pay to
 This minimum return depends upon the risk. the investors.

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GTU MBA II Sem Financial management

Introduction
 The project’s cost of capital is the
minimum required rate of return on funds
committed to the project, which depends
on the riskiness of its cash flows.

 The firm’s cost of capital will be the

overall, or average, required rate of
return on the aggregate of investment
projects.

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Explicit and Implicit Cost of Capital

Significance of the Cost of Capital  Explicit COC: Interest or dividend that the firm
has to pay to the suppliers of funds.
It is useful as a standard for:
(Payment by the firm)

 Evaluating investment decisions (NPV, IRR)

 Implicit COC: Retained earnings does not
involve any payment.
 Designing a firm’s debt policy, and
The implicit cost of the retained earnings is the
return which could have been earned by the
 Appraising the financial performance of top
investors, had the profit been distributed to them
management. (they could have invested these funds
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The Concept of the Opportunity Cost General Formula for the Opportunity
of Capital Cost of Capital
 The opportunity cost is the rate of return  Opportunity cost of capital is given by the
following formula:
foregone on the next best alternative
investment opportunity of comparable risk. C1 C2 Cn
I0    
(1  k ) (1  k ) 2 (1  k ) n

where Io is the capital supplied by

investors in period 0 (it represents a net
cash inflow to the firm),
Ct are returns expected by investors
(they represent cash outflows to the firm)
k is the required rate of return or the
cost of capital.
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GTU MBA II Sem Financial management

Cost of Capital Weighted Average Cost of Capital Vs. Specific

Costs of Capital

 The cost of capital of each source of capital

is known as component, or specific, cost
of capital.

 The overall cost is also called the weighted

average cost of capital (WACC).

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Cost of Debt
It is the rate of return required by lenders.

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Example:
Cost of Preference Capital

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Example:
Weighted Average Cost of Capital

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Ko= k1w1 + k2w2 + k3w3 + …….

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