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Determination of Cost of Capital

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Capital Cost forms to be an important and controversial aspect in the financial management decision of a company. Thus, determining the capital cost is not at all an easy task. With such difficulty, it is obvious that the financial manager faces various conceptual and practical problems while assessing the capital cost incurred by a company.

The problems faced by a finance manager are-

  1. Computing Equity Cost

Evaluating the equity capital cost is a difficult task. From theoretical point of view, equity capital cost can be defined as the minimum rate of return which a company needs to earn as per its employed capital. This leads to an unaffected market price. Since quantification of the expectations of equity shareholders is needed, it is a difficult task as various authorities have applied various approaches for quantifying the expectations of equity shareholders.

  1. Conceptual Controversy

Whether the capital cost depends on the method and level of financing is a major controversy. According to traditional theorists, a company can change its total capital cost by changing its debt-equity mix. However, modern theorists believe that a change in debt-equity ratio has no effect on the total capital cost incurred by an enterprise.

  1. Problems in calculating capital cost of retained earnings and Depreciation of funds

Price of depreciated funds and retained earnings is evaluated as per the approach used for calculating the equity capital cost.

  1. Problems while considering historical and future cost

If considered from the point of decision making process, historical cost has no relevance. However, future expenses are an important consideration. A finance manager often faces problem regarding whether he should consider marginal expenses or the total fund cost.

  1. Problem of Weights

While determining the average capital cost, the finance manager faces difficulties related to weights as there are aspects like computation as well as evaluating weights to each fund type.

Computing Capital Cost

Calculation of capital cost comprises of-

  • Computing cost of every specific financial source
  • Computing weighted average capital cost

Computation of every specific financial source

Expenses of specific financial sources can be further divided into-

  1. Preference Shares
  2. Debt
  3. Retained Earnings
  4. Equity Capital
  1. Preference Shares Expenditure

ย 

  1. Price of Redeemable Preference Share

Formula for calculating this expenditure is-

K = DP + (P-NP) /n / (P + NP) / 2

Here,

DP stands for Fixed Preference Share Dividend; n stands for Number of Preference Shares; NP stands for Net Proceeds of Preference Shares.

  1. Expense of Preference Capital

Formula for evaluation-

Kp = DP / NP

Here,

Kp stands for Cost of Preference Share Capital; NP stands for Net Proceeds of Preference Shares; DP stands for Fixed Preference Dividend

  1. Cost of Debt
  1. Ratio of Debt issued at per is proportionate to premium or discount

Formula-

Kd = (1 โ€“ T) R

Here,

Kd means Cost of Debt; T means Marginal Tax Rate; R means Debenture Interest Rate

  1. Cost of redeemable Debt

Formula-

Kd = I + (P โ€“ NP) / n / (P + NP) /2

Here,

I denotes Annual Interest Payment; P denotes Par value of debentures; NP denotes Net Proceeds of Debentures; n denotes Remaining years to mature.

 

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