Cost of Capital | Forms of Capital | Importance of Cost of Capital

         It may wonder you why do company raise capital or funds for operation in various forms such as Equity Capital, Preference Capital, Debt Capital or Retained Earnings. The reason behind this is to maintain the capital structure and maximize the returns by raising capital or fund for operation in cost efficient manner. So today in this article we will be studying the cost of capital concept which is one of the most important concept in Financial Management and helping you to form an efficient capital structure of the company.

Cost of Capital

          Cost of Capital can be defined as the minimum rate of return that a firm or company is required to earn in order to satisfy its investors and also to price of the equity share remains unchanged. The main objective behind the cost of capital is to maximize the returns to investors.

Forms of Capital

§  Equity Capital

§  Preference Capital

§  Debt Capital

§  Retained Earnings Capital

Cost of Equity Share Capital

Cost of new equity represents what the shareholders of the company who have made earned if they had made the investment elsewhere instead of this stock. In case of equity share capital company or firm has no obligation to pay any fixed rate of dividend as the cost of equity is always based on the earnings and dividends payable to the Equity Shareholders. In order to raise equity capital equity shares are to be issued by the company. In order to calculate the cost of equity following formula is being used.

K_e = D/NP + g *100 ( Dividend yield with growth in dividend)

K_e = D/NP*100 (Dividend yield model with no growth in dividend)

Where,

     D : Expected Dividend

     g : Rate of Growth

     NP: Net Proceeds

Cost of Preference Capital

Cost of preference capital represents the dividend expense that is payable to preference shareholders that would company bear in order to raise the preference capital. Preference Share Capital has fixed percentage of dividend just like interest to debt. In order to raise the preference capital preference shares are issued by the company. The cost of preference share capital is calculated using the following formula depending on the type of preference share.

K_p = Dp/NP*100          (For Irredeemable PSC)

K_p = Dp+(RP – IP)/n    (For Redeemable PSC)

                                      (RP+IP)/n

Where,

            K_p : Cost of PSC

             Dp: Preference Dividend

   NP: Net Proceeds (Issued Price – Floatation cost)

   IP : Net Proceeds Realized

    R : Redemption Price

   N : Redemption Period

Cost of Debt

Cost of debt would represent the interest expense that firm or company has to raise in order to raise the borrowed funds. Debt is a form external fund in the form of loan, public deposits for a specific period at a fixed rate of return.  Debentures are issued to at par, premium or discount in two forms such as irredeemable debentures and redeemable debentures in order to raise the debt capital. In order to calculate the cost of capital following formula is being used.

K_d = I(1-t)/NP * 100 (For Irredeemable Debt Capital)

K_d = C(1-t) + (RP- IP)/n *100  (For Redeemable Debt Capital)

                         (RP +IP)/2

Where,

          t: tax

NP/IP: Net Proceeds

C : Coupon Rate of Interest

R : Redemption Price

N: Maturity Period of debt

Cost of Retained Earning

 The cost of retained earnings represents what would be the earnings earned by existing shareholders if the dividend had been paid to them and they had invested the fund.

K_r = Ke(1-f) (1-t) *100

Where,

          Ke : Cost of equity.

          f: Floatation cost

t: Tax

Importance of Cost Capital

          Now that we have understood what does cost of capital means and different types of cost of capital. Let us now try to understand the importance of the cost of capital or why do we need to consider cost of capital before raising capital or fund.

§  Cost capital plays on of the vital role in structuring the company’s capital structure for maximizing the returns.

§  For making better capital budgeting decisions as the acceptance and rejections will be based on the cost of capital with greater rate of returns.

§  Helps to study the various sources of financing or raising capital or fund with cost efficient capital.

§  Helps to assess the performance of the capital invested in various projects.

§  Helps the company or firm to know expected profits and risk inherited.

§  Helps in making better financing and dividend decisions.

§  Helps in framing a optimal credit policy by studying cost of capital and credit period current allowed to debtors.