Computation of Cost of Capital: Financial Management

In this article, we will learn how to computation cost of capital which is meaningful to commerce and management of financial students.

Computation of cost of capital:
Computation of cost of capital has two important parts – Financial Management:

1. Measurement of specific costs
2. Measurement of the overall cost of capital

Measurement of Cost of Capital:

It refers to the cost of each specific sources of finance  – financial management such as:

• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings

Cost of Equity: Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value. Theoretically, the cost of equity capital is described as the “Minimum rate of return that a firm must earn on the equity-financed portion of an investment project in order to leave unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:

• Dividend price (D/P) approach.
• Dividend price plus growth (D/P + g) approach.
• Earning price (E/P) approach.
• Realized yield approach.

Dividend Price Approach: The cost of equity capital will be the rate of expected dividend which will maintain the present market price of equity shares.
Dividend price approach can be measured with the following formula:

ke=D/Np

Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Dividend Price Plus Growth Approach: The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend .
It can be measured by the following formula:

ke=(D/ Np )+g

Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
Earning Price Approach: The cost of equity regulates the market price of the shares. It is based on the future earnings forecasts of equity. The formula for calculating the cost of equity according to this approach is as follows.

ke=E/Np

Where,
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share
Realized Yield Approach: It is a simple method to compute the cost of equity capital. Under this method, the cost of equity is calculated by

ke=PVf * D

Where,
Ke = Cost of equity capital.
PVf = Present value of the discount factor.
D = Dividend per share.

II. Cost of Debt: Cost of debt is the after-tax cost of long-term funds through borrowing. Debt may be issued at par, at a premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par: Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with the following formula

kd= (1-t)R

Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount: If the debt is issued at premium or discount, the cost of debt is calculated with the following formula.

Kd=I/Np (1-t)

Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Cost of Perpetual Debt and Redeemable Debt: It is the rate of return which the lenders expect. The debt carries a certain rate of interest.

Kdb=(I+1/n (P-Np)n)/(1/n (P+Np)/2)

Where,
I = Annual interest payable
P = Par value of debt
Np = Net proceeds of the debenture
n = Number of years to maturity
Kdb = Cost of debt before tax
Cost of debt after tax can be calculated with the following formula:

kda=kdb*(1-t)

Where,
Kda = Cost of debt after tax
Kdb = Cost of debt before tax
t = Tax rate
III. Cost of Preference Share Capital: The cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share. There are two types of preference shares irredeemable and redeemable.
The following formula is used to calculate the cost of redeemable preference share capital:

kp=Dp/Np

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
Cost of irredeemable preference share is calculated with the following formula:

kp=(Dp+(P-Np)/n)/((p+Np)/2)

Where,
Kp = Cost of preference share
Dp = Fixed preference share
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.
IV. Cost of Retained Earnings: Retained earnings is one of the sources of finance for an investment proposal. It is dissimilar from other sources like debt, equity, and preference shares. The cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital.
Cost of retained earnings can be calculated with the following formula:

kr=Ke(1-t)(1-b)

Where,
Kr = Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b = Brokerage cost

Measurement of Overall Cost of Capital/ weighted average cost of capital – financial management:
It is also known as the weighted average cost of capital and composite cost of capital. The weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure.

The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the following formula – financial management;

Ko=kdWd+Kpwp+KeWe+KrWr

Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following formula also:

Kw={XW/{W

Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, the proportion of specific sources of finance.
To, summarize, the cost of the return is defined as the return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk. The cost of capital signifies the overall cost of financing to the firm. It is normally the relevant discount rate to use in evaluating an investment. The cost of capital is important because it is used to assess the new project of the company and permits the calculations to be easy so that it has a minimum return that investors expect for providing investment to the company.

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