Cost Of Capital

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Information about Cost Of Capital

Published on April 21, 2009

Author: prachigupta787


UNIT-2 : UNIT-2 COST OF CAPITAL Cost of capital : Cost of capital The concept of cost of capital budgeting is concerned with cost of capital . The concept of cost of capital is significant not only for capital budgeting it is also indispensable in other areas of financial management. In operational terms the cost of capital is the rate of return of a firm must earn on its investments so that market value of the concern remain unchanged. DEFINITION : DEFINITION “ Cost of capital is the minimum required rate of earning or the cut off rate for capital expenditure.” Soloman Ezra Importance of the concept of cost of capital : Importance of the concept of cost of capital (i) Designing the optimal Capital structure (ii) Assisting in investment decisions (iii) Helpful in evaluation of expansion projects (iv) Rational allocation of national resources MEASUREMENT OF COST OF CAPITAL OR COMPONENT : MEASUREMENT OF COST OF CAPITAL OR COMPONENT 1. Debts 2. Preference share capital 3. Equity Share capital 4. Retained earning 5. Depreciation fund 6. Short – term credit Cost of debts : Cost of debts A company obtains debts generally by issue of debentures . Usually rate of interest payable on debenture is related as its cost but it is not correct . types 1. Irredeemable 2. Redeemable Slide 7: after tax= Before tax ( 1- tax rate) Example : Example Monika ltd issued 10000,14% debentures of Rs 100 each at a discount of 5%. The debenture are irredeemable . Cost of issue is 2% and the rate of tax is 50% .Calculation of cost of capital before tax. expample : expample A company issued 10000 ten years 8% debentures of Rs 100 each at 4% discount . Under the terms trust, these debentures are to be redeemed after 10 years at 5% premium . The cost of issue is 2%. Assuming tax rate at 50% . Calculate the cost of capital. Cost of equity : Cost of equity The calculation of cost of equity share capital is relatively difficult task because alike preference share capital there is neither any pre fixed rate of dividend payable on these shares nor there is any legal obligation to pay dividend on them. Types : Types 1.Dividend yield method 2. Earning yield method 3.Dividend yield + growth in dividend method DIVIDEND YEILD : DIVIDEND YEILD Ce (after tax)= DPS x100 MP dividend per share= divisible profit x payout ratio no of equity shares

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