1. Meaning Of Cost of Capital
Minimum required Rate Of Return
Which A Project MUST earn.
a) The Minimum Earning by a firm
b) In order to satisfy
c) The Expectations of Those Persons
d) Who have invested their funds in the firm.
DEFINITION

2. Cost Of Capital also known as:
TARGET RATE
HURDLE RATE
CUT-OFF RATE

3. What If a firm fails to earn returns at
expected rate…..
M.V. of shares REDUCE
Overall Wealth of Shareholders REDUCE
Value of The Firm REDUCE
No. of Prospective Investors REDUCE
Moreover,
Acceptance Or Rejection
Of an Investment depends on
The Cost Of Capital
ADDITIONAL POINT :-

4. Importance of Cost Of Capital
For Capital Budgeting Decisions
For Capital Structure Decisions
For Working Capital Policy Decisions
For Comparative Analysis of various sources of Finance
For Evaluation of Fin. Efficiency of TOP MGMT.

5. Equity share
Holders
Pref. share
Holders
Debenture
Holders
INVESTMENT in the Company
EARNINGS
If Fulfills the Expectations of
The Investors
If doesn’t Fulfills the Expectations
of The Investors
Value of Firm DecreaseValue of Firm Increase
ADVERSE
CONDITION
FAVOURABLE
CONDITION

6. Cost of RETAINED EARNINGS
The earnings FORGONE by the ShareholdersThe earnings FORGONE by the Shareholders
Part of Profits, Retained for Future Expansion of BusinessPart of Profits, Retained for Future Expansion of Business
NOT FREE of COST i.e. Involve Cost
As
Part of the Shareholders’ Funds which is blocked as Reserves
If it is Invested
Anywhere else,
It will produce some
Extra Earnings
Opportunity
Cost
FORMULA-
KRE = D1 / MP + g
Or
D / MP
Equity Share
Holders
Investment in
The Company
Blocked in Two Ways
SHARE CAPITAL
RETAINED EARNINGS

7. Weighted Avg. Cost of Capital
Also Known As :- Combined Cost of Capital
Composite Cost of Capital
Overall Cost of Capital
Combination of
Component Costs
i.e.
Kd, Kp, Ke, Kre
According to the
Weights of each
Component Capital
Meaning:-
Weights are Assigned
As per
The Proportion of each
Component capital
In the Capital Structure
Any Fin. Decision
Should be taken with reference to
‘WACC’
& Not with reference to
Cost of Component Capital
Main Objective :-

8. Formula of W.A.C.C.
(D / T.F. * Kd) + (P / T.F. * Kp) + (E / T.F. * Ke)
Kp Ke
Composition according to the respective weights
WACC
Kd

9. Explicit Cost
The Discount Rate which
Equates
The PV of Cash Inflows
&
The PV of Cash Outflows
It Arises
When
The Funds
Are
Raised
Implicit Cost
The Rate of Return
Which will be
Forgone
If the project presently
Under consideration
Is accepted
It Arises
When
The Funds
Are
Used
Also
Known as
Opportunity
Cost

10. Assignment of Weights
Book Value Weights
Simple Computations
Wrong Estimates
No Fluctuations
Operationally convenient
Readily Available
Market Value Weights
Difficult To Compute
Good Estimates
Fluctuate Widely
Theoretically consistent
Difficult to calculate

11. Which Weights Should be used in the calculation
of WACC ?
Market Value weights
Should ALWAYS
Be given
Preference
As these provide
A Good Estimate of
Cost of Capital
In Case,
M.V. Weights
Are not readily avlbl.
Then,
Book Value Weights
Can be Used.

12. Economic Value Added (EVA)
Profits Over And Above the Cost of Capital
ROCE > Ko
A Test of Profit Adequacy
A Measure of Corporate Growth
Formula
Actual Earnings – Earnings at Ko

13. Marginal Cost of Capital
Cost of Raising ADDITIONAL Funds
Marginal Weights
are used
i.e. The Proportion of Funds,
The firm intends to Employ
The Problem of choosing
b/w. B.V. and M.V.
Doesn’t arise in
The case of
WMACC, Why ?
Because WMACC uses
Marginal Weights
Which represents the
Proportion of funds,
The firm intends to employ.

14. Why should a firm periodically re-examine its Cost of
Capital before determining Annual Capital Budget ?
REASONS :-
Firm’s Internal Structure
Capital Market Conditions
Supply and Demand for Funds
Subtle change in Capital Structure