Components of Cost of Capital

Cost of capital refers to the rate of return that a firm needs from its investments to maximize its value. The Cost of Capital consists of two categories:

  1. Cost of Equity

This refers to the cost of leveraging financial capital or equity provided by shareholders, which are repayable in capital gains and higher share price. The cost of equity can be determined using the dividend price approach or the earning price approach.

The dividend price approach involves calculating the expected future dividend payments. In this approach, the cost of equity refers to the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. The cost of equity using dividend price approach can be calculated as follows:

KE = (Dividend per share / Market price per share) x 100; where:

  • KE = Cost of Capital

On the other hand, the earning price approach is used to calculate the future stream of earnings from shareholders’ investments. The formula for calculated the cost of equity using the earning price approach is given as:

KE = E / MP; where:

  • E = Earnings per share
  • MP = Market price
  1. Cost of Debt:

This is the cost incurred when borrowing funds from a bank or financial institution for investment purposes. The financing institution recovers its principal amount and earns profit by charging interest on the borrowed amount. This interest contributes to the total cost of debt. The cost of debt when issued at par is calculated as follows: KD= [(1 – T) x R] x 100; where

  1. KD = Cost of Debt
  2. T = Tax Rate
  3. R = Rate of interest on debt capital

When debt is issued at premium, the cost of debt can be calculate as follows:

KD = [1 / NP x (1 -T) x 100]; where:

  1. KD = Cost of Debt
  2. NP = Net proceeds of debt
  3. T = Tax Rate
  4. R = Rate of interest on debt capital
  1. Cost of Preference Capital:

The cost of preference capital refers to the sum of dividends paid and expenses incurred to raise preference shares. The dividend paid on preference shares is not deducted from tax, as dividend is an appropriation of profit and not considered as an expense. Cost of preference share can be calculated as follows:

Kp = [{D + F / N (1 – T) + RP / N} / {P + NP / 2}] x 100; where:

  • KP = Cost of preference share
  • D = Annual preference dividend
  • F = Expenses including underwriting commission, brokerage, and discount
  • N = Number of years to maturity
  • RP = Redemption premium
  • P = Redeemable value of preference share
  • NP = Net proceeds of preference shares

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