Cost of Capital : Management Accounting
Cost of Capital
- — The cost of capital is the cost of using the funds of creditors and owners.
- — It is the Rate of Return that a company must pay to the suppliers of capital as nothing is free of cost.
- — It is the minimum required rate of return on the investment project that keeps the present wealth of shareholders unchanged.
- — Cost of capital also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard return, etc.
• Cost
of capital is a combined cost of each type of source by which a firm
raises funds.
• A
firm obtains capital from various sources. The component cost are combined
according to weight of each component capital to obtain the average cost of
capital.
• Thus
the overall cost is also called weight average cost of capital(WACC)
— Example
:
Source of Capital Cost after tax
Weights Weighted cost
i. Debt ……(
Kd
)
7.05%
30%
2.12%
ii. Preferred
Stock(Kp) 10.04
10
1.09
iii. Common Stock
(Ke)
12.09
60
7.20
-------
Weighted Average cost of
capital(Ka)
10.41%
Importance of Cost of Capita
Cost
of capital is the key to all business decisions.
- — It is useful as a standard for evaluating investment decision.
- — It helps in designing the Corporate Financial Structure
- — It uses in deciding about the method of financing .
- — It can be used to evaluate the performance of top management
- — It also plays useful role in dividend decision, investment in current assets.
Component of Cost of Capital:
- Cost of Equity Capital
- Cost of Preference
Shares
- Cost of Debt – Bond/
Debenture
- Cost of Retained
Earnings
Cost of Equity Capital (ke)
- — Ke is the return that equity investors require on their investment in the firm.
- — Ke is defined 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.
- — It is the rate at which investors discount the expected dividends of the firm to determine its share value.
- — The cost of equity capital is higher than that of preference and debt because of greater uncertainty of receiving dividends and repayment of principal at the end.
- — Cost of Equity = Current dividend / Market price
— Ke
= ( Do / Po ) x 100 Here, Do = Dividend per share Po =
Market price per share.
— Let
,the current dividend rate of a company is Tk.12 and the market price of the
share is Tk.150, what is the cost of equity share ?
K e = ( Do / Po ) x
100 = ( 12 / 150 ) x 100 = 0.08 x 100 = 8 %
— The
two approaches to measure Cost of Equity ( ke )
— i.
Dividend valuation approach and
— ii.
Capital asset pricing model.
— Dividend
valuation approach:
— This
model assumes that the value of a share equals the present value of all future
dividends that it is expected to provide over an indefinite period.
— Ke
accordingly is defined as 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.
Category: Management Accounting (MA)
0 Comments