session 5 coc - Concept and Measurement of Cost of Capital...

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1 Concept and Measurement of Cost of Capital
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Cost of Capital The cost of capital is an integral part of investment decisions as it is used to measure the worth of investment proposal. It is used as a discount rate in determining the present value of future cash flows associated with capital projects. Conceptually, it is the minimum rate of return that a firm must earn on its investments so as to leave market price of its shares unchanged. It is also referred to as cut-off rate, target rate, hurdle rate, required rate of return and so on. In operational terms, it is defined as the weighted average cost of capital ( k 0 ) of all long-term sources of finance. The major long-term sources of funds are 1) Debt, 2) Preference shares, 3) Equity capital, and 4) Retained earnings.
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3 Explicit and Implicit Costs Explicit Cost The explicit cost of capital is associated with the raising of funds (from debt, preference shares and equity). The explicit cost of any source of capital ( C ) is the discount rate that equates the present value of the cash inflows ( CI o ) that are incremental to the taking of financing opportunity with the present value of its incremental cash outflows ( CO t ). Symbolically, where CI 0 = initial cash inflow, that is, net cash proceeds received by the firm from the capital source at time O, CO 1 + 2 ... + n = cash outflows at times 1, 2 . .. n , that is, cash payment from the firm to the capital source. ( 29 ) 1 ( C 1 CO CI n 1 t t t 0 = + =
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4 If CI 0 is received in instalments, then, CI 0 It is evident from the above mathematical formulation that the explicit cost of capital is the ‘rate of return of the cash flows of the financing opportunity Implicit Cost Retained earnings involve no future cash flows to, or from, the firm. Therefore, the retained earnings do not have explicit cost. However, they carry implicit cost in terms of the opportunity cost of the foregone alternative ( s ) in terms of the rate of return at which the shareholders could have invested these funds had they been distributed to them/or not retained by the firm. ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ) 2 ( C 1 CO ... C 1 CO C 1 CO C 1 CO C 1 CI ... C 1 CI C 1 CI C 1 CI CI n n 3 3 2 2 1 1 n n 3 3 2 2 1 1 0 + + + + + + + = + + + + + + + +
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5 Measurement of Specific Costs There are four types of specific costs 1) Cost of Debt 2) Cost of Preference Shares 3) Cost of Equity Capital 4) Cost of Retained Earnings
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6 Cost of Debt Cost of debt is the after tax cost of long-term funds through borrowing. The debt carries a certain rate of interest. Interest qualifies for tax deduction in determining tax liability. Therefore, the effective cost of debt is less than the actual interest payment made by the firm by the amount of tax shield it provides. The debt can be either 1) Perpetual/ irredeemable Debt 2) Redeemable Debt
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7 Perpetual Debt In the case of perpetual debt, it is computed dividing effective interest payment, i.e., I (1 – t ) by the amount of debt/sale proceeds of debentures or bonds ( SV ). Symbolically k i = Before-tax cost of debt k d = Tax-adjusted cost of debt I = Annual interest payment SV = Sale proceeds of the bond/debenture t = Tax rate ( 29 ) 4 ( SV t 1 I k ) 3 ( SV 1 k d t - = =
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This note was uploaded on 03/03/2011 for the course MARKETING 101 taught by Professor Singh during the Spring '11 term at Management Development Institute.

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session 5 coc - Concept and Measurement of Cost of Capital...

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