A PROJECT REPORT ON

“COST OF CAPITAL”

GUIDANCE OF:
Priyanka Mam
Apptunix

Submitted By:
Rajat Salaria
B.Com (Prof.
Roll No-1518319
 INDEX

S. NO. PARTICULARS

1. Acknowledgement

2. Preface

3. Meaning of cost of capital

4. Importance of cost of capital

5. Different types of cost of capital

6. Significance of cost of capital

7. Classification of cost of capital

8. The cost of capital is everywhere in finance

9. Mechanics of computing of cost of capital

10. Factors Affecting cost of capital

11. Weighted Average cost of capital and their

steps to calculate

12. How to calculate the cost of capital

13. Impact of cost of capital

14. Issue with WACC

15. Company's Profile

16. Summary of Formulae

17. Issues In Estimating The cost Of Debt

18. Cost Of Capital Key Concepts

19. Determination Of Cast Of Capital

20. What Is WACC?

 Debt Tax Considerations

 Leveraging Up With Debt
 Weighted Average Cost Of Capital

 Weighted Average Cost Of Capital

Formula
 Advantages Of Weighted Average
Cost Of Capital(WACC)
 Disadvantages Of Weighted Average
Cost Of Capital(WACC)
 Types Of Weighted Average Cost Of
Capital

21. Accepting Bad Projects And Rejecting Good

Projects

22. Bibliography

23. Questionnaire
ACKNOWLEDGEMENT

A large number of individual has contributed to this report. I am thankful to all of them
for their help and enlargement. Like other reports, this report is also drawn from the
work of large number of researchers and author in the field of finance.

I would like to express my gratitude to Mr. Gaurav Sharma {finance} for giving me the
opportunity and enough of support to undergo training in their organization.

I shall like to thanks finance department for their able guidance, support, supervision
and care during the whole training programme and to whom words can never express
my feeling of gratitude and reverence.

The successful completion of my project has been carried out under the able guidance
of Mr. Gaurav Sharma {finance}. I take upon this opportunity to thank them for
encouragement and guidance in completion of project. Their knowledge and expertise
was great help for the project study.

We would like to thank our project guide, Mr. Gaurav Sharma, for consultative help and
constructive suggestion on the matter in this project.
I have tried to give credit to all sources from where i have drawn material in this project
still I feel obliged if they are brought to my notice.

My thanks and appreciation also go to my colleague in developing the project and

people who have willingly helped me out with their abilities
I have tried to give credit to all sources from where i have drawn material in this project
still I feel obliged if they are brought to my notice.

Last but not least, I would like to express my deep sense of gratitude to my parents and
friends for their unflinching moral support. Their towering presence instilled in me the
carving to the work harder and completes this daunting task timely with a sufficient
degree of in depth study.

Rajat Salaria
PREFACE

About three decade ago, the scope of financial management was confined to the raising
of funds, whenever needed and little significance used to be attached to financial
decision-making and problem solving.

As a consequence, the traditional finance texts were structured around this theme and
contained description of the instruments and institution of raising funds and of the major
events, such as promotion, reorganization, readjustment, merger,consolidation etc.

When funds were raised. In the mid fifties, the emphasis shifted to the judicious
utilization of funds. The modern thinking financial management acord a far greater
importance to management decision-making and policy.

Today, financial management do not perform the passive role of scorekeeper of

financial data and information, and arranging funds, whenever directed to do so. Rather,
they occupy the key position in top management areas and play a dynamic role in
solving complex management problems.

They are now responsible for the fortune of the enterprises and are involved in most
vital management decision of allocation of capital.It is their duty to ensure the funds are
raised most economically and used in the most efficient effective manner.

The philosophy of this report is to emphasize the practical understanding of basic

concept, which has been studied in the class.

Because of this change in emphasis, the descriptive treatment of the subject of financial
management is being replaced by growing analytical content and sound theoretical
underpinnings.

Rajat Salaria
COST OF CAPITAL

MEANING OF COST OF CAPITAL :

Cost of capital refers to the opportunity cost of making a specific investment. It is

the rate of return that could have been earned by putting the same money into a
different investment with equal risk. Thus, the cost of capital is the rate of return
required to persuade the investor to make a given investment

Defining Cost of Capital:

The cost of capital is the rate of return that could be earned on an investment with
similar risk. It can be defined from two points of view, that of a company and that of an
investor. From an investor's point of view, the cost of capital is the required return
investment must provide in order to be worth undertaking. From a company's point of
view, the cost of capital refers to the cost of obtaining funds—debt or equity—to finance
an investment. The cost of capital is used to evaluate new projects of a company, as it
is the minimum return that investors expect for providing capital to the company. Thus,
the cost of capital is a benchmark that a new project has to meet.

Internal Rate of Return

The cost of capital serves as a benchmark in financial decision-making. The cost of

capital can be compared to the internal rate of return (IRR) of a project or investment.
IRR is the rate of return that makes the net present value of all cash flows from an
investment equal zero. Since IRR measures the efficiency of investments, as opposed
to magnitude, IRRs are commonly used to evaluate the desirability of investments or
projects. If the IRR of an investment exceeds its cost of capital, the project should be
undertaken.

FORMULA:
Risks Associated with the Cost of Capital

The cost of capital is comprised of three key risk components: (1) risk free rate of return,
(2) business risk premium, and (3) financial risk premium.
Risk Free Rate of Return:
The risk free rate of return is an investment completely free of risk (i.e. Treasury Note)
Business Risk Premium:
A business risk premium is a reason to increase the rate of return due to the uncertainty
of the future. For example, potential investors would heavily factor in the business risk
premium with the major U.S. automakers since the auto industry as a whole is influx.
Financial Risk Premium:
The financial risk premium is another factor into the cost of capital since a company's
current debt levels and interest payment to debt holders will play a role in their attempts
at profitability.
Importance of cost of capital

The importance of cost of capital is that it is used to evaluate new project of company
and allows the calculations to be easy so that it has minimum return that investor expect
for providing investment to the company. It has such an importance in financial decision
making. It actually used in managerial decision making in certain field such as-

1) Decision on capital budgeting- It is used to measure the investment proposal to

choose a project which satisfies return on investment.

2) Used in designing corporate financial structure- it is used to design the market

fluctuations and try to achieve the economical capital structure for firm.

3) Top management performance- It evaluates the financial performance of top

executives. It involves the comparison of actual profit of the projects and taken project
overall cost.

How is the cost of capital measured?

Cost of capital is measured in terms of weighted average cost of capital. In this the total
capital value of a firm without any outstanding warrants and the cost of its debt are
included together to calculate the cost of capital.

To calculate the company's weighted cost of capital, first the calculation of the costs of
the individual financing sources:

Cost of Debt Cost of Preference Capital, Cost of Equity Capital, and cost of stock capital
take place and the formula is given as:-
WACC= Wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. Stock)

Cost of the capital is the rate of return which is minimum which has to be earned on
investments in order to satisfy the investors of various types who are making
investments in the company in the form of shares, debentures and loans. It is used in
financial investment which refers to the cost of a company's funds or the shareholders
return on the company's existing deals.
Basic concept of cost of capital

1. Cost of Equity Capital

2. Cost of Preference Shares
3. Cost of Debt
4. Cost of Retained Earning

Different types of costs related to the cost of capital

The following are the various relevant costs associated with the problem of
measurement of firm’s cost of capital.

1. Marginal Cost of Capital. It is the current interest on long term debt. In other words,
the marginal cost of capital is the weighted average cost of new or additional funds
raised by the company.

2. Specific Cost. Specific cost is the cost which is associated with the particular
component of a capital structure.
For example. Equity shares, debentures etc. It is also known as component cost.

3. Combined Cost. It is the cost of capital of all the sources taken together i.e., debt,
equity and preference share capital. The combined cost of capital can be otherwise
called as average cost or weighted cost of capital.

4. Spot Cost. Spot cost represents costs prevailing in the market at certain point of
time.

5. Future Cost. It is the cost which is related to the cost of funds intended to finance the
expected project.

6. Historical Cost. Historical costs are the costs which are calculated on the basis of
existing capital structure of the firm.

7. Explicit Cost. Explicit cost of any source of fund may be expressed as the discount
rate that equates the present value of cash inflows that are incremental to the taking of
the financial opportunity with the present value of its incremental cash outflows.

8. Implicit Cost . Implicit cost is the opportunity cost. It is the rate of return associated
with the best investment opportunity for the firm and its shareholders that will be forgone
if the project presently under consideration by the firm were accepted.
 COST OF EQUITY CAPITAL

1 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.

2 It is the rate at which investors discount the expected dividends of the firm to determine
its share value.

3 The two approaches to measure ke are

i. Dividend valuation approach and

ii. Capital asset pricing model
iii. Most difficult and controversial cost to work out. Conceptually, the cost of equity
ke may be 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.
iv. 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.

APPROCHES TO MEASURES TO KE

Dividend approach – dividend valuation 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.
Significant of the Cost of Capital

Financial experts express conflicting option as to the correct way in which the cost of
capital can be measured.it is a concept of vital important in the financial decision
making. It is useful as a standard for:
 Evaluating investment decisions.
 Designing a firm’s debt policy.
 Appraising the financial performance of top management.
Investment evaluation
The primary purpose of measuring the cost of capital is its use as a financial standard
for evaluating the investment projects. In the net present value (NPV) method, an
investment project is accepted if it has a positive NPV. The project’s NPV is calculated
by discounting its cash flows by the cost of capital.
Designing debt policy
The debt policy of a firm is significantly influenced by the cost consideration. In
designing the financing policy, that is, the proportion of debt and equity in the capital
structure, the firm aims at maximizing the overall cost of capital.

Performance appraisal
The cost of capital framework can be used to evaluate the financial performance of top
management. Such an evaluation will involve a comparison of actual profitability of the
investment projects undertaken by the firm with the projected overall cost of capital, and
the appraisal of the actual costs incurred by management in raising the required funds.

Assumption of Cost of Capital

Cost of capital is based on assumptions which are closely associated calculating and
measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks i-e: zero risk level, business risk and financial risk.
K = rj + b + f.
Where, K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
ASSUMPTIONS OF THE DIVIDEND APPROACH

The market value of shares depends upon the expected dividends.

 Investors can formulate subjective probability distribution of dividends

per share expected to be paid in various future periods. The initial
dividend is greater than 0.

 Dividend payout ratio is constant.

 Investors can accurately measure the riskiness of the firm so as to

agree on the rate at The market value of shares depends upon the
expected dividends.
 Investors can formulate subjective probability distribution of dividends
per share expected to be paid in various future periods. The initial
dividend is greater than 0.

 Dividend payout ratio is constant.

Investors can accurately measure the riskiness of the firm so as to agree

on the rate at which to discount the dividends which to discount the
dividends
CLASSIFICATION OF COST OF CAPITAL

Cost of capital may be classified into the following types on the basis of nature and
usage:
• Explicit and Implicit Cost.
• Average and Marginal Cost.
• Historical and Future Cost.
• Specific and Combined Cost.

Explicit and Implicit Cost

The cost of capital may be explicit or implicit cost on the basis of the computation of
cost of capital.
Explicit cost is the rate that the firm pays to procure financing.

Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital
employed by the company. It considers weighted average cost of all kinds of financing
such as equity, debt, retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is
the additional cost of capital when the company goes for further raising of finance.

Historical and Future Cost

Historical cost is the cost which an already been incurred for financing a particular
project.
It is based on the actual cost incurred in the previous project.
Future cost is the expected cost of financing in the proposed project. Expected cost is
calculated on the basis of previous experience.

Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is
called as specific cost of capital. It is very useful to determine the each and every
specific source of capital.
The composite or combined cost of capital is the combination of all sources of capital.
It is also called as overall cost of capital. It is used to understand the total cost
associated with the total finance of the firm.
The Cost of Capital is everywhere in finance

In corporate finance
: In corporate finance, the cost of
capital plays a central role in investment analysis,
capital structure and dividend policy, helping to
determine whether and where a business should
invest, how much it should borrow and how much it
should return to stockholders.
In valuation
: In valuation, the cost of capital operates
as the primary mechanism for measuring and
adjusting for risk in the expected cash flows

 Cost of capital is the minimum rate of investment which a company has to earn
for getting fund .
When any company investor invests his money , he sees the rate of return . So ,
company has to mention , what will company pay , if investors provide their money to
company . That average cost on the investment is called cost of capital . We calculate it
with following way :-
Cost of capital = interest rate at zero level risk + premium for business risk +
premium for financial risk
The cost of equity is the return that stockholders require for their investment in a
company. The traditional formula for cost of equity (COE) is the dividend capitalization
model:

A firm's cost of equity represents the compensation that the market demands in
exchange for owning the asset and bearing the risk of ownership.
Mechanics of Computing the Cost of Capital

Cost of Capital

Cost of equity Weight Weight

Cost of
of debt of debt
equity

Risk free Risk premium Defaul (1-

Risk t
rate free tax
sprea rate
rate d )

FACTORS AFFECTING COST OF CAPITAL:

CONTROLLABLE FACTORS AFFECTING COST OF CAPITAL:

1. Capital Structure Policy
As we have been discussing above, a firm has control over its capital structure,
targeting an optimal capital structure. As more debt is issued, the cost of debt
increases, and as more equity is issued, the cost of equity increases.
2. Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule
can be changed. For example, as the payout ratio of the company increases the
breakpoint between lower-cost internally generated equity and newly issued equity is
lowered.
3. Investment Policy
It is assumed that, when making investment decisions, the company is making
investments with similar degrees of risk.

UNCONTROLLABLE FACTORS AFFECTING THE COST OF CAPITAL:

1. Level of Interest Rates
The level of interest rates will affect the cost of debt and, potentially, the cost of equity.
For example, when interest rates increase the cost of debt increases, which increases
the cost of capital.
2. Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt
decreases, decreasing the cost of capital.

What are the two ways that companies can raise common equity?
„
 Directly, by issuing new shares of
common stock.
„
 Indirectly, by reinvesting earnings that
are not paid out as
dividends (i.e.,
retaining earnings)

Weighted Average Cost of Capital

• The cost of capital is the rate of return that the suppliers of capital
require as compensation for their contribution of capital.
• Alternatively it can be defined as the opportunity cost of funds for the
suppliers of capital who will not voluntarily invest in a company unless
its return meets or exceeds what the supplier could earn elsewhere in an
investment of comparable risk.
• WACC of capital is a weighted average of the
marginal cost of various components of capital.
• MCC or WACC is the cost of next dollar to be raised.
WACC =wdrd(1-t) + wprp + were
– wd proportion of debt that the company uses when it raises
new funds
– rd before - tax marginal cost of debt
– t company’s marginal tax rate
– wp proportion of preferred stock the company uses when it raises new funds
– r p marginal cost of preferred stock
– we proportion of equity that the company uses when it raises new funds
The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summed:
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Steps for Calculating Weighted Average Cost of Capital

There are three steps for calculating the WACC of an organization.

1) Determine the proportionate weighting of each source of capital financing based on
their market value.
2) Calculate the after-tax rate of return or cost of each source.
3) Calculate the weighted average cost of all sources.
How do we calculate the cost of capital
- or -
cost of obtaining funds for a project.

A Use the average of the sources of funds (r)a

Sources
(1) debt (r)p
(2) preferred stock (r)d
(3) common stock
- retained earnings (r)s
- new issue of common stock (r)e

Cost of Debt (rd)

Use after tax yield-to-maturity of bond net of issuance costs [flotation costs
(f)] Yield-to-maturity is the rate of return paid to bondholders over the life of
a bond Because companies benefit from the tax deductions available on
interest paid, the net cost of the debt is actually the interest paid less the tax
savings resulting from the tax-deductible interest payment.
 ex .sell bond for $1,000 (Vb=$1,000)
flotation costs =3% (fd=3%)
coupon rate = 10%
n =30(annual coupon payments)

solve for i =(r)d= 10.32%

But from a company's viewpoint their cost is net of taxes because they can
deduct bond interest from tax return.
After-tax cost of debt = rd(1-t)
If t = 40% then rd(1-t) =10.32 (.60) =6.2%

Cost of Preferred Stock

Calculating the Cost of Preferred Stock

As we discussed in section 6 of this walkthrough, preferred stocks straddle
the line between stocks and bonds. Technically, they are equity securities, but
they share many characteristics with debt instruments. Preferreds are issued
with a fixed par value and pay dividends based on a percentage of that par at
a fixed rate.
Cost of preferred stock (Rps) can be calculated as follows:
Rps =
Dps/Pnet
where:

Dps = preferred

dividends

Pnet = net

issuing price
Estimating the Cost of Common Stock

The cost of common equity is represented as re, and it is the rate of return
required by the common shareholders.
The cost of common equity can be measured using the following methods:

Where:
 E(Ri) is the expected return on the security
 Rf is the risk-free rate of return
 Β is the beta of the stock
 Rm is the expected return from the market

Impact the cost of capital

Before-tax vs. After-tax Capital Costs
„
 Tax effects associated with financing
can be incorporated
either in capital
budgeting cash flows or in cost of
Capital.
„
 Most firms incorporate tax effects in the
cost of capital. Therefore, focus on
after-tax costs.
„
 Only cost of debt is affected.

Issues with WACC

(1) Factors the firm cannot control

• Interest rates in the economy
• If interest rates in the economy rise, the cost of debt increases because firms must
pay bondholders more when it borrows
• The general level of stock prices
• If stock prices in general decline, pulling the firm’s stock price down, its cost of equity
will rise.
• Tax rates
• Tax rates are used in the calculation of the cost of debt, which is one of the
components of WACC
(2) Factors the firm can control
• Changing its capital structure
• If a firm changes its target capital structure, the weights used to calculate the WACC
will change
• By changing its dividend payout ratio
• The higher the dividend payout ratio, the smaller the addition to retained earnings and
thus the higher the cost of equity and therefore the WACC
 Company’s Profile
Apptunix is a software development and designing service provider company. Apptunix
is founded by a group of young and energetic entrepreneurs focused on leveraging its
customer with state of the art technology by offering innovative, contemporary and cost-
effective technology solutions.

Our vision is to establish our self as the next generation development company offering
top of the line solutions. Our core values revolve around 6 key principles-

Honesty
Integrity
Accountability
Quality
‘Results’

Our team is our strength and their ability to deliver things under budget and on time can
easily be appraised by our client manifestations & testimonies.

Our offerings span across :-

Native Apps development (iOS/Android/Windows)

Cross-Platform Apps development (Xamarin/Titanium/Phonegap)
Games Development (Unity3D/Cocos2D)
Web development (Php, .Net, Wordpress, Magento, Joomla)
Web Designing (Graphics, UI, Illustration, Photoshop)

We will be happy to establish a long standing business relationship with you and your
company and we sincerely believe that our company could be a reliable partner for you.
 Summary of Formulae
S.No Purpose Formula

1 Before tax cost of debt K =

db

2 After cost of debt K = K (1-t) =

da db

3 Before tax cost of redeemable debt

4 After tax cost of redeemable debt K = K (1-t)

da db

5 Cost of debt redeemable at premium

6 Cost of debt redeemable in

instalments V =
d

7
Cost of irredeemable preference K = p

share capital

8
 Cost of redeemable preference share
capital

9
Cost of equity –dividend yield
approach

10
K =
e

Cost of equity – dividend yield plus

constant growth
11 K =
e

Cost of retained earnings

12
Weighted average cost of capital Kr =

13
K =
w

Cost of equity – CAPM approach

Ke = R + b (R - R )
f I m f
 Issues in estimating the cost of debt

• The cost of floating-rate debt is difficult because the cost depends not only on current
rates but also on future rates.
- Possible approach: Use current term structure to estimate future rates.
• Option-like features affect the cost of debt.
- If the company already has debt with embedded options similar to what it may
issue, then we can use the yield on current debt.
- If the company is expected to alter the embedded options, then we would need to
estimate the yield on the debt with embedded options.
• Nonrated debt makes it difficult to determine the yield on similarly yielding debt if the
company’s debt is not traded.
- Possible remedy: Estimate rating by using financial ratios.
• Leases are a form of debt, but there is no yield to maturity.
- Estimate by using the yield on other debt of the company.