The cost of capital

11/July/2025 01:25 Share:

? Cost of Capital: Meaning, Content, and Importance

The Cost of Capital refers to the minimum rate of return a business must earn on its investments to maintain the market value of its shares and satisfy its investors. It is the cost of obtaining funds — either through debt, preference capital, or equity — to finance a project or investment. Cost of capital acts as a benchmark to evaluate the profitability of investment decisions.

The concept of cost of capital includes the following components:

Cost of Debt – Interest paid to lenders
Cost of Preference Capital – Dividend paid to preference shareholders
Cost of Equity – Expected return demanded by equity shareholders

Importance of Cost of Capital:

Helps in evaluating investment and financing decisions
Serves as a discount rate for NPV and IRR calculations
Assists in capital structure optimization
Determines economic feasibility of expansion or new projects

? Measurement of Specific Costs

1. Cost of Debt (Kd)

The cost of debt is the effective interest rate a company pays on its borrowed funds. Interest is a tax-deductible expense, so cost of debt is calculated after tax.

Kd = I × (1 – T)

Where: I = Interest rate, T = Tax rate

Example: If a company pays 10% interest on loans and its tax rate is 30%, then:
Kd = 10% × (1 – 0.30) = 7%

2. Cost of Preference Shares (Kp)

Preference shareholders receive fixed dividends. The cost of preference capital is the ratio of the dividend to the market price or issue price of shares.

Kp = D / P

Where: D = Annual Dividend, P = Price of preference share

Example: If a preference share pays ₹10 annually and is priced at ₹100:
Kp = 10 / 100 = 10%

3. Cost of Equity Shares (Ke)

The cost of equity is the return expected by shareholders. It is difficult to determine because dividends are not fixed. The most common method used is the Dividend Discount Model (DDM).

Ke = (D1 / P0) + g

Where: D1 = Expected dividend next year, P0 = Current market price of equity share, g = Growth rate of dividends

Example: If next year's dividend is ₹5, current share price is ₹100, and growth rate is 4%:
Ke = (5 / 100) + 0.04 = 0.05 + 0.04 = 9%

? Computation of Weighted Average Cost of Capital (WACC)

WACC is the average cost of each component of capital (debt, preference, equity) weighted by its proportion in the overall capital structure. It gives a combined rate the company must earn to satisfy all sources of capital.

WACC = (E/V × Ke) + (P/V × Kp) + (D/V × Kd)

Where:
E = Market value of equity
P = Market value of preference shares
D = Market value of debt
V = E + P + D (Total capital)
Ke, Kp, Kd = Cost of equity, preference, and debt respectively

Example: Let’s say: Equity = ₹5,00,000 (Ke = 12%) Preference = ₹1,00,000 (Kp = 10%) Debt = ₹4,00,000 (Kd = 7%) V = ₹10,00,000

WACC = (5,00,000 / 10,00,000 × 0.12) + (1,00,000 / 10,00,000 × 0.10) + (4,00,000 / 10,00,000 × 0.07)
= 0.06 + 0.01 + 0.028 = 0.098 or 9.8%

Therefore, the company must earn at least a **9.8% return** on its investments to cover the cost of capital and create shareholder value.

✅ Conclusion

The cost of capital is a foundational concept in financial management. It influences everything from project selection to financing structure and valuation. By carefully measuring each component — debt, preference, and equity — and computing WACC, companies ensure they maintain profitability, manage risk, and make decisions that align with long-term financial health.