Page 125 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

6.7 Keywords Notes

Cost of Capital: It is that minimum rate of return, which a firm must earn on its investments so
as to maintain the market value of its shares.
Explicit Cost: It is the discount rate that equates the present value of the cash inflows with the
present value of its increments cash outflows.

Future Cost: It is the cost of capital that is expected to raise the funds to finance a capital budget
or investment proposal.
Implicit Cost: It is the cost of opportunity which is given up in order to pursue a particular
action.
Marginal Cost of Capital: The additional cost incurred to obtain additional funds required by a
firm.
Opportunity Cost: The benefit that the shareholder foregoes by not putting his/her funds
elsewhere because they have been retained by the management.

Specific Cost: It is the cost associated with particular component or source of capital.
Spot Cost: The cost that are prevailing in the market at a certain time.

6.8 Review Questions
1. Examine the relevance of cost of capital in capital budgeting decisions.

2. Elucidate the importance of CAPM approach for calculation of cost of equity.
3. “Marginal cost of capital nothing but the average cost of capital”. Explain.
4. Analyse the concept of flotation costs in the determination of cost of capital.
5. AMC Engineering Company issues 12 per cent, 100 face value of preference stock, which
is repayable with 10 per cent premium at the end of 5 years. It involves a flotation cost of
5 per cent per share. What is the cost of preference share capital, with 5 per cent dividend
tax?
6. “Evaluating the capital budgeting proposals without cost of capital is not possible.”
Comment.
7. VS International is thinking of rising funds by the issuance of equity capital. The current
market price of the firm’s share is 150. The firm is expected to pay a dividend of 3.9 next
year. At present, the firm can sell its share for 140 each and it involves a flotation cost of
10. Calculate cost of new issue.

8. WACC may be determined using the book values & the market value weights. Compare
the pros & cons of using market value weights rather than book value weights in calculating
the WACC.
9. Critically evaluate the different approaches to the calculation of cost of equity capital.
10. A company issues 12,000, 12 per cent perpetual preference shares of 100 each. Company
is expected to pay 2 per cent as flotation cost. Calculate the cost of preference shares
assuming to be issued at (a) face value of par value, (b) at a discount of 5% and (c) at a
premium of 10%.
11. An investor supplied you the following information and requested you to calculate. Expected
rate of returns on market portfolio – Risk free returns = 10 per cent

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