Page 59 - DMGT409Basic Financial Management

Basic Financial Management Mahesh Kumar Sarva, Lovely Professional University

Notes Unit 4: Cost of Capital

CONTENTS

Objectives
Introduction
4.1 Cost of Capital – Concept

4.2 Significance of Cost of Capital
4.3 Measurement of Cost of Capital

4.3.1 Cost of Equity
4.3.2 Cost of Preference Shares
4.3.3 Cost of Debentures/Debt/Public Deposits
4.4 Weighted Average Cost of Capital (WACC)

4.5 Summary
4.6 Keywords
4.7 Self Assessment
4.8 Review Questions
4.9 Further Readings

Objectives

After studying this unit, you will be able to:

Describe concept and significance of cost of capital
Explain measurement of cost of equity shares, preference shares and debentures

Define weighted average cost of capital
Introduction

The cost of capital is an important concept in formulating a firm’s capital structure. Cost of capital

is a central concept in financial management. It is also viewed as one of the corner stones in the

theory of financial management. It has received considerable attention from both theorists and
practitioners. Two major schools of thought have emerged having basic difference on the relevance

of cost of capital. In one camp, Modigline Miller argued, that a firm’s cost of capital is constant
and it is independent of the method and level of financing. In another camp (traditionalists) cost

of capital is varying and dependent on capital structure. In both the camps, optimal policy is
taken as the policy that maximizes the value of a company.
Cost of capital is still largely an academic term and the problem of measuring it in operational
terms is a recent phenomena. Prior to this development, the problem was either ignored or by
passed. In modern times, it is widely used as basis of investment projects and evaluating the
alternative sources of fi nance.

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