Page 96 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Self Assessment Notes

Fill in the blanks:
7. A ……………... cost is the additional cost incurred to obtain additional funds required by
a firm.

8. ……………... is the cost of capital that is expected to raise funds to finance a capital budget
or investment proposal.
9. ……………... Cost is the cost that is prevailing in the market at a certain time.

5.4 Measurement of Specific Cost of Capital

The financial manager has to compute the specific cost of each type of funds needed in the
capitalisation of a company. The company may resort to different financial sources (equity
share, preference share, debentures, retained earning public deposits; or it may prefer internal
source (retained earnings) or external source (equity, preference and public deposits). Generally,
the component cost of a specific source of capital is equal to the investors' required rate of
returns. Investors required rate of returns are interest, discount on debt, dividend, capital
appreciation, earnings per share on equity shareholders, dividend and share of profit on
preference shareholders funds. But investors' required rate of returns should be adjusted for
taxes in practice for calculating the cost of a specific source of capital, to the firm.
Compensation of specific source of finance, viz., equity, preference shares, debentures, retained
earnings, public deposits is discussed below:

5.4.1 Cost of Equity

Firms may obtain equity capital in two ways (a) retention of earnings and (b) issue of additional
equity shares to the public. The cost of equity or the returns required by the equity shareholders
is the same in both the cases, since in both cases, the shareholders are providing funds to the firm
to finance their investment proposals. Retention of earnings involves an opportunity cost. The
shareholders could receive the earnings as dividends and invest the same in alternative
investments of comparable risk to earn returns. So, irrespective of whether a firm raises equity
finance by retaining earnings or issue of additional equity shares, the cost of equity is same. But
issue of additional equity shares to the public involves a floatation cost whereas, there is no
floatation cost for retained earnings. Hence, issue of additional equity shares to the public for
raising equity finance involves a bigger cost when compared to the retained earnings.
In the following cost of equity is computed in both sources point of view (i.e., retained earnings
and issue of equity shares to the public).

Cost of Retained Earnings (K )
re
Retained earnings is one of the internal sources to raise equity finance. Retained earnings are
those part of (amount) earnings that are retained by the form of investing in capital budgeting
proposals instead of paying them as dividends to shareholders. Corporate executives and some
analysts too normally consider retained earnings as cost free, because there is nothing legally
binding the firm to pay dividends to equity shareholders and the company has its own entity
different from its stockholders. But it is not so. They involve opportunity cost. The opportunity
cost of retained earning is the rate of return the shareholder forgoes by not putting his/her
funds elsewhere, because the management has retained the funds. The opportunity cost can be
well computed with the following formula.

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