1. Financial Management Unit – 2 Cost of Capital and Leverages

2. The Cost of Capital is the minimum rate of return a firm can earn on its investment. Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the ''risk-adjusted'' return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.

3. James C. Van Horne – Cost of Capital as “ a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”. Hampton and John.J – Cost of Capital is the rate of return the firm requires from investment in order to increase the value of the firm in the market place. Definitions expresses that the cost of capital is otherwise called as minimum rate of return or cut-off rate which a firm must expected to earn on its investment.

4. Determination of Capital Budgeting decisions To assist Capital Structure Decisions To assist Project Expansion To Evaluate the Financial Performance Basis for taking other financial decisions Designing Debt policy

5. It is the minimum rate of return expected by the investors in the their investments It is normally related to long term funds Cost of Capital consists of the three components: * Normal rate of return at the Zero risk level * Premium for business risk * Premium for financial risk It is generally calculated on the basis of actual cost of different components of capital.

6. Computation of Cost of Capital 1.Based on Specific Sources of Finance a.Cost of Debt b.Cost of Equity share Capital c.Cost of Preference Share Capital d.Cost of Retained Earnings 2. Weighted Average Cost of Capital

7. A company may raise debt in a variety of ways. It may borrow funds from financial institutions or public either in the form of public deposits or debentures for a specified period of time at a certain rate of interest A debenture may be issued at par, premium or discount.

8. Cost of Debt Before Tax K db = Interest / Principal After Tax K da = Interest/ Net Proceeds x (1- tax rate)

9. For Redeemable Cost of Debt Before Tax K db = Interest + 1/No. of years (Redeemable Value – Net Proceeds) ½ (Redeemable Value + Net Proceeds) After Tax K da = Interest (1 – tax rate)+ 1/No. of years (Redeemable Value – Net Proceeds) ½ (Redeemable Value + Net Proceeds)

10. The cost of equity is broadly defined as the risk- weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore ''inferred'' by comparing the investment to other investments with similar risk profiles to determine the "market" cost of equity. The cost of capital is often used as the discount rate, the rate at which projected cash flow will be discounted to give a present value or net present value.

11. Cost of Equity Share Capital Ke = Dividend Net Proceeds or Market Value

12. A fixed rate of dividend is payable on preference shares. The cost of preference capital is a function of dividend expected by its investors. Incase dividends are not paid to preference share holders; it will affect the fund raising capacity of the firm. Hence, dividends are usually paid regularly on preference shares except when there are not profits to pay dividends.

13. Cost of Preference Capital K p = Dividend Preference Share capital (Proceeds) For Redeemable Preference Capital K pr = Dividend + Maturity Value – Net Proceeds No. of years ½ (Maturity Value + Net Proceeds)

14. The cost of retained earnings may be considered as the rate of return which the existing shareholders can obtain by investing the after – tax dividends in alternative opportunity of equal qualities. It is thus, the opportunity cost of dividends foregone by the shareholders.

15. Cost of Retained Earnings K r = K e (1- t) (1- b) K e = Return Available to share holders t = Tax Rate b = Brokerage cost

16. The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. The total capital for a firm is the value of its equity plus the cost of its debt. Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet. Weighted average cost of capital (WACC) is the rate that a company is expected to pay to finance its assets. WACC is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital.

17. Weighted Average Cost of Capital K w =  xw  w K w = Weighted Average Cost of Capital  xw = Cost of Specific Source of finance  w = Weight/ Proportion of Specific source of finance

18. Firm’s ability to use fixed cost assets or Funds to increase the return to its owners. According James Horn – “the employment of an assets or sources of funds for which the firm has to pay a fixed cost or fixed return” Fixed Cost (also called fixed operating Cost) and Fixed return (called financial Cost) remains constant irrespective of the change in volume of output or sales.

19. Operating Leverage – employment of fixed cost Financial Leverage – use of fixed cost or return on source of funds Composite Leverage – Combined effect of leverage

20. Funds to run and manage the firms activities. Sources are owners equity and outsiders funds (Creditors) The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called as Financial Leverage. Fixed Interest + Preference Share Capital + Equity Share Captial

21. Favorable Leverage – Earnings are more than debt would cost. Unfavorable Leverage – Does not earn as much as the debt cost. Degree of Financial Leverage: DFL = EBIT / % of changes in EPS EBIT – Interest / % of Changes in EBIT

22. Significance: 1. Planning of Capital Structure 2. Profit Planning Limitations: 1. Double edged weapon 2. Beneficial only stable earnings firms 3. Increase risk and rate of interest 4. Restrictions from financial Institutions

23. It helps to know the net operating income fluctuations flow from small variations in revenue. Operating Leverage = Contribution Operating Profit Degree of Operating Leverage DOL = % of changes in profit % of changes in Sales

24. Operating leverage has its effects on operating risk and financial leverage has its effects on financial risk. Since both these leverages are closely concerned with ascertaining the firm’s ability to cover fixed charges, if we combine them, the result is total leverage and the risk associated with combined leverage is known as total risk.

25. Combined Leverage