25. Cost Of Capital Introduction - Financial Management Subject

Summary

This script delves into the critical financial concept of 'cost of capital', essential for commerce and management students. It explains the various sources of capital, such as equity shares, preference shares, debentures, and retained earnings, and the importance of calculating the cost associated with each. The script emphasizes the significance of cost of capital in making informed financial decisions, such as capital budgeting and structuring. It outlines methods to calculate the cost of capital, including for debt, preference shares, equity shares, and retained earnings, and stresses the need for managers to understand these costs to ensure company profitability and investor satisfaction.

Takeaways

• 😀 The cost of capital is a crucial concept for commerce and management students, as it represents the cost of acquiring funds for a company.
• 💼 Capital can be sourced from various means such as equity shares, preference shares, debentures, and retained earnings.
• 📈 A wise management team must carefully consider the cost of capital when deciding how to raise funds to ensure the company can meet its financial obligations.
• 💡 The cost of capital includes the interest paid to debenture holders and the dividends paid to shareholders, which are essential for maintaining investor satisfaction.
• 🔢 The cost of capital is calculated as the minimum rate of return that a company must earn on its investments to meet investor expectations.
• 📉 Failing to meet the cost of capital can lead to a decrease in a company's share value and negatively impact its reputation in the market.
• 💹 The cost of capital plays a significant role in capital budgeting decisions, capital structure decisions, evaluation of financial performance, and other financial decisions.
• 📚 There are different methods to calculate the cost of capital, including for irredeemable and redeemable debt, preference shares, equity shares, and retained earnings.
• 📊 The cost of equity shares can be determined using the dividend price approach, dividend price plus growth approach, and the earnings yield method.
• 📝 Retained earnings are calculated by assuming the dividends that would be paid if the earnings were distributed to equity shareholders and then reinvested in the company.

Q & A

What is the significance of the cost of capital in financial management?

The cost of capital is crucial in financial management as it represents the minimum rate of return a company must earn on its investments to meet the expectations of investors. It is also a key factor in capital budgeting decisions, capital structure decisions, evaluation of financial performance, and other financial decisions such as market value of shares and earnings per share.

What are the different sources through which a company can raise capital?

A company can raise capital through various sources including issuing equity shares, preference shares, debentures, and utilizing retained earnings.

What are the two types of shares mentioned in the script, and how do they differ?

The two types of shares mentioned are equity shares and preference shares. Equity shares represent ownership in a company and entitle shareholders to receive dividends based on the company's profits. Preference shares, on the other hand, have a fixed dividend rate and are paid before any dividends are issued to equity shareholders.

What is the cost of debt and how is it calculated?

The cost of debt refers to the interest a company must pay on borrowed funds, such as debentures. It can be calculated using two methods: for irredeemable debt (with no maturity period) and redeemable debt (with a known maturity period).

What is the difference between irredeemable and redeemable debentures?

Irredeemable debentures have no maturity period and are intended to be held by the company until winding up, while redeemable debentures have a specified maturity period after which they must be repaid.

How does the cost of preference shares differ from the cost of equity shares?

The cost of preference shares is calculated based on the fixed dividend rate, and it can be for irredeemable or redeemable preference shares. The cost of equity shares, however, is calculated using three methods: dividend price approach, dividend price plus growth approach, and earning yield method, as equity shares do not have a maturity period.

What is the role of retained earnings in the context of the cost of capital?

Retained earnings are profits that are not distributed as dividends but are reinvested in the company. The cost of retained earnings is calculated by assuming what dividend would have to be paid to equity shareholders if the retained earnings were distributed, and then determining the return that would be expected from reinvestment.

Why is it important for a company to earn at least the cost of capital?

Earning at least the cost of capital is important because it ensures that a company can meet its obligations to pay dividends and interest, thereby maintaining investor confidence and the market value of the company's shares.

What are the implications if a company fails to earn the cost of capital?

If a company fails to earn the cost of capital, it may not be able to pay the required dividends or interest, leading to dissatisfaction among investors, a potential decline in the company's share value, and a negative impact on its financial health.

How does the cost of capital influence capital budgeting decisions?

The cost of capital influences capital budgeting decisions by helping to determine the feasibility of investment projects. Projects are evaluated based on whether their expected returns exceed the cost of capital, using techniques such as Net Present Value (NPV) and Internal Rate of Return (IRR).

Outlines

00:00

💼 Introduction to Cost of Capital

The script introduces the concept of cost of capital, emphasizing its importance for commerce and management students. It explains that capital is the funds a company needs for investment and can be acquired through various sources such as equity shares, preference shares, debentures, and retained earnings. The speaker highlights the responsibility of management to make wise decisions on capital accumulation, considering the costs associated with each source, such as dividends for shareholders and interest for debenture holders. The cost of capital is defined as the minimum rate of return a company must earn on its investments to meet the expectations of investors, including the cost of dividends and interest that the company is obligated to pay.

05:00

📈 The Role of Cost of Capital in Financial Decisions

This section delves into the significance of cost of capital in various financial decisions. It is referred to as the break-even rate, minimum rate, cut-off rate, and hurdle rate, indicating the minimum return a company must earn to satisfy investors. The script explains that failing to meet this rate can lead to dissatisfaction among shareholders and a decrease in the company's market value. The importance of earning at least the cost of capital is stressed, as it ensures the company can pay the required dividends and interest. The speaker also provides an example to illustrate the concept, discussing the implications of earning more or less than the expected return on investment.

10:02

🔍 Importance and Applications of Cost of Capital

The paragraph outlines the importance of cost of capital in capital budgeting decisions, such as net present value calculations, and in determining the company's capital structure. It also touches on how cost of capital is used to evaluate financial performance and make other financial decisions like assessing the market value of shares and earnings per share. The speaker emphasizes that understanding cost of capital is crucial for making informed financial decisions that affect the company's profitability and stability.

15:05

📊 Methods for Calculating Cost of Capital

This section introduces the methods for calculating the cost of capital from different sources. It discusses two types of debt: irredeemable (with no maturity period) and redeemable (with a known maturity period). The script also mentions the calculation of cost for preference shares, which can be either irredeemable or redeemable, and equity shares, which are always irredeemable as they have no maturity period. The speaker outlines three methods for calculating the cost of equity shares: the dividend price approach, the dividend price plus growth approach, and the earnings yield method. Lastly, it briefly introduces the concept of calculating the cost of retained earnings, which involves determining the return that would be earned if the retained earnings were distributed to shareholders and reinvested in the company.

20:05

🏫 Summary and Advice for Future Learning

The final paragraph summarizes the key points discussed about cost of capital and provides advice for future learning. The speaker encourages students to watch the video on a computer or TV, take notes, and use a calculator for better understanding. They also recommend focusing in a separate room for effective learning. The speaker assures that the next class will delve deeper into the calculation of cost of capital, covering various formulas and examples. They remind students to stay connected, explore the available resources, and share the video for mutual benefit.

Keywords

💡Cost of Capital

Cost of capital refers to the minimum rate of return that a company must earn on its investments to meet the expectations of its investors. It is the cost a company incurs to acquire capital, including the interest paid on debt and the dividends paid to shareholders. In the video, the lecturer emphasizes the importance of understanding the cost of capital for making informed financial decisions, such as capital budgeting and capital structure decisions.

💡Equity Shares

Equity shares represent ownership in a company and are a source of capital for the company. They are one of the two types of shares mentioned in the script, the other being preference shares. Equity shareholders are entitled to dividends, which are not fixed and depend on the company's profits. The video discusses how the cost of equity shares is calculated as part of the overall cost of capital.

💡Preference Shares

Preference shares are a type of share capital that offers certain preferences over equity shares, typically in terms of dividend payments and asset claims in the event of liquidation. They are one of the sources of capital discussed in the video, and the cost of preference shares is calculated based on the fixed dividend rate that must be paid to preference shareholders.

💡Debentures

Debentures are a type of debt instrument issued by a company as a means of raising capital. They are not backed by physical assets but by the creditworthiness and reputation of the company. The video explains that the cost of debentures is part of the cost of debt and is calculated based on the interest rate that the company must pay to debenture holders.

💡Retained Earnings

Retained earnings refer to the portion of a company's profits that are not distributed as dividends but are instead reinvested in the company. The video discusses how retained earnings are considered as a source of capital and that the cost of retained earnings is calculated based on the opportunity cost of not distributing these earnings to shareholders.

💡Dividend

A dividend is a distribution of profits to a company's shareholders, typically paid out of the company's earnings. The script mentions that the cost of equity shares can be calculated using the dividend price approach, which considers the dividends paid to equity shareholders as part of the cost of capital.

💡Interest

Interest is the cost of borrowing money, typically paid by the borrower to the lender. In the context of the video, interest is a key component of the cost of debt, which must be paid to debenture holders and is factored into the overall cost of capital.

💡Capital Budgeting

Capital budgeting is the process of evaluating and deciding on long-term investments, such as purchasing固定资产 or starting new projects. The video explains that the cost of capital is an important factor in capital budgeting decisions, as it influences the discount rates used to evaluate the profitability of potential investments.

💡Capital Structure

Capital structure refers to the composition of a company's funding sources, including debt and equity. The video discusses how understanding the cost of capital is crucial for determining the optimal capital structure, as it affects the company's overall cost of financing and risk profile.

💡Financial Performance

Financial performance is the assessment of a company's financial health and profitability. The script mentions that the cost of capital can be used to evaluate a company's financial performance by comparing the returns generated from investments to the cost of those investments.

💡Earnings Per Share

Earnings per share (EPS) is a financial metric that represents the amount of profit allocated to each outstanding share of common stock. The video implies that the cost of capital can influence EPS, as higher costs may reduce the profits available for distribution to shareholders.

Highlights

Cost of capital is a crucial topic for Commerce and management students.

Capital refers to the funds a company needs for its operations.

There are various sources of capital, including equity shares, preference shares, debentures, and retained earnings.

A wise manager must decide on the best way to accumulate funds considering the cost of capital.

The cost of capital represents the cost of acquiring funds, including interest and dividends.

The cost of capital is the minimum rate of return a company must earn to meet investor expectations.

Failure to meet the cost of capital can lead to a decrease in a company's share value.

The cost of capital is also known as the break-even rate, cutoff rate, and hurdle rate.

Capital budgeting decisions are influenced by the cost of capital, especially when calculating NPV.

Capital structure decisions are also impacted by the cost of capital, determining the mix of equity and debt.

The cost of capital is used to evaluate a company's financial performance.

Calculating the cost of capital involves considering the cost of debt, preference shares, equity shares, and retained earnings.

Cost of debt can be calculated for irredeemable and redeemable debentures.

Cost of preference shares is calculated for both irredeemable and redeemable types.

Cost of equity shares is calculated using the dividend price approach, dividend price plus growth approach, and earning yield method.

Cost of retained earnings is calculated based on the assumption that if distributed, shareholders would reinvest in the company.

The importance of understanding the cost of capital for making informed financial decisions.

Transcripts

foreign

management Academy

today one important topic I'm taking

that is

cost of capital

it is also must and mandatory for all

the Commerce and management students

you cannot skip this topic the

importance is like that

I'll take you slowly in depth please

Focus not so tough very easy to

understand very important also now cost

of capital capital means you know our

investment

company needs some kind of funds so that

funds we call it as capital where do we

get the capital

there are many sources we can issue the

shares Shares are of two types Equity

shares preferentiates

and we can issue the debentures also we

can take the loans we can take even from

the retained earnings also there are

many sources anyway all these sources we

have learned in depth in the previous

classes right you have good knowledge it

is must

so when we wanted to get the funds we

have different sources but a wise

manager wise management

will take proper decision

how to accumulate the funds if I

accumulate the funds in the form of

preferentiates equity shares and also

debate and also debentures if I

accumulate I have to pay something to

them to shareholders what do I pay

shareholders dividend and debenture

holders we give the interest so am I in

a position to pay back them

some kind of benefit that other either

either it is interest or dividend am I

in a position that is very important

so that is why every management they

have to be very careful while

taking the capital how much is the cost

for that capital

through example I'll make you to

understand say I want to

one crore rupee

one crore rupee I want okay so 50

percent I have issued preference shares

and 50 Equity shares or otherwise

let us assume

50 percent equity shares

and 25 percent preference shares

and 25 percent debentures issued

when I am issuing it

I have to pay something so for the

equity shareholders based on the

earnings based on the profit will pay

the interest sorry dividend it is not

decided dividend is not decided to the

equity shareholders but preference

holders shareholders a perceptual

percent I have to pay and debenture

holders also suppose the 13 percent I

have to pay

how to pay so what I'm paying interest

and dividend here dividend and here

interest ramping so this is cost of

capital

I'm getting but on that I have to pay

something

so that something is we say it as a cost

of capital this is the cost I have to

pay at any cost I have to pay them this

dividend and interest

at least company has to come to that

stage they are they should be in a

position to pay back this interest and

dividend principle of course they cannot

touch

right so this cost of capital because

this is the cost

we are praying we are going to pay to

the shareholders and debenture holders

so for that cost of capital we have to

calculate what is the cost you are

paying

right are you getting it in a very

simple way I'll give you what is cost of

capital cost of capital is a cost of

acquiring the funds

cost of acquiring the funds I need funds

I need funds one crude what is the cost

I'm paying

that cost is cost of capital cost of

capital is the cost of acquiring the

funds one simple sentence you can

remember

if somebody asked you what is cost of

capital cost of capital is nothing but

the cost which is acquired to the

required to pay the cost of capital

acquired for the capital okay acquiring

the funds or Capital simple one

definition

now what is this cost of capital in

depth we'll see on raising funds from

various sources when we have to raise

the funds from various sources the

company has to pay some additional

amount in the form of

in the form of

in the form of Interest this is here

in the form of Interest apart from the

principal amount

whenever we are raising the funds the

company has to pay some additional

amount in the form of Interest as I gave

you raising one crore I have to pay

something additional what is that

something additional interest or

dividend

so that is so this additional cost means

this additional cost

this additional cost is the cost of

capital

remember either this one this one

additional you have to pay additional

cost you have to pay that is nothing but

cost of capital in another form you can

just simply say interest or dividend

which is to be payable to the

shareholders and Venture holders is cost

of capital

am I clear now one simple definition

important definition you have to

remember the cost of capital is the

minimum rate of return

what is cost of capital cost of capital

is the minimum rate of return

that company must

on its must earn

must earn earn its investment to fulfill

the expectations of investors

cost of capital is minimum rate of

return minimum this much of interest and

dividend they have to earn why they have

to earn must earn on its investment why

they have to earn to fulfill the

expectations of investors

investors at least they'll expect this

if you don't pay what happens

if you are not in a position to pay the

dividend decided dividend or decided

interest if you are unable to pay then

that's a bad Mark for the organization

automatically the shareholders

debentures holder there will be

unsatisfied that spreads the ma the

rumors spreads threats in the market and

automatically shares value will come

down

that is why you need to be very careful

at least you must earn this much of

[Music]

return

this much of return so that you will be

in a position to pay I'll give you

another example

okay let it be so another example say I

have borrowed 10 lakh Rupees

10 lakh Rupees in the form of debentures

in the form of debentures okay

and uh debentures this is already

decided that I have to pay 12 percent

interest

to the debenture holders decided

now I started focusing on my business I

got profits and as per the profit uh

12 percent I have to pay but I got a

profit of out of this 17 percent profit

I got when I took 10 000 rupees

10 000 rupees on that I have to pay 12

percent but my return is 17 percent

return is 17 percent means it is a wise

decision five percent extra is there

profit 12 percent I have to pay but I

got 17 percent five percent extra profit

either that I am going to use it

isn't it so this is wise decision in

case the company is unable to earn 12

percent

if the company is earning say 10 percent

only

earning 10 percent what about the rest

of the two percent they are not in a

position to pay even 12 percent also

so this is going to make burden on the

company

extra two percent where do they pay from

where they can if they don't pay that's

a bad remark for the company as I told

you so that is why this point also just

remember

so what is cost of capital till

definition you understood now let's see

the importance of cost of capital cost

of capital first of all before

importance cost of capital also called

it is referred as B rate Break Even rate

Break Even rate 12 percent I am giving

means it is 12 percent I have to earn

Ms 12 percent is a break-even rate

like break-even point we have learned

the same thing okay this is also called

as break-even rate and also minimum rate

minimum at least they have to earn

minimum to survive

and cut off rate what is the cutoff rate

12 percent we have taken at least twelve

percent we have to take so that's called

as a cutoff rate a Target rate

or there is hurdle rate standard rate

these are all the other names of this

cost of capital okay this is also called

as like this and now coming to the

importance

first thing is that Capital budgeting

decisions it is useful

Capital budgeting we have learned in the

previous class

especially when you talk about npv Net

Present Value we'll be seeing about the

discounting factors

and we'll be calculating that what is in

flow

and what is outflow is we know outflow

how much I am investing one like I'm

investing what is the inflow

inflow is more than that then it is

acceptable

isn't it so this is somewhat related to

the cost of capital

while taking the capital budgeting

decisions

how much is the cost you are paying I

have invested 1 lakh

for that

something I have to get it it's how much

I am getting it when you know this

Capital budgeting that you can

interrelate that you can correlate with

the cost of capital

this is one advantage another thing is

that Capital structured decision also it

is useful in the coming classes we are

going to learn capital structure simply

I'll tell you what is capital structure

I wanted to get as I said one crore

rupee how should I accumulate this one

crore fund

capital structure capital structure

means how do you want to in different

forms will be accumulating we don't

depend only on one source

like one crore are you going to issue

only the equity Capital no

are you going to issue one crore

debentures only no we take some

variations something from this something

from there something from another way

like as you can take the same example I

want one crore 50 lakh 50 Equity shares

25 percent preferentials and 25 percent

debenture holders so like I wanted to

get this is we call it as a capital

structure how do you want to get the

capital so at the time of capital

structure also when you want to take the

capital structural decision how much

should be the preference shares how much

should be the equity shares and

according to the income I'm expecting so

I can increase or decrease issue more

Equity shares

so that if I get the profits I'll give

otherwise no problem

always on safe side

if the company is in not in a good

position I will always remember Equity

shares must be more

and debentures and preferentiates it

must be less because it's a burden you

have to pay at any cost

so that is about Capital structural

decision this cost of capital is going

to be useful and in the same way

evaluation of financial performance how

is the financial performance also you

will come to know through the cost of

capital

cost how much you are paying for that

capital

you know that 12 15 how much you got

that you can compare it now according to

that you can decide that companies going

towards the progress

a company is not up to the mark going

down whatever that performance you will

come to know

isn't it so this is another important

Advantage another thing is that other

financial decisions if you want to take

other financial decisions specially like

market value of shares what is the

market value of shares and earnings

capacity

so like this kind of things also will be

knowing through the

Capital cost of capital importance just

four points you have to remember what

are the four points Capital budgeting

decision capital structure decision

Capital budgeting capital structure and

evaluation of financial performance and

other financial decisions other

Financial distance mainly market value

of shares earnings per share that you

will come to know

now how do we calculate this cost of

capital

very important

please Focus

in depth we are going to discuss each

and every point in the next class but

right now you just focus how do we

calculate so computation or calculation

of cost of capital total four sources

are there to get the funds to accumulate

the funds one is

cost of debt means a debentures

preferentiates Equity shares and also

written earnings

through these four sources

debentures preferentiates Equity shares

and return earnings these are the four

sources so we are going to calculate

these four separately

first one is let's talk about first one

cost of debt cost of that means whenever

you take the loan

whenever you take the loan specially you

can say it as debentures debentures are

loan only

you have to pay

and principal amount you have to pay

interest also at any cost you have to

pay

so that's about cost of debt cost of

debt how do you calculate

there are two methods first one is

irredeemable debt second one is

redeemable

so irritable that means there is no

uh no information about the maturity

maturity is unknown you can say

maturity is unknown we don't know

when it is going to mature we have

learned about debentures types of

debentures there I thought you some

debentures can be redeemable some are

unredeemable irredeemable sorry not done

is redeemable now right now irredeemable

that means it is maturity period is

unknown irredeemable it will be in the

organization itself only till the last

existence till the end of the working

day of the organization till winding up

it will be so how do you calculate if

debt is given irredeemable means matured

period is not given

second thing is that redeemabled it some

period is given so 20 years maturity is

known you can say it as a maturity is

known

foreign

debentures I have issued

at the rate of 10 percent for 10 years

10 for 10 years 10 years day that years

is given it means it is redeemable

debentures

now here for example I have issued two

lack of debentures at the rate of 12

percent

maturity year is not mentioned 10 years

here it is mentioned it is not mentioned

here

when it is irredeemable debentures okay

that's about cost of debt now second one

is that cost of reference shares we have

learned about cost preference shares in

depth what are preference shares

features advantages disadvantages

everything we have learned now

so no preferentials also we can

calculate in the same two ways just like

this

irredamable preferences

redeemable preferences

irredeemable means maturity period is

unknown redeemable is maturity period is

known

unknown

foreign

aturity

and

non-maturity

referencia sometimes the years may not

be mentioned for how many years we are

issuing if not mentioned then

irredeemable

if mentioned issued preferentiates for

five years

known so that is redeemable preference

shares so we'll be calculating cost of

debt two ways irradiable debt and

redeemable debt

redeemable preferences and third one is

cost of equity shares same like this

cost of capital cost of differentiates

in the same cost of equity shares cost

of equity shares we don't have

irredeemable or redeemable

always cost of capital is irredeemable

there's no maturity period once if you

issue the cost uh prefer sorry Equity

shares once if we issue the equity

shares it will be in the organization

till winding up with the organization so

that is why we cannot describe like a

redeemable or redeemable everything is

irredeemable only it will be in the

organization so anyway cost of uh cost

of this Equity Capital we can calculate

through three methods one is dividend

price approach

dividend price

how much dividend is to be paid

deciding about the dividend

suppose company guards lots of profit

one crore I have invested I got 50 or 25

lakhs of profit 25 of profits first of

all I am going to distribute it to the

debenture holders in the form of

Interest preference shareholders in the

form of dividend now leftover whatever

is there that will be given to the

Equity shareholders

so that calculation dividend price

approach how much dividend is to be

given to the equity shareholders this

one and the second method is dividend

Price Plus growth approach dividend

Price Plus growth some extra growth they

are expecting

so that extra growth

we can calculate through the second

method and third one is earning yield

method per share how much is the value

of this

Equity shares that is yield method

earnings

earning yield methods so three methods

are there

and lastly cost of retained earnings

what is returned earnings this is also

we have learned returned earnings myth

whenever company gets a profit out of

the profit sum amount

some amount to be kept it as a returned

earnings

but why do we calculate this we kept

already

I got a profit of one crore out of that

one crore

retained earnings

I kept it 20 lakh

when I know that I kept 20 lakh as

pretend earnings where is the question

of calculating this returned earnings

there is a way there is a method because

if we give the 20 lakh rupees retained

earnings to the shareholders Equity

shareholders they'll be reinvesting in

the company itself only when they

reinvest in the company how much in uh

how much is the dividend we have to pay

so that same calculation we'll be doing

here

no confusion at all we know that we have

kept it this much amount we are assuming

that if we distribute this retained

earnings to the equity shareholders

they'll be reinvesting in the company

itself only when they reinvest we have

to pay something to them in that way

we'll be calculating return earnings

okay so calculation of

cost of capital four ways one is cost of

debt

that is irredeemable debt redeemable

debt second one is cost of preference

shares this is also a redeemable

preferential redeemable preferentials

third one cost of equity shares

no redeemable readable everything is

redeemable so here we are calculating

dividend price approach dividend Price

Plus growth approach this is Plus

don't get confused

plus growth dividend Price Plus growth

and the retail earning yield methods

fourth Methodist cost of retained

earnings got an idea next to class we'll

be focusing on the cost of debt

calculation how do you kill there are

different formulas

formulas you have to learn

remember and understand the problem we

can work out and after that slowly we'll

go for cost of differentiates cost of

equity shares and also cost of retained

earnings you want to take screenshot go

ahead

you got an understanding now what is

cost of capital

this picture is clear the next class

will be easy

only how to focus I would advise you to

watch this videos

on computer

if you have personal computer use it a

TV you can use it take notes spend

calculator and sit Focus sit in a

separate room if you have separate room

so that you will understand very well

okay my idea students there are many

videos already I prepared I think 600

700 videos are there check out the

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