25. Cost Of Capital Introduction - Financial Management Subject
Summary
TLDRThis 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
- ๐ The cost of capital is a crucial concept for commerce and management students, as it represents the cost of acquiring funds for a company.
- ๐ผ Capital can be sourced from various means such as equity shares, preference shares, debentures, and retained earnings.
- ๐ 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.
- ๐ก The cost of capital includes the interest paid to debenture holders and the dividends paid to shareholders, which are essential for maintaining investor satisfaction.
- ๐ข The cost of capital is calculated as the minimum rate of return that a company must earn on its investments to meet investor expectations.
- ๐ 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.
- ๐น The cost of capital plays a significant role in capital budgeting decisions, capital structure decisions, evaluation of financial performance, and other financial decisions.
- ๐ There are different methods to calculate the cost of capital, including for irredeemable and redeemable debt, preference shares, equity shares, and retained earnings.
- ๐ The cost of equity shares can be determined using the dividend price approach, dividend price plus growth approach, and the earnings yield method.
- ๐ 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
๐ผ 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.
๐ 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.
๐ 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.
๐ 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.
๐ซ 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.
Mindmap
Keywords
๐กCost of Capital
๐กEquity Shares
๐กPreference Shares
๐กDebentures
๐กRetained Earnings
๐กDividend
๐กInterest
๐กCapital Budgeting
๐กCapital Structure
๐กFinancial Performance
๐กEarnings Per Share
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
playlist clearly prepared playlist
whatever subject you want most of the
time 80 to 90 percent it is available in
our Channel
please check it out use it don't forget
to share this video
stay connected good luck yeah
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