Question

PLEASE ANSWER ASAP. WILL RATE.

define the inputs to the cost of capital calculation and define what cost of capital means. Also, relate the calculation of the required rate of return on equity (from the CAPM) to the calculation of cost of capital.

Answer 1

ANSWER

$\rightarrow$ WHAT IS OVERALL COST OF CAPITAL {Ko}

• Any Company in order to run its Business and for Expansion purposes requires Funds. Now such funds can be borrowed by Company from various sources such as Loans, Equity, Debt etc
• But any Lender wont lend his money for free of cost. They will be having their own Expectations for Returns in the form of Interest, Dividends and so on.
• Now this Expectation of the Lenders are called "Cost of Capital" to the Company as this much is what costs company in order to Borrow Money.

$\rightarrow$ INPUTS TO COST OF CAPITAL CALCULATION

• Cost of Debt {Kd} : this is the Expectations of the Long Term loan provider like Debenture holders, Bank loans etc in return for the Money they have lended to Company. This basically represents the "INTEREST COSTS" that are attached to the Loans.
• Tax Rate {t} : Tax Rate is another Input for the Calculation of the Overall Cost of Capital for the Company because the Interest Cost that we pay to Debt is a "Tax Deductable Expense" hence our Debt Cost gets reduced by the amount of Tax Saving on such Interest Cost.
• Cost of Equity {Ke} : this is the Expectations of the Equity Investors that have Invested their hard earned money into such Company. They Expect a Return in the form of Dividends and Growth in their Share Value. Cost of Equity can be Computed using Capital Asset Pricing Model {CAPM} .
• Cost of Preference Capital {Kp} : this is the Expectations of Preference Shareholders from the Company in the form of Preference Dividends.

$\rightarrow$ Cost of Equity {CAPM} v/s Cost of Caital

• Cost of Capital of Company is the Overall Weighted Average Cost of Capital which includes Cost of Equity.
• Whereas Cost of Equity is just a part of Overall Cost of Capital.
• Cost of Equity is computed as follows :

​Ke = Risk free Rate + Beta (Market Risk Premium)

whereas

Ko = (Ke*weight of Equity) + (Kd(1-t) * weight of Debt) + (Kp*weight of Pref)