Cost of Capital

INTRODUCTION 

It is important that a company is aware of its cost of capital.  In certain cases it is not initially apparent what this cost is (e.g. new share issue, retained earnings etc.) and a number of models have been developed to assist in calculating the cost of individual sources of finance. Having calculated the cost of each individual source of finance it is then important to calculate an overall cost for the company, based on the mix of funds which it chooses to use.

   CALCULATION OF COST OF CAPITAL

   Equity

   Constant Dividends d r =

MV

Where: r =  cost of capital    d   =  annual dividend    MV =  market value (ex. div)

Preference Shares

d

r =

MV

Where: r          =          cost of capital                                     d      =  annual dividend

MV      =          market value (ex. div)

Irredeemable Debentures

k

r =  (l – t) MV

 

Where: r      =   cost of capital

k     =   coupon rate  t      =   rate of corporation tax

MV =  market value (ex. interest)

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Equity RWF15m                     75%   16%   12%
Debt RWF5m                     25%   8%   2%
  RWF20m  100%       14%

                          Market Val.           Weighting               Cost                          WACC

 

Assumptions:

  • Weightings do not
  • Business risk does not
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