MODULE IX: COST OF CAPITAL INTRODUCTION capital associated Before making any investment decision, one should know the cost of the to the with the investment. This should be used as a yardstick for measuring equal the investment. If the rate of return on the investment exceeds or at is the cost of in percentage term), the investment should be made. Thus, the capital is the minimum required rate of retum on any investment is not going be profitable. associated with each component we speak of cost of capital, we really mean costs costs include: of capital and the overall cost of capital. The component I. Cost of debt after tax, ka (-T), 2. Cost of preferred stock, kp. 3, Cost of retained earnings, kes issued by the firm. 4. Costs of new common stock, ke, marginal Before proceeding, you should bear in mind that the cost we discuss here is the the firm not the historical cost associated with each source of capital. That is, had of borrowed today, how much would cost the for borrowing from each source capital? The prevailing market information is normally used to estimate the marginal cost. The cost at which the fi has borrowed in the past is irrelevant for cost of purposes, COST OF DEBT borrowing An important source of capital is borrowing or debt. The costs associated with For include interest expenses on the loan plus other fees involved in securing the loan. larger businesses that are able to issue bonds, the costs are interest expenses in the form of coupon obligation plus the issuance or flotation costs. As discussed in the Bond and Stock Valuation Module, the equation used to find the value of an annual coupon bond is where C annual interest payment ka the appropriate interest rate on the bond; F the par value of the bond S1,000; and n the number of years to maturity. Excel Pva, N, PMT, Fv, type) where I kd, PMT C,Fv F, and type-0