Introduction:- The cost of equity Capital from investors’ points of view is considered as the expected profit on a portfolio of all the company existing securities. The company cost is used by the firm for an evaluation of main projects and also expert to receive high returns on it after deciding the benchmark rate for return on capital. Cost of equity is the company cost of using funds provided by vendors/Creditors and shareholders of the company.
The cost of equity is the cost of long-term sources, such as debts, amount of debentures, common capital and preferred capital which is subscribed by the General public. The cost of equity represents the level of risk that is attached to sources (Debts and Equity) that are secured against the assets of the company. All these companies which make investments in assets have little risk in earning income that able for an investor to bear the lower cost of capital than all these companies which make an investment in long-term assets having a high risk of earning income, Such as retail store has a low risk as compared to oil refining companies.
Those companies are in a liquidity position and are not sufficient to fulfil the obligations of the business. Creditors have the first right to claim against the resources of the business before the common and the preferred shareholders.
- At the time of liquidation when assets are sale then first of all amount paid to creditors than to preferred and common shareholders.
- The preferred shares are highly risky than the common shares and the debts of the company. In the case of distribution of dividend on capital Preferred shareholders has the first right and also received a high rate of returns.
- Cost of capital is determined by business first all by finding the cost of each source of capital that is expected the company raises the amount of capital after utilization of these sources.
Definition of Cost of Equity Capital:-
The cost of capital is the minimum required rate of return on investments
The cost of capital is very important for the financial strength of the business. The source of finance has a cost that is meeting by an alternative mode of investment. Cost of capital has various types into the business which are given below.
- Cost of debts
- Cost of equity
- Cost of preferred share
- Cost of retained earnings
Types of Cost of Capital
Cost of equity:-
When the investors make an investment in shares and also expected to obtain the right rate of returns on them. It’s represented by the formula such as;
Cost of debts:-
The cost which companies paid in case of borrowing debts which secured against assets kept as security and also expected to receive high risk along with. The rate of cost on debts is decided by the benchmark rate which is launched in stock exchanged and all other capital & money markets.
Cost of debts= I (1-Tax)
Interest is represented by (I). Interest is paid as rent on the use of the finance into business for its operating and financial activities.
Cost of preference share:-
The preference share capital is different from the ordinary share capital on the basis of some basic features.
1. Preference shareholder has a preference on receiving the dividend and also received the high and fixed return than the equity share.
2. In the case of liquidation, the preferred share has the priority to receive the return and in case of repayment as compared to the other equity shares.
3. It is denoted by Kp.
The weighted average cost of capital:-
In the case of weighted average cost of capital, the average portion of each cost is considered for the calculation of the total cost of capital of the firm.
WACC= Total weighted cost /Total capital *100
The capital structure represents the way in which a company utilizes the amount of its finance and assets for the effectiveness of the business. The capital structure shows the mode from which the amount of corporate capital is subscribed.
Money is borrowed by the business to meet financial needs. There are generally two types of debt financing.
- Long term financing
- Short term financing
It represents the amount of capital that the business utilized for planning processes such as used capital for long term investment in form of purchasing long term assets and short term investments.
The duration of time required to recover the cost of investments.
Payback period =Cost of project/Annual cost inflow
Return on new invested capital:-
The calculation used by the firm investors and all those parties which are related to the formation of the capital. They all received a high rate of return on capital and on investments.