Cost of Capital is the minimum rate of return or profit a company must earn. It is extremely important to investors and analysts. It’s the cost of obtaining funds, whether through equity or debt and includes the returns expected by shareholders and the interest expenses on debt. Companies look for the optimal mix of financing that provides adequate funding and minimizes the cost of capital.
We know various theories under capital structure and it includes
- NI
- NOI
- MM
- Trade-Off
What exactly changes when we change capital structure?
Ans:
- Debt increases
- Risk increases
- EPS changes
- Firm value changes
Now the questions?
- What is the connecting variable that links capital structure and firm value?
- If value increases when debt increases (under some theories), what must be happening to WACC?
Ans: WACC must be decreasing.
Capital structure affects firm value because it affects the cost of capital.
There are some possible questions-
- Is debt cheaper than equity? Why?
- Why does cost of equity increase with debt?
- Why does WACC first fall and then rise under Trade-Off Theory?
Cost of capital is nothing but the return required by investors for the risk they bear.
So,
- More debt → More financial risk
- More risk → Higher required return
- Higher required return → Higher cost of capital
Concept Flow
Capital Structure → Risk → Required Return → Cost of Capital → Firm Value
Why Retained Earnings are not free?
Ans: Retained earnings belong to shareholders. If profits were distributed, shareholders could invest elsewhere and earn return.
Cost of Retained Earnings (Kr): Kr = Ke ( Because both represent shareholders’ funds).
Let’s understand from this example how to calculate WACC
Suppose capital structure (Market Value):
- Equity Share Capital = Rs. 6,00,000
- Retained Earnings = Rs. 2,00,000
- Preference Shares = Rs. 2,00,000
- Debt = Rs. 5,00,000
Total = Rs. 15,00,000
Given:
- Cost of Equity (Ke) = 15%
- Cost of Retained Earnings (Kr) = 15%
- Cost of Preference (Kp) = 10%
- Interest on Debt = 12%
- Tax Rate = 30%
Step 1: After-Tax Cost of Debt= Kd= 12%(1-0.30) = 8.4%
Cost of Equity (Ke) = Cost of Retained Earnings (Kr) = 15%
Step 2: Calculate Weights
| Source | Amount | Weight |
| Equity | 6,00,000 | 0.40 |
| Retained Earnings | 2,00,000 | 0.133 |
| Preference | 2,00,000 | 0.133 |
| Debt | 5,00,000 | 0.334 |
Step 3: Compute WACC
WACC= (WeKe) + (WrKr)+(WpKp)+ (WdKd)
| Equity: | 0.4*15 = 6.00 |
| Retained Earnings: | 0.133*15 = 1.995 |
| Preference | 0.133*10 = 1.33 |
| Debt | 0.334*8.4 = 2.81 |
Step 4: Total WACC = 6.00+1.995+1.33+2.81 = 12.14%
Why cost of equity has a cost?
Equity does not require fixed payment like interest, so why does it have a cost?
Ans: Because Equity Investors Expect Return
Shareholders invest money in the company.
They expect:
- Dividends
- Capital appreciation
If the company does not provide adequate return, investors will sell the shares.
Therefore:
Cost of Equity = Required Rate of Return by Shareholders
Just imagine: If an investor puts Rs.1,00,000 in your company, could he invest somewhere else?
Yes.
Maybe:
- Bank deposits
- Mutual funds
- Other shares
So, equity has a cost because: Investors sacrifice alternative investment opportunities.
This is called opportunity cost.
Risk-Return Relationship
Equity is riskier than debt because:
- No fixed dividend
- Paid after debt holders
- Residual claim
Higher risk → Higher required return
Hence equity has a cost.
Market Expectation
Cost of equity is not an accounting cost. It is an economic cost.
If company pays no dividend this year:
- Share price will fall if return is inadequate.
- That fall reflects cost of equity.
Now the important question?
If a company earns profit, does it automatically mean it has created value?
Next question
What if the company earns 12%, but shareholders expect 15%?
Here the concept of EVA is coming
What is EVA?
EVA = NOPAT – (WACC*Capital Employed)
Where:
- NOPAT = Net Operating Profit After Tax
- WACC = Weighted Average Cost of Capital
- Capital Employed = Total Funds Invested
EVA measures:
Profit after charging the cost of ALL capital — including equity.
Accounting profit ignores cost of equity.
EVA includes it.
Suppose:
Capital Employed = Rs. 10,00,000
WACC = 12%
NOPAT = Rs. 1,50,000
Required return: 12%*10,00,000 = 1,20,000
EVA: 1.50,000—1,20,000 = Rs. 30,000
Positive EVA → Value Created
If NOPAT were Rs. 1,00,000:
EVA: 1,00,000 – 1,20,000 = (20,000)
Negative EVA → Value Destroyed.
Takeaway:
- Accounting profit measures performance.
- EVA measures value creation