It is imperative to study the importance of cost of capital to the tune of financing decision of the firm. The financing decision of the firm normally facilitates the firm to raise the financial resources to the requirements of the firm. The raising of the financial resources should be carried out not only to the tune of financial requirements but also it should mind about the cost of availing the resource; which means that the cost of raising and applying the resources in and of the organization. The cost is the most limiting factor of influence for the success of the firm, the reason is that the cost of capital is the major determinant of success of the business firm. The firm must be facilitated to raise the financial resources at cheaper cost in order to earn more and more. The cost of capital is used as a phenomenon for the decision criterion in the case of studying the worth of long-term assets, which have got greater importance in the success
of the firm. The cost of capital is instrumented in the Net present value method and Internal rate of return method of studying the worth of long-term assets under the capital budgeting decisions of the enterprise.
The next specific source of cost is cost of preference share capital Cost of preference share capital - From the angle of interest on the amount of debentures it is also like a fixed in charge but not contractual obligation, but the interest payment is contractual in obligation in accordance with the terms and conditions of the issue agreement reached earlier with the company, irrespective
of the profits earned.
Preference dividend is to be paid only with reference to availability of profits.
Normally the Expectations of the preference shareholders are nothing but the
preference dividends. The preference shares are classified into two categories viz
Redeemable and Irredeemable Let us discuss at first about the Irredeemable preference shares during the issue The first one is the methodology for the computation of the cost of irredeemable
preference share
The next important cost of specific source of capital is cost of retained earnings. The cost of retained earnings is to be computed on the basis of opportunity cost. It does not have any direct cost, instead, the amount of retained earnings loses the opportunity
of the investors to earn in the form of dividends due to retained earnings; which are
foregone by them one side and on the other side the earnings which are retained are
invested in some other investments, would be in a position to yield the return, is the cost
of retained earnings.
It could be defined as "cost of retained earnings is the opportunity cost in terms of
dividends foregone by with held from the equity shareholders." The cost of retained
earnings is nothing but the external criterion which is equal to the Ke. Practically speaking,
Ke is more than the Kr due to the floatation cost involved in the process of issue of
The term cost of capital is nothing but the overall cost of capital which is to be computed
to the tune of the proportion of the funds in the mixture; should computed only to the tune
of assignment of weights. The weight average cost of capital has its own steps to follow
during the process of computation.
Assigning the weights
Multiplying the weights with the specific cost of the fund
Dividing the total cost immediately after adding them together by the summation of
It is denominated by Ko
The weights are normally classified into two major classification viz
Marginal weights
Historical weights
Marginal weights: Assignment of weights to the specific cost by the proportion of the
each fund to be raised to the total fund
Historical weights: The weights are assigned to the specific source of fund to the tune
of the proportion of the fund in the existing capital structure. This type of historical
weight is further classified into two different categories viz:
Book value weights and Market value weights.
Book value weights are assigned to the tune of book values to measure the proportion
of each type of capital.
Market value weights are assigned to the tune of market value to measure the proportion
of each type of capital.

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