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  Method of computing cost of capital

Method of computing cost of capital:

1. Cost of debt:

The company wants to obtain debt from public, then computing the cost of debt is the rate which is computed by dividing the value of interest on loan with amount of principal.

a) Cost of debt prior to tax adjustment:

Kd = (interest/principal) x 100

When company issues debentures on premium or discount, then for computing cost of debt, principal amount will be adjusted with such amount. Subsequent to adjust amount will be net proceed

Kd = I/ (N.P.)

b) Cost of debt subsequent to tax adjustment

Kd = [IX (1-t)]/N.P.

2. Cost of pref. share capital:

The cost of pref. share capital is rate that company must earn for paying dividend to pref. share holders since it affects as well the value of shares. With the following formula we can compute cost of pref. share capital

Kpc = Dividend/Net proceed of pref. share capital

3. Cost of equity:

The cost of equity is computed with dividend yield technique, or dividend yield plus growth rate technique or earning yield technique or realized yield technique.

a) Dividend yield technique:-

Under this technique, company can compute cost of equity on the base of formula given below:
Ke = Dividend per share/Net proceed of per share

b) Dividend yield plus growth rate of the dividend technique:
Ke = (Dividend per share/Net proceed per share) + Growth rate

c) Earning yield technique:
Ke = Earnings per share/net proceed per share

4. Weighted average cost of capital:

When we multiply all cost of capital with the proportion of capital structure and divides with total proportion of capital structure percentage. Subsequent to this what we receive is termed as weighted average cost of capital.

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