# Cost of Capital — Introduction & Building Blocks
## What is cost of capital?
Cost of capital is the return expected by the providers of capital (shareholders, lenders, debt-holders) as compensation for contributing to the firm's total capital. It is expressed as a rate (%).
When a firm raises finance from any source, it pays something extra beyond the principal — this 'additional money' is the cost of using that capital.
### Other names for cost of capital
Cost of capital is also called the cut-off rate, hurdle rate, or minimum rate of return. It serves as the benchmark for capital budgeting decisions — projects must earn at least this rate to be worthwhile.
> Key link to TVM: cost of capital is simply the discount rate from the Time Value of Money chapter, now applied to compound/discount the firm's cash flows.
## Source-wise notation
| Source of finance | Symbol | Meaning |
|---|---|---|
| Equity | Ke | Cost of Equity |
| Debenture | Kd | Cost of Debt |
| Preference | Kp | Cost of Preference |
| Retained Earnings | Kr | Cost of Retained Earnings |
| Overall | Ko | Weighted Average Cost of Capital (WACC) |
## Important terms used throughout the chapter
### A. Types of Issue Price
Securities may be issued at par (e.g., ₹100), at discount (e.g., ₹90), or at premium (e.g., ₹110).
### B. Types of Redemption Value
Securities may be redeemed at par, at discount, or at premium.
> Default: In the absence of information, assume redemption is at par.
### C. Flotation Cost / Issue Cost
- Costs associated with issuing NEW securities — brokerage, commission, underwriter commission, etc.
- Apply only to new issues, never to existing securities.
- When given, deduct flotation cost from the issue price to arrive at NET PROCEEDS (it is an outflow, so it reduces what the firm actually receives).
- Doubt buster: A flotation cost of, say, 1% may be applied on the issue price or on face value when not specified — state the assumption you adopt in your solution.
### D. Tax Savings on Interest (Tax Shield)
- Interest paid to debenture-holders is a tax-deductible expense, so it reduces the firm's tax liability. This saving is called the tax shield.
- Dividends (equity/preference) are NOT tax-deductible — they are an appropriation of after-tax profit.
#### Illustration: debt vs preference, same EBIT
Co A raises funds via debentures (₹30 interest); Co B raises the same via preference shares (₹30 dividend). Tax @ 30%.
| Particulars | Co A (Debt) | Co B (Pref) |
|---|---|---|
| EBIT | 100 | 100 |
| Less: Interest | (30) | – |
| EBT | 70 | 100 |
| Tax @ 30% | (21) | (30) |
| EAT | 49 | 70 |
| Less: Pref Dividend | – | (30) |
| Net Earnings to Equity SH | 49 | 40 |
Takeaway: Despite identical EBIT, Co A leaves more for equity shareholders because interest is tax-deductible while dividend is not. This is why debt carries a built-in tax advantage, captured as ₹(1 − t)₹ in the cost-of-debt formulas.