Meaning of Nominal Cost of Capital
The nominal Cost of Capital is inclusive of Inflation. It means the Nominal cost of capital calculation is without adjustment of general Inflation. In comparison to the real cost of capital, it comes after the adjustment of general inflation.
The cost of Capital is important for reviewing the organization’s financial performance. For Evaluation, the Organization Compare Cost of Capital with Standard Return to check how viable this project is. Cost of Capital is generally known as Weighted Average Cost of Capital (WACC).
“Lower the Cost of Capital (WACC) is better.”
Let see the example for proper clarification, the Inflation rate is 4.8% and the real cost of capital Is 2.6%.
So, what is the Nominal Cost of Capital?
Nominal cost of capital = (1+Inflation) (1+realcoc)
= (1+4.8%) (1+2.6)
= 1.0752 or 7.5% approx.
realcoc = Real Cost of Capital
It Is advisable to use the Real Cost of Capital rather than the Nominal Cost of Capital because the Real cost of capital comes after the adjustment of general inflation, and it shows the actual picture to the organization.
In Nominal Cost of capital inflation is included, but in Real Cost of Capital Inflation is not included.
How to Calculate Cost of Capital?
Cost of Capital comes after the averaging of debt, equity, and preference share in their weights.
The Formula of Cost of Capital is:
(Cost of debt x weightage of debt) + (Cost of equity x weightage of equity) + (cost of preference x weightage of preference)
It is derived in percentage form
*Reference of this formula taken from Institute of Chartered Accountant of India Intermediate Book/Financial Management Subject/Chapter4/Heading4.10/WACC/ https://resource.cdn.icai.org/66670bos53808-cp4.pdf
Step-by-step calculation of the cost of capital
1. Cost of Debt (Kd)
Cost of debt is the simple interest rate effectively paid by the company on its borrowing/debt and creditors’ liabilities with a tax rate adjustment. Cost of debt derived in the percentage form. The cost of debt formula is:
Cost of debt = Interest expenses x (1-tax rate)
For Example: Interest Expenses = $1000, Tax Rate = 20%, Total Debt = $10000
Kd = [Interest Expenses x (1-Tax rate)]/Total debt
Kd = $1000(1-20%)/$10000
Kd = 8%
2. Cost of Equity (Ke)
Cost of Equity is the return that is required by the individual or organization on the amount invested in the company or project. Cost of equity derived in the percentage form. There are many methods to calculate the cost of equity, which are as follows:
CAPM (Capital Asset Pricing Model):
In this model, the expected return is calculated based on the level of risk. The formula of the Capital Asset Pricing Model (CAPM) is:
= RF + B(RM-RF)
RF = Risk-free rate of return
B = Beta of Asset (with the help of this we measure risk)
RM = Market Return
For Example: RF = 1.5%, RM = 6.5%, B = 0.8
CAPM = RF + B(RM-RF)
CAPM = 1.5% +0.8(6.5%-1.5%)
CAPM = 5.5%
Dividend Discount Model (Constant Growth):
In this model, we assume dividends grow at a constant rate over the year.
The formula of the Dividend Discount Model is:
= D1/(P0+g)
D1 = Next Year Dividend Value
P0 = Current Year Share Price
G = growth rate
For Example: D1 = $8, P0 = $100, g = 2%
Ke = D1/(P0+g)
Ke = $8/($100+2%)
Ke = 7.84%
3. Cost of Preference (Kp)
It is calculated by the dividend amount of preference divided by the total preference amount. Cost of preference derived in the percentage form. The formula of cost of preference is:
= preference dividend/Total Preference Amount
For Example: Dividend = $100, Total Preference = $1000
Kp = Dividend/Total Preference
Kp = $100/$1000
Kp = 10%
How to Calculate Weightage?
Weightage of debt, preference, and equity is calculated with the base value of the Total Capital amount.
Total Capital = Debt/Borrowing + Amount of Preference share + Amount of Equity (market value)
- Weightage of debt = amount of debt/Total Capital
- Weightage of equity = Market Value of equity/Total Capital
- Weightage of preference = Amount of Preference/Total Capital
Use of Cost of Capital in business
With the help of the Cost of Capital, we calculate the Net Present Value of an organization after discounting Free cash flows with the Cost of Capital. It is used to review the Investment opportunity in the organization for the individual or company. In Layman means, with the help of this Organization evaluate the financial performance of the company.
Example of Cost of Capital
Extract from ABC Incorporation Financial Statement for the year 2019-2020
Extract from Balance Sheet
| Particulars | Amount in ($) |
| Equity Share capital | 400,000,000 |
| Preference Share Capital | 100,000,000 |
| Debt/Borrowing (Outstanding) | 250,000,000 |
Additional Information:
Risk free rate of Return (Government Bond) 3.5%
Market Return (New York Exchange Industrial Data) 12.5%
Beta of the ABC Inc. Is 1.2
Tax rate 30%
Interest Expenses $ 25,000,000
Preference Dividend $ 5,000,000
General Inflation 3.8%
Company Return is 14 %
Calculate Cost of Capital (Nominal Cost of Capital and Real Cost of Capital both)
Solution:
CALCULATION OF COST OF CAPITAL
Cost of Capital =
(Cost of debt x weight of debt) + (cost of equity x weight of debt) + (cost of preference x weight of preference)
| S.No. | Particulars | Amount in $ million |
| A | Debt/Borrowing | 250 |
| B | Equity | 400 |
| C | Preference | 100 |
| D | Interest Expenses | 25 |
| E | Preference Dividend | 5 |
| F | Tax rate | 30% |
| G | Risk Free Return | 3.50% |
| H | Market Return | 12.50% |
| I | Beta | 1.2 |
| J | Total Capital (a+b+c) | 750 |
| K | Cost of Equity (CAPM) [(g)+(i*(h-g))] | 14.30% |
| L | Weightage of Equity (b/j) | 0.53 |
| M | Cost of Preference (e/c) | 5.00% |
| N | Weightage of Preference (c/j) | 0.13 |
| O | Cost of Debt {[d(1-f)]/a} | 7.00% |
| P | Weightage of debt (a/j) | 0.34 |
| Cost of Capital [(k*l) + (m*n) + (o*p)] | 10.61% | |
| Nominal Cost of Capital | 10.61 % | |
| General inflation | 3.8 % | |
| Real Cost of Capital after Inflation adjustment (1+realcoc) = (1+NCOC)/(1+Inflation) | 6.57% | |
| Real COC = Real Cost of Capital | ||
| NCOC = Nominal Cost of Capital |
Comment: Cost of Capital is lower than the Company Return, So it is advisable to invest in this company.