Definition of Cost of Capital
Cost of Capital is the rate of return the firm expects to earn from its investment in order to increase the value of the firm in the market place.It is the rate of return that the suppliers of capital require as compensation for their contribution of capital. An investor provides long-term funds (i.e., Equity shares, Preference Shares, Retained earnings, Debentures etc.) to a company and he expects a good return on his investment.

Measurement of Cost of Capital:

Cost of capital is measured for different sources of capital structure of a firm.

It includes cost of debenture, cost of loan capital, cost of equity share capital, cost of preference share capital, cost of retained earnings etc.

Cost of Debentures:

When the debentures are issued at a premium or discount but redeemable at par

K_d = I/NP (1 – t)

where, K_d = Cost of debenture

I = Annual interest payment calculated on face value 

t = Tax rate

NP = Net proceeds from the issue of debenture.
When the debentures are redeemable at a premium or discount and are redeemable after ‘n’ period:

K_d=  I(1-t)+1/N(Rv – NP) / ½ (RV – NP)

where K_d = Cost of debenture .

I = Annual interest payment

t = Tax rate

NP = Net proceeds from the issue of debentures

RV = Redeemable value of debenture at the time of maturity

n = number of years of life of debentures

Cost of Preference Share Capital:

For preference shares, the dividend rate can be considered as its cost, since it is this amount which the company wants to pay against the preference shares. The issue expenses or the discount/premium on issue/redemption are also to be taken into account.

(i) The cost of preference shares (K_P) = DP / NP

Where, DP = Preference dividend per share

NP = Net proceeds from the issue of preference shares.

(ii) If the preference shares are redeemable after a period of ‘n’, the cost of preference shares (K_P) will be:

    = DP  + [RV-NP/n}  / RV + NP/2   x  100
where NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares

DP = Annual dividend amount.
n= Number of years of life of preference shares

There is no tax advantage for cost of preference shares, as its dividend is not allowed deduction from income for income tax purposes.