COST OF CAPITAL AND LEVERAGES
SY B.Sc. Finance: Group 5
B021- Parth Maheshwari
B022- Poorva Mendiratta
B023- Prachi Ranka
B025- Priyam Agarwal
COST OF CAPITAL
It refers to the cost that is required to access funds for financing a business entity. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity or to the cost of debt if it is financed solely through debt. The importance and usefulness of cost of capital as a financial tool for both investors and the companies are well accepted among the financial analysts. It is important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks. From an investor’s view point, it is the opportunity cost. Had he invested the same money in some other place with equal or similar risks what would’ve been the returns. The cost of capital depends on the mode of financing used by the company and may defer from company to company.
COST OF DEBT
Cost of debt refers to the effective rate a company pays on its current debt. In most cases, it refers to after-tax cost of debt, but it also refers to a company’s cost of debt before taking taxes into account. Cost of debt becomes a concern for stockholders, bondholders, and potential investors when a company is highly leveraged.
To calculate cost of debt, a company needs to figure out the total amount of interest it is paying on each of its debts for the year. Then, it divides this number by the total outstanding debt. The quotient is its cost of debt. As borrowing costs are tax deductible, the cost of debt is adjusted for the tax rate. Hence the cost of debt that is considered is almost always post-tax. [Kd(1-t)]
The yield to maturity of a bond is another method we can use in determining the cost of debt. It is the internal rate of return (IRR) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity. In other words, yield to maturity is the discount rate at which the sum of all future cash flows from the bond (coupons and principal) are equal to the price of the bond.
COST OF EQUITY
is the return a company requires to decide if an investment meets capital return requirements; it is often used as a capital budgeting threshold for required rate of return.
Two methods can be used to calculate the cost of equity for a company; the Gordon’s model or the CAPM (Capital Asset Pricing Model)
Gordon’s model is a method for calculating the intrinsic value of a stock, exclusive of current market conditions. The model equates this value to the present value of a stock’s future dividends.
D1 = D0/P0 + g
CAPM is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital. The cost of equity is expressed as:
Ke = Rf + β *(Rm – Rf)
Where:
Ke = cost of equity or the required rate of return on equity
Rf = the risk free rate
Rm – Rf = the market risk premium
β = beta coefficient = systematic risk
RF: The risk-free rate in the CAPM model is a theoretical interest rate that would be paid by an investment with zero risk, and long-term yields on Indian treasuries. It is the minimum rate an investor would receive on an investment if it had no risk. While calculating cost of equity, we consider the current risk-free rate as investors investing in the company would expect anything over and above the government bond which is the closest approximation to the risk-free rate and since investments in companies carry more risk, higher returns are expected.
BETA: Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Why is the cost of capital different across firms? One key factor is the risk which is captured by the beta of the company. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.
Beta is calculated using regression analysis. Beta represents the tendency of a security’s returns to respond to swings in the market. In finance, the beta (β) of an investment is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1.
A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market.
MARKET RISK PREMIUM – The equity market risk premium represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate.
Hence multiplying the risk associated with the company, with the market premium i.e. compensation for taking extra risk and adding to it the bare minimum rate of return a person would get if he invested in a risk free bond gives us the cost of equity i.e. the minimum rate of return to be given to the investor.
Apart from equity shareholders and loan providers, businesses also issue preference shares on which they have to pay dividends at a fixed rate and hence this also is included in the cost of capital. The cost of preference shares is calculated as
Kp = Dividends/Net profit
After we have all the costs i.e. cost of debt, equity, preference shares, we assign weights to these costs to arrive at Weighted Average Cost of Capital (WACC).
Typically, formula for calculating WACC is:
Kd (1-T) (D/ D+E) + Ke (E/ D+E)
Where D is the amount of debt and E is the amount of shareholder’s equity.
Now we will apply all these concepts to a real life company to get the cost of capital and understand how these are helpful for investors and companies.
The company we have chosen is Sun Pharmaceuticals India Ltd. Cost of capital of sun pharma are compared with the industry standards. For the industry standards an average of 5-6 big market players are taken as it will give a more accurate measure. The competitors thus considered are:
Lupin, Glenmark, Dr. Reddy’s Laboratories Ltd. Cipla and Aurobindo.
INDUSTRY: PHARMACEUTICALS
Indian pharmaceutical sector accounts for about 2.4 per cent of the global pharmaceutical industry in value terms and 10 per cent in volume terms and is expected to expand at a Compounded Annual Growth Rate (CAGR) of 15.92 per cent to US$ 55 billion by 2020 from US$ 20 billion in 2015.
About the company
Sun Pharmaceutical Industries Ltd is an international specialty pharma company. The company manufactures and markets pharmaceutical formulations as branded generics as well as generics in India the United States and several other markets across the world. Sun Pharma is currently the biggest market player in the country with a market share of 9%.
CALCULATION OF COST OF CAPITAL
COST OF DEBT-
Rs. In crores
PARTICULARS
2014
2015
2016
INTEREST EXPENSE
44.19
578.99
476.86
OUTSTANDING DEBT
1410.29
8996.11
8518.44
COST OF DEBT(KD)
3.13340
6.43600
5.59833
KD POST TAX
2.1938
4.50520
3.91883
The cost of debt has increased considerably from 2013-14 to 2014-15, clearly because of increase in the borrowings. The outstanding debt has become nearly 8 times in 2015 than what it was in 2014. The reason behind this was, Sun Pharma acquired Ranbaxy in December 2014, which is considerably a large company. The deal was valued at around $3.2 bn. This explains the increase in cost of debt. Post-merger Sun Pharma became a leading market player also its revenues increased considerably and hence it paid off a part of its debt. The cost of debt reduced from 4.502 in 2015 to 3.91 is 2016.
INDUSTRY AVERAGE-
PARTICULARS
2014
2015
2016
KD
10.70661
7.53789
7.4715
KD POST TAX
7.49462
5.276523
5.23005
When compared to the industry standards, the cost of debt of Sun Pharma is considerably low. Being a major market player could help it acquire debt at a lower cost as compared to around 10-15% of companies like Aurobindo or Cipla.
COST OF EQUITY-
1. BETA: The calculation of beta is done by regression analysis of the stocks returns and the index stock returns. By using the regression formula, we have beta as 0.499. This implies that the securities are theoretically less volatile than the market. So if the beta is 0.2, it implies that it is 80% less volatile than the market. Pharmaceutical companies are doing well in India.). Overall, the entire Pharma industry has beta less than 1. Since these companies deal in medicines which are a necessity, the market fluctuations or growth in economy does not affect these sales of these companies. This is the main reason for a low beta for Sun Pharma Industries Ltd.
2. MARKET RATE OF RETURN: We have taken Sensex prices as the benchmark. Data for a period of 18 years is taken into consideration (annual). The price per year increases by the percent of return provided by the market that year, compounded annually. Therefore, if you bought a bond in 1998 for invested ₹100 you would get a ₹854.23 in 2016. Therefore the compounded annual growth rate 13.448%.
3. RISK-FREE RATE: to be comparable to the market rate of return, the risk free rate of return is also taken for a period of 18 years on a CAGR basis. A 10-year government bond would give a compounded annual growth rate of 8.78403%
Hence the market premium for the Pharma sector is 4.66397.
Cost of Equity for Sun pharma:
ke = current Rf + beta( Rm-Rf)
Cost of equity for the industry is 7.611874
Cost of equity of Sun Pharma is lower than that of the industry mainly because of beta of Sun pharma as the company has maintained its stability and is perceived as less risky by the investors. Lower the risk, lower is the expected return.
THE COST OF CAPITAL OF SUN PHARMA USING WACC
COST OF CAPITAL
2016
2015
2014
INDUSTRY AVERAGE
7.065404
7.061665
7.74247
SUN PHARMA LTD
6.823889
6.80497
7.22856
The Cost of Capital of Sun Pharmaceuticals Ltd. is in line with the industry average which is slowly seeing a decline post 2014 because of both the cost of debt and equity, which are lower than the industry standards. A stable, predictable company has a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital. Companies always prefer low WACC as a higher cost of capital reduces their profitability and riskiness. Sun Pharma is able to maintain its WACC and both the costs lower than the industry standard which is a good sign.
LEVERAGES
Leverage refers to debt or to the borrowing of funds to finance the purchase of a company’s assets. Leverage happens mainly because of fixed costs that a firm incurs. There are three types of leverage:
OPERATING LEVERAGE:
Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.
It is essential to compare operating leverage among companies in the same industry, as some industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly determined.
Most of a company’s costs are fixed costs that occur regardless of sales volume. As long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered and profits are earned. Other company costs are variable costs incurred when sales occur.
Operating leverage is calculated as the Contribution in ratio to the Earnings before interest and tax of the company. Contribution is calculated as the Net Sales of the company less the variable costs.
OL = Contribution/EBIT.
The variable costs considered here are, Raw materials, Power and Fuel, Other Manufacturing expenses and Miscellaneous expenses (on assumption).
FINANCIAL LEVERAGE
Financial leverage is the degree of which a company uses its capital such as debt and preferred equity. The more debt financing a company has in its capital structure, the higher is its financial leverage. A high financial leverage means high interest on debt payments, which negatively affects the earnings per share of the company.
Financial Leverage is calculated as the profit that is generated pre deduction of interest and tax in ratio to the profits before deducting tax. EBIT is the operating profit as mentioned in the statement of profit and loss account of the firm’s report.
Financial Leverage (FL) = EBIT/[EBT – ( Preference dividend / ( 1 – t )) ]
COMBINED LEVERAGE
The combination of operating leverage and financial leverage is called total leverage or combined leverage. Operating leverage measures operating risk whereas financial leverage measures financial risks. Total leverage or combined leverage measures total risk of the business.
Combined Leverage = Contribution / [EBT – {Dividend / ( 1 – t )}]
OL ANALYSIS:
The operating leverage has decreased from 1.211 in 2014 to 0.89 in 2015. This is because the power and fuel cost as well as the employee cosy has considerably gone up. The reason being, the company has significantly increased its production capacity to match the increasing demand for medicines. Therefore the sales have increased considerably but the fixed costs not in the same proportion. Also, Sun Pharma outsources a lot of its activities and keeps the core business activities with itself. Hence is as a lower operating leverage. The operating leverages for all pharma companies is generally low as they have low fixed costs and high variable costs.
FL ANALYSIS:
The financial leverage has increase from 1.09 from 2014 to 1.27 in 2015. This is because the huge increase in sales in the financial year 2014-15 because of acquisition of Ranbaxy which resulted in increase in operating profit. Also the interest paid on debt is very high which resulted in low EBT as compared to EBIT. However, the financial leverage decreased minimally from 1.27 in 2015 to 1.22 in 2016. This is because the debt had been paid off more in 2015 as in proportion to 2016. This resulted in higher Earnings Before Tax in 2016. It is suggested that the financial leverage should be less than 2 as it depicts that the company is leveraged highly. This may result into the company not securing new capital if it is not capable to meet its current COST OF CAPITAL AND LEVERAGES
SY B.Sc. Finance: Group 5
B021- Parth Maheshwari
B022- Poorva Mendiratta
B023- Prachi Ranka
B025- Priyam Agarwal
COST OF CAPITAL
It refers to the cost that is required to access funds for financing a business entity. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity or to the cost of debt if it is financed solely through debt. The importance and usefulness of cost of capital as a financial tool for both investors and the companies are well accepted among the financial analysts. It is important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks. From an investor’s view point, it is the opportunity cost. Had he invested the same money in some other place with equal or similar risks what would’ve been the returns. The cost of capital depends on the mode of financing used by the company and may defer from company to company.
COST OF DEBT
Cost of debt refers to the effective rate a company pays on its current debt. In most cases, it refers to after-tax cost of debt, but it also refers to a company’s cost of debt before taking taxes into account. Cost of debt becomes a concern for stockholders, bondholders, and potential investors when a company is highly leveraged.
To calculate cost of debt, a company needs to figure out the total amount of interest it is paying on each of its debts for the year. Then, it divides this number by the total outstanding debt. The quotient is its cost of debt. As borrowing costs are tax deductible, the cost of debt is adjusted for the tax rate. Hence the cost of debt that is considered is almost always post-tax. [Kd(1-t)]
The yield to maturity of a bond is another method we can use in determining the cost of debt. It is the internal rate of return (IRR) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity. In other words, yield to maturity is the discount rate at which the sum of all future cash flows from the bond (coupons and principal) are equal to the price of the bond.
COST OF EQUITY
is the return a company requires to decide if an investment meets capital return requirements; it is often used as a capital budgeting threshold for required rate of return.
Two methods can be used to calculate the cost of equity for a company; the Gordon’s model or the CAPM (Capital Asset Pricing Model)
Gordon’s model is a method for calculating the intrinsic value of a stock, exclusive of current market conditions. The model equates this value to the present value of a stock’s future dividends.
D1 = D0/P0 + g
CAPM is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital. The cost of equity is expressed as:
Ke = Rf + β *(Rm – Rf)
Where:
Ke = cost of equity or the required rate of return on equity
Rf = the risk free rate
Rm – Rf = the market risk premium
β = beta coefficient = systematic risk
RF: The risk-free rate in the CAPM model is a theoretical interest rate that would be paid by an investment with zero risk, and long-term yields on Indian treasuries. It is the minimum rate an investor would receive on an investment if it had no risk. While calculating cost of equity, we consider the current risk-free rate as investors investing in the company would expect anything over and above the government bond which is the closest approximation to the risk-free rate and since investments in companies carry more risk, higher returns are expected.
BETA: Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Why is the cost of capital different across firms? One key factor is the risk which is captured by the beta of the company. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.
Beta is calculated using regression analysis. Beta represents the tendency of a security’s returns to respond to swings in the market. In finance, the beta (β) of an investment is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1.
A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market.
MARKET RISK PREMIUM – The equity market risk premium represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate.
Hence multiplying the risk associated with the company, with the market premium i.e. compensation for taking extra risk and adding to it the bare minimum rate of return a person would get if he invested in a risk free bond gives us the cost of equity i.e. the minimum rate of return to be given to the investor.
Apart from equity shareholders and loan providers, businesses also issue preference shares on which they have to pay dividends at a fixed rate and hence this also is included in the cost of capital. The cost of preference shares is calculated as
Kp = Dividends/Net profit
After we have all the costs i.e. cost of debt, equity, preference shares, we assign weights to these costs to arrive at Weighted Average Cost of Capital (WACC).
Typically, formula for calculating WACC is:
Kd (1-T) (D/ D+E) + Ke (E/ D+E)
Where D is the amount of debt and E is the amount of shareholder’s equity.
Now we will apply all these concepts to a real life company to get the cost of capital and understand how these are helpful for investors and companies.
The company we have chosen is Sun Pharmaceuticals India Ltd. Cost of capital of sun pharma are compared with the industry standards. For the industry standards an average of 5-6 big market players are taken as it will give a more accurate measure. The competitors thus considered are:
Lupin, Glenmark, Dr. Reddy’s Laboratories Ltd. Cipla and Aurobindo.
INDUSTRY: PHARMACEUTICALS
Indian pharmaceutical sector accounts for about 2.4 per cent of the global pharmaceutical industry in value terms and 10 per cent in volume terms and is expected to expand at a Compounded Annual Growth Rate (CAGR) of 15.92 per cent to US$ 55 billion by 2020 from US$ 20 billion in 2015.
About the company
Sun Pharmaceutical Industries Ltd is an international specialty pharma company. The company manufactures and markets pharmaceutical formulations as branded generics as well as generics in India the United States and several other markets across the world. Sun Pharma is currently the biggest market player in the country with a market share of 9%.
CALCULATION OF COST OF CAPITAL
COST OF DEBT-
Rs. In crores
PARTICULARS
2014
2015
2016
INTEREST EXPENSE
44.19
578.99
476.86
OUTSTANDING DEBT
1410.29
8996.11
8518.44
COST OF DEBT(KD)
3.13340
6.43600
5.59833
KD POST TAX
2.1938
4.50520
3.91883
The cost of debt has increased considerably from 2013-14 to 2014-15, clearly because of increase in the borrowings. The outstanding debt has become nearly 8 times in 2015 than what it was in 2014. The reason behind this was, Sun Pharma acquired Ranbaxy in December 2014, which is considerably a large company. The deal was valued at around $3.2 bn. This explains the increase in cost of debt. Post-merger Sun Pharma became a leading market player also its revenues increased considerably and hence it paid off a part of its debt. The cost of debt reduced from 4.502 in 2015 to 3.91 is 2016.
INDUSTRY AVERAGE-
PARTICULARS
2014
2015
2016
KD
10.70661
7.53789
7.4715
KD POST TAX
7.49462
5.276523
5.23005
When compared to the industry standards, the cost of debt of Sun Pharma is considerably low. Being a major market player could help it acquire debt at a lower cost as compared to around 10-15% of companies like Aurobindo or Cipla.
COST OF EQUITY-
1. BETA: The calculation of beta is done by regression analysis of the stocks returns and the index stock returns. By using the regression formula, we have beta as 0.499. This implies that the securities are theoretically less volatile than the market. So if the beta is 0.2, it implies that it is 80% less volatile than the market. Pharmaceutical companies are doing well in India.). Overall, the entire Pharma industry has beta less than 1. Since these companies deal in medicines which are a necessity, the market fluctuations or growth in economy does not affect these sales of these companies. This is the main reason for a low beta for Sun Pharma Industries Ltd.
2. MARKET RATE OF RETURN: We have taken Sensex prices as the benchmark. Data for a period of 18 years is taken into consideration (annual). The price per year increases by the percent of return provided by the market that year, compounded annually. Therefore, if you bought a bond in 1998 for invested ₹100 you would get a ₹854.23 in 2016. Therefore the compounded annual growth rate 13.448%.
3. RISK-FREE RATE: to be comparable to the market rate of return, the risk free rate of return is also taken for a period of 18 years on a CAGR basis. A 10-year government bond would give a compounded annual growth rate of 8.78403%
Hence the market premium for the Pharma sector is 4.66397.
Cost of Equity for Sun pharma:
ke = current Rf + beta( Rm-Rf)
Cost of equity for the industry is 7.611874
Cost of equity of Sun Pharma is lower than that of the industry mainly because of beta of Sun pharma as the company has maintained its stability and is perceived as less risky by the investors. Lower the risk, lower is the expected return.
THE COST OF CAPITAL OF SUN PHARMA USING WACC
COST OF CAPITAL
2016
2015
2014
INDUSTRY AVERAGE
7.065404
7.061665
7.74247
SUN PHARMA LTD
6.823889
6.80497
7.22856
The Cost of Capital of Sun Pharmaceuticals Ltd. is in line with the industry average which is slowly seeing a decline post 2014 because of both the cost of debt and equity, which are lower than the industry standards. A stable, predictable company has a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital. Companies always prefer low WACC as a higher cost of capital reduces their profitability and riskiness. Sun Pharma is able to maintain its WACC and both the costs lower than the industry standard which is a good sign.
LEVERAGES
Leverage refers to debt or to the borrowing of funds to finance the purchase of a company’s assets. Leverage happens mainly because of fixed costs that a firm incurs. There are three types of leverage:
OPERATING LEVERAGE:
Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.
It is essential to compare operating leverage among companies in the same industry, as some industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly determined.
Most of a company’s costs are fixed costs that occur regardless of sales volume. As long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered and profits are earned. Other company costs are variable costs incurred when sales occur.
Operating leverage is calculated as the Contribution in ratio to the Earnings before interest and tax of the company. Contribution is calculated as the Net Sales of the company less the variable costs.
OL = Contribution/EBIT.
The variable costs considered here are, Raw materials, Power and Fuel, Other Manufacturing expenses and Miscellaneous expenses (on assumption).
FINANCIAL LEVERAGE
Financial leverage is the degree of which a company uses its capital such as debt and preferred equity. The more debt financing a company has in its capital structure, the higher is its financial leverage. A high financial leverage means high interest on debt payments, which negatively affects the earnings per share of the company.
Financial Leverage is calculated as the profit that is generated pre deduction of interest and tax in ratio to the profits before deducting tax. EBIT is the operating profit as mentioned in the statement of profit and loss account of the firm’s report.
Financial Leverage (FL) = EBIT/[EBT – ( Preference dividend / ( 1 – t )) ]
COMBINED LEVERAGE
The combination of operating leverage and financial leverage is called total leverage or combined leverage. Operating leverage measures operating risk whereas financial leverage measures financial risks. Total leverage or combined leverage measures total risk of the business.
Combined Leverage = Contribution / [EBT – {Dividend / ( 1 – t )}]
OL ANALYSIS:
The operating leverage has decreased from 1.211 in 2014 to 0.89 in 2015. This is because the power and fuel cost as well as the employee cosy has considerably gone up. The reason being, the company has significantly increased its production capacity to match the increasing demand for medicines. Therefore the sales have increased considerably but the fixed costs not in the same proportion. Also, Sun Pharma outsources a lot of its activities and keeps the core business activities with itself. Hence is as a lower operating leverage. The operating leverages for all pharma companies is generally low as they have low fixed costs and high variable costs.
FL ANALYSIS:
The financial leverage has increase from 1.09 from 2014 to 1.27 in 2015. This is because the huge increase in sales in the financial year 2014-15 because of acquisition of Ranbaxy which resulted in increase in operating profit. Also the interest paid on debt is very high which resulted in low EBT as compared to EBIT. However, the financial leverage decreased minimally from 1.27 in 2015 to 1.22 in 2016. This is because the debt had been paid off more in 2015 as in proportion to 2016. This resulted in higher Earnings Before Tax in 2016. It is suggested that the financial leverage should be less than 2 as it depicts that the company is leveraged highly. This may result into the company not securing new capital if it is not capable to meet its current COST OF CAPITAL
It refers to the cost that is required to access funds for financing a business entity. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity or to the cost of debt if it is financed solely through debt. The importance and usefulness of cost of capital as a financial tool for both investors and the companies are well accepted among the financial analysts. It is important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks. From an investor’s view point, it is the opportunity cost. Had he invested the same money in some other place with equal or similar risks what would’ve been the returns. The cost of capital depends on the mode of financing used by the company and may defer from company to company.