Cost of Capital

Introduction to Cost of Capital

The cost of capital is an important factor while planning the capital structure of an organization. The cost of capital is concerned with what a firm has to pay for the capital it uses to finance new investments. The capital may be in the form of debt, retained earnings, preference shares and equity shares.

Every firm, for its survival and growth, has to earn a sufficient return to cover its costs of capital and also to have surplus for its growth. If a firm’s rate of return on its investment exceeds its cost of capital, the wealth of equity stockholders is enhanced.

It is, because, the firm’s rate of return on its investments is greater than its cost of capital, the rate of return earned on equity capital (after nearing the costs of other forms of financing) will exceed the rate of return required by equity stockholders. Hence, the wealth of equity stockholders will increase.

Cost of Capital Definition

‘Cost of Capital’ is a concept having manifold meanings. Cost of capital, for an investor is the measurement of disutility of funds in the present as compared to the return expected in the future. From the firm’s point of view, its meaning is somewhat different.

From its point of view, cost of capital is the required rate of return needed to justify the use of capital. This very idea has been subscribed by the following authorities also:

The cost of capital is the minimum required rate of earnings or the cut off rate for capital expenditureSolomon Ezra
The cost of capital is the rate of return a company must earn on an investment to maintain the value of the companyM.J. Gorden
Cost of capital is the rate of return, the firm requires from investment in order to increase the value of the firm in the market rateJohn J. H.
The cost of capital is the minimum rate of return which a firm requires as a condition for undertaking an investmentMilton H. Spencer
The cost of capital represents a cut off rate for the allocation of capital to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stockJames C. Van Home

Classification of Cost of Capital

Historical Cost and Future Cost

Historical cost are those which are calculated on the basis of existing capital structure. Future cost relates to the cost of funds intended to finance the expected project, historical costs are useful for analyzing the existing capital structures. Future costs are widely used in capital budgeting and capital structure designing decisions.

Specific Cost and Composite Cost

The cost of individual source of capital is referred to as the specific cost and the cost of capital of all the sources combined is termed as composite cost. It is, thus the weighted cost of capital.

Average Cost and Marginal Cost

The average cost is the average of the various specific costs of the different components of capital structure at a given time. The average cost is relevant for overall investment decision as on enterprise employs a mix of different sources. The marginal cost of capital is that average cost which is concerned with the additional funds raised by the firm. It is very important in capital budgeting decisions. Marginal cost tends to increase proportionately as the amount of debt increases.

Explicit Cost

An explicit cost is the discount rate which equates the present value of cash inflows with the present value of cash outflows. In other words, it is the internal rate of return of cash flows.

Implicit Cost

Implicit cost is also known as opportunity cost. It may be defined as the rate of return associated with the best investment opportunity for the firm. It is generally said that cost of retained earnings is an opportunity cost in the sense that it is the rate of return at which the shareholders could have invested these funds had they been distributed among them.

Weighted Average Cost of Capital (WACC)

A company has to employ owner’s fund as well as creditors’ funds to finance its projects so as to make the capital structure of the company balanced and to increase the return to the shareholders. Weighted average cost of capital is the average cost of various sources of financing. According to CIMA the weighted average cost of capital “as the average cost of the company’s finance (equity, debentures, bank loans) weighted according to the proportion each element bears to the total pool of the capital, weighting is usually based on market valuations current yields and costs after tax.”

Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. The composite cost ol capital is the weighted average of the cost of various sources of funds, weights being the proportion of each source of funds in the capital structure.

The following steps are used to calculate the weighted average cost of capital :

  • Calculate the cost of the specific sources of funds (i.e., cost of lit, cost of equity share capital, cost of preference share ital, cost of retained earnings etc.). These should be calculated after tax.
  • Multiply the cost of each source by its proportion in the capital structure.

Apply the following formula:

——- =CW

CW = Weighted average cost of capital
X = Cost of different sources of capital
W = Weights given to different sources of capital
∑XW = Summation of the product of the specific cost of capital with the relative proportions
∑W = Summation of weights.

Assignment of Weights: The assignment of weight to specific sources of funds is a difficult task. Several approaches are followed in this regard but two of them are commonly used which are

  • Book value weights: Book value weights mean the weights according to the values shown in respect of the different sources of finance in the balance sheet (or in the books of accounts).

  • Market value weights: Market value weights mean the weights of different components of capital, according to the value prevailing in the market. The cost of capital of the market value is usually higher than it would be if the book value is used. The market value weights are more logical to be adopted due to the following reasons
  • It represents the true value of funds invested by investors.
  • Historic book value have no relevance in calculation of real cost of capital.
  • It represents near to the opportunity cost of capital.

However, the market value weights suffer from the following limitations

  • It is difficult to determine the market values because of frequent fluctuations.
  • With the use of market value weights, equity capital gets greater importance.

Significance of Cost of Capital

The cost of capital is very important concept in financial management. Prior to the development of the concept of cost of capital the problem was ignored or by passed.

The progressive management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions

  1. Capital Budgeting Decisions: Cost of capital may be used as the measuring rod for adopting as investment proposal. In various methods of capital budgeting cost of capital is the key factor in deciding the project out of various proposals pending before the management.

    It measures the financial performance and determines the acceptability of all investment opportunities by discounting cash flows under present value method. The cost of capital being the minimum rate of return desired is used to compare with the actual rate of return (internal rate of return).

    Thus, the cost of capital provides the criterion of accepting or rejecting the proposals in capital expenditure decisions.

  2. Capital Structure Decisions: While designing an optimal capital structure, the management should raise capital from different sources in such a way that it optimizes the risk and cost factors.

    Raising of loans may be cheaper on account of income tax benefits, but it involves heavy risk because a slight fall in the earning capacity of the company may bring the firm near to cash insolvency.

    It is, therefore, necessary that cost of cash source of funds is carefully considered and compared with the risk involved in it.

  3. Evaluation of Financial Performance: The cost of capital framework can be used to evaluate the financial performance of top management.

    If the actual profitability, of the project is more than the projected and the actual cost of capital, the performance may be said to be satisfactory.

  4. Allocation of Capital: This concept is very useful in allocation of capital to various investment proposals. It is the corner stone of the investment decisions.

    The main goal of financial management is the wealth maximization of its shareholders. So the company must choose only those investment opportunities that are financially beneficial to the shareholders.

  5. Helpful in Dividend Policy and Working Capital Management: The measurement of the cost of capital helps the management in taking decisions relating to dividend policy and working capital requirements.

Problems in Determining Cost of Capital

The determination of cost of capital is not an easy task. The financial manager is confronted with a large number of problems.

These problems can briefly be summarized as follows

  • Conceptual Controversy: There is major controversy whether or not the cost of capital is dependent upon the method and level of financing by the company.

    According to traditional theorists, a firm can change its overall cost of capital by changing debt-equity mix. On the other hand, the modern theorists, reject the traditional view and holds that cost of capital is independent of the method and level of financing.

  • Computation of Cost of Equity: Determination of cost of equity is a difficult task because the equity shareholders value the equity shares of company on the basis of a large number of factors, financial as well as psychological.

  • Determination of Cost of Retained Earnings: The cost of retained earnings is determined according to the approach adopted for computing the cost of equity shares which is it self a controversial problem.

  • Future Cost Versus Historical Cost: It is argued that for decision making purposes, the historical cost is not relevant. The future cost should be considered. It, therefore, creates another problem whether to consider marginal cost of capital or average cost of capital.

  • Problems of Weight: The assignment of weights to each type of funds is a complex. The finance manager has to make a choise between the book value to each source of funds and the market value of each source of funds. The result would be different in each case.

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