What is Cost of Capital?

Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern. It is used as a discount rate in determining the present value of future cash flows associated with capital projects.

Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are using different sources of finance, the finance manager must take careful decision with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity of the firm.

Meaning of Cost of Capital

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds.

Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.

Definitions

The following important definitions are commonly used to understand the meaning and concept of the cost of capital.

According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.

According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.

According to the definition of James C. Van Horne, Cost of capital is “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 stock”.

According to the definition of William and Donaldson, “Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due”.

Assumption of Cost of Capital

Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consis of three important risks such as zero risk level, business risk and financial risk.

Classification of Cost of Capital

Cost of capital may be classified into the following types on the basis of nature and usage:

Explicit and Implicit Cost

The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital. Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently under consideration by the firm were accepted.

Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital employed by the company. It considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc. Marginal cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when the company goes for further raising of finance.

Historical and Future Cost

Historical cost is the cost which as already been incurred for financing a particular project. It is based on the actual cost incurred in the previous project. Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of previous experience.

Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of capital. It is very useful to determine the each and every specific source of capital. The composite or combined cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. It is used to understand the total cost associated with the total finance of the firm.

Importance of Cost of Capital

Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.

Importance to Capital Budgeting Decision

Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.

Importance to Structure Decision

Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.

Importance to Evolution of Financial Performance

Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.

Importance to Other Financial Decisions

Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.

Computation of Cost of Capital

Computation of cost of capital consists of two important parts:

Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:

Cost of Equity

Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value.

Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares”.

Cost of equity can be calculated from the following approach:

• Dividend Price. Approach The cost of equity capital will be that rate of expected dividend which will maintain the present market price of equity shares.
• Dividend Price Plus Growth Approach. The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend.
• Earning Price Approach. Cost of equity determines the market price of the shares. It is based on the future earning prospects of the equity.
• Realized Yield Approach. It is the easy method for calculating cost of equity capital. Under this method, cost of equity is calculated on the basis of return actually realized by the investor in a company on their equity capital.

Cost of Debt 

Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual or redeemable.

• Debt Issued at Par. Debt issued at par means, debt is issued at the face value of the debt.
• Debt Issued at Premium or Discount. If the debt is issued at premium or discount
• Cost of Perpetual Debt and Redeemable Debt. It is the rate of return which the lenders expect. The debt carries a certain rate of interest.

Cost of Preference Share

Capital Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share. There are two types of preference shares irredeemable and redeemable.

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment proposal; it is different from other sources like debt, equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital.

Measurement of Overall Cost of Capital

It is also called as weighted average cost of capital and composite cost of capital. Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firms capital structure.

The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.