In this article, we will go through the concept of cost of capital which is important for business organizations and for commerce and management students.
Cost of capital
Cost of capital is vital part of investment decision as it is used to measure the value of investment proposal provided by the business concern. It is used as a discount rate to determine the present value of future cash flows related with capital projects. Cost of capital is also termed as cut-off rate, target rate, hurdle rate and required rate of return. When the companies are using different sources of finance, the finance manager must take vigilant 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.
Concept of Cost of Capital
There is bulk of finance literature to describe this concept. Numerous studies have shown that 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. It 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 decrease of overall prosperity of the shareholders. Famous theorist, John J. Hampton described cost of capital as “the rate of return the firm required from investment in order to increase the value of the firm in the market place”. Solomon Ezra stated that “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure” According to 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”. Another theorist, William and Donaldson explained that “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
It is documented in theoretical studies that cost of capital is based on some assumptions which are directly related while calculating and measuring the cost of capital. There are three basic concepts:
- It is not a cost as such. It is merely a hurdle rate.
- It is the minimum rate of return.
- It consists of three important risks such as zero risk level, business risk and financial risk.
Cost of capital can be measured with the following equation:
K = Cost of capital.
rj = The risk free cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
Classification of Cost of Capital
Cost of capital may be categorized into the following types on the basis of nature and usage:
- Explicit and Implicit Cost.
- Average and Marginal Cost.
- Historical and Future Cost.
- Specific and Combined Cost.
1.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. An explicit cost is one that has occurred and is evidently reported as a separate cost. It is defined as direct payment to others in doing business such as wage, rent and materials.
Implicit cost is the rate of return linked with the best investment opportunity for the firm and its shareholders that will be inevitable if the projects presently under consideration by the firm were accepted. It is the opportunity cost equal to what a firm must give up in order to use factor of production which it already owns and thus does not pay rent for.
Both implicit and explicit costs are actual business cost of firms .
- Average and Marginal Cost:
Average cost of capital is the weighted average cost of each element of capital employed by the company. It reflects weighted average cost of all kinds of financing such as equity, debt, retained earnings.
Marginal cost is the weighted average cost of new finance raised by the company. It is the extra cost of capital when the company goes for further raising of finance.
- Historical and Future Cost:
Historical cost is the cost which is already been incurred for financing a particular project. It is based on the actual cost incurred in the earlier 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 termed as specific cost of capital. It is beneficial to determine the each and every specific source of capital. The composite or combined cost of capital is the amalgamation of all sources of capital. It is also called as overall cost of capital. It is used to recognize the total cost associated with the total finance of the company.
The factors which determine the cost of capital are:
- Source of finance
- Corresponding payment for using finance.
On raising funds from the market, from various sources, the firm has to pay some additional amount, apart from the principal itself. The additional amount is nothing but the cost of using the capital, i.e. cost of capital which is either paid in lump sum or at periodic intervals.
Importance of Cost of Capital
- It helps in evaluating the investment options, by converting the future cash flows of the investment avenues into present value by discounting it.
- It is helpful in capital budgeting decisions regarding the sources of finance used by the company.
- It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is maximum, and the cost of capital is minimum.
- It can also be used to appraise the performance of specific projects by comparing the performance against the cost of capital.
- It is useful in framing optimum credit policy, i.e. at the time of deciding credit period to be allowed to the customers or debtors, it should be compared with the cost of allowing credit period.
Cost of capital is also termed as cut-off rate, the minimum rate of return, or hurdle rate.