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A firm raises funds from various sources, which are called the components of
capital. Different sources of fund or the components of capital have different costs.
For example, the cost of raising funds through issuing equity shares is different from
that of raising funds through issuing preference shares. The cost of each source is
the specific cost of that source, the average of which gives the overall cost for
acquiring capital.
The firm invests the funds in various assets. So it should earn returns that are
higher than the cost of raising the funds. In this sense the minimum return a firm
earns must be equal to the cost of raising the fund. So the cost of capital may be
viewed from two viewpointsacquisition of funds and application of funds. From the
viewpoint of acquisition of funds, it is the borrowing rate that a firm will try to
minimize.
On the other hand from the viewpoint of application of funds, it is the required rate
of return that a firm tries to achieve. The cost of capital is the average rate of return
required by the investors who provide long-term funds. In other words, cost of
capital refers to the minimum rate of return a firm must earn on its investment so
that the market value of companys equity shareholders does not fall.
This foregone return then is the opportunity cost of undertaking the investment and
consequently, is the investors required rate of return. This required rate of return is
used as a discounting rate to determine the present value of the estimated future
cash flows.
Thus the cost of capital is also referred to as the discounting rate to determine the
present value of return. Cost of capital is also referred to as the breakeven rate,
minimum rate, cut-off rate, target rate, hurdle rate, standard rate, etc. Hence cost
of capital may be defined according to the operational as well as the economic
sense.
In the operational sense, cost of capital is the discount rate used to determine the
present value of estimated future cash inflows of a project. Thus, it is the rate of
return a firm must earn on a project to maintain its present market value.
In the economic sense, it is the weighted average cost of capital, i.e. the cost of
borrowing funds. A firm raises funds from different sources. The cost of each source
is called specific cost of capital. The average of each specific source is referred to as
weighted average cost of capital.
From the view point of return, cost of capital is the minimum required rate of return
to be earned on investment. In other words, the earning rate of a firm which is just
sufficient to satisfy the expectation of the contributors of capital is called cost of
capital. Shareholders and debenture holders are the contributors of the capital. For
example, a firm needs $ 5,00,000 for investing in a new project. The firm can collect
$3,00,000 from shares on which it must pay 12% dividend and $ 2,00,000 from
debentures on which it must pay 7% interest. If the fund is raised and invested in
the project, the firm must earn at least $50,000 which becomes sufficient to pay
$36,000 dividend(12% of $3,00,000) and $14000 interest(7% of $2,00,000). The
required earning $50,000 is 12% of the total fund raised. This 12% rate of return is
called cost of capital.
In this way, cost of capital is only minimum required rate of return to earn on
investment and it is not the actual earning rate of the firm. As per above example, if
the firm is able to earn only 10%. all the earnings will go in the hands of
contributors of capital and nothing will be left in the business. Therefore, any
business firm should try to maximize the earning rate by investing in the projects
that can provide the rate of return which is more than the cost of capital.
Why it Matters:
Cost of capital is an important component of business valuation work. Because an
investor expects his or her investment to grow by at least the cost of capital, cost of
capital can be used as a discount rate to calculate the fair value of an investment's
cash flows.
We have seen that cost of capital is the average rate of return required by the
investors.
Various authors defined the term cost of capital in different ways some of which are
stated below:
Milton H. Spencer says cost of capital is the minimum required rate of return which
a firm requires as a condition for undertaking an investment.
According to Ezra Solomon, the cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure.
L. J. Gitman defines the cost of capital as the rate of return a firm must earn on its
investment so the market value of the firm remains unchanged.
The definition given by Keown et al. refers to the cost of capital as the minimum
rate of return necessary to attract an investor to purchase or hold a security.
Analysing the above definitions we find that cost of capital is the rate of return the
investor must forego for the next best investment. In a general sense, cost of
capital is the weighted average cost of fund used in a firm on a long-term basis.
The significance and relevance of cost of capital has been discussed below:
Investment Evaluation:
The cost of capital influences the financing policy decision, i.e. the proportion of
debt and equity in the capital structure. Optimal capital structure of a firm can
maximize the shareholders wealth because an optimal capital structure logically
follows the objective of minimization of overall cost of capital of the firm. Thus while
designing the appropriate capital structure of a firm cost of capital is used as the
yardstick to determine its optimality.
Project Appraisal:
The cost of capital is also used to evaluate the acceptability of a project. If the
internal rate of return of a project is more than its cost of capital, the project is
considered profitable. The composition of assets, i.e. fixed and current, is also
determined by the cost of capital. The composition of assets, which earns return
higher than cost of capital, is accepted.
Financial experts express conflicting options as to the correct way in which the cost
of capital can be measured. Irrespective of the measurement problems, it is a
concept of vital important in the financial decision making. It is useful as a standard
for:
Investment evaluation
The primary purpose of measuring the cost of capital is its use as a financial
standard for evaluating the investment projects. In the net present value (NPV)
method, an investment project is accepted if it has a positive NPV. The projects NPV
is calculated by discounting its cash flows by the cost of capital.
The cost of capital can also be useful in deciding about the methods of financing at
a point of time.
Performance appraisal
The cost of capital framework can be used to evaluate the financial performance of
top management. Such an evaluation will involve a comparison of actual
profitability of the investment projects undertaken by the firm with the projected
overall cost of capital, and the appraisal of the actual costs incurred by
management in raising the required funds.
The cost of capital also plays a useful role in dividend decision and investment in
current assets.
Cost of capital is used as discount factor in determining the net present value.
Similarly, the actual rate of return of a project is compared with the cost of capital of
the firm. Thus, the cost of capital has a significant role in making investment
decisions.
The proportion of debt and equity is called capital structure. The proportion which
can minimize the cost of capital and maximize the value of the firm is called optimal
capital structure. Cost of capital helps to design the capital structure considering
the cost of each sources of financing, investor's expectation, effect of tax and
potentiality of growth.
3. Evaluating The Performance
Out of the total profit of the firm, a certain portion is paid to shareholders as
dividend. However, the firm can retain all the profit in the business if it has the
opportunity of investing in such projects which can provide higher rate of return in
comparison of cost of capital. On the other hand, all the profit can be distributed as
dividend if the firm has no opportunity investing the profit. Therefore, cost of capital
plays a key role formulating the dividend policy.
Designing the capital structure: The cost of capital is the significant factor in
designing a balanced and optimal capital structure of a firm. While designing it, the
management has to consider the objective of maximizing the value of the firm and
minimizing cost of capital. Comparing the various specific costs of different sources
of capital, the financial manager can select the best and the most economical
source of finance and can designed a sound and balanced capital structure.
Capital budgeting decisions: The cost of capital sources as a very useful tool in
the process of making capital budgeting decisions. Acceptance or rejection of any
investment proposal depends upon the cost of capital. A proposal shall not be
accepted till its rate of return is greater than the cost of capital. In various methods
of discounted cash flows of capital budgeting, cost of capital measured the financial
performance and determines acceptability of all investment proposals by
discounting the cash flows.
Knowledge of firms expected income and inherent risks: Investors can know
the firms expected income and risks inherent there in by cost of capital. If a firms
cost of capital is high, it means the firms present rate of earnings is less, risk is
more and capital structure is imbalanced, in such situations, investors expect higher
rate of return.
In sum, the importance of cost of capital is that it is used to evaluate new project of
company and allows the calculations to be easy so that it has minimum return that
investor expect for providing investment to the company
Capital Budgeting Decisions. Cost of capital may be very much used as the
measuring rod for adopting an investment proposal. Generally, the company has to
choose project based upon the satisfactory return on investment. It measures the
financial performance and also determines acceptability of the project by
discounting cash flows under present value method. Commonly, it is the technique
used to accept or reject the project.
Designing the Optimal Capital Structure. The cost of capital is very much
helpful in formulating firms sound and economic capital structure. An excellent
financial expert keeps an eye on the capital market fluctuations and analyses the
comparative interest rate, and trend of the capital movement. Based upon the
analysis, finance manager comes to correct conclusion and forms a suitable capital
structure of the firm.
Helpful i n the Evaluation of Expansion Projects. With the help of the cost of
capital the financial manager can easily examine the financial possibilities of a
given expansion project. If marginal return on investment exceeds the cost of
financing, the expansion project should be accepted, otherwise it should be
rejected.
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 Decision. Cost of capital may be used as the measuring
road for adopting an investment proposal. The firm, naturally, will choose the
project which gives a satisfactory return on investment which would in no case be
less than the cost of capital incurred for its financing. 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.
(5) Other Areas. The concept of cost of capital is also important in many others
areas of decision making, such as dividend decisions, working capital policy etc.