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Concept:

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.

It is the yardstick to evaluate the worthiness of an investment proposal. In this


sense it may be termed as the minimum rate necessary to attract an investor to
purchase or hold a security. From the viewpoint of economics, it is the investors
opportunity cost of making an investment, i.e. if an investment is made, the
investor must forego the return available on the next best investment.

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.

Introduction Of Cost Of Capital


Investment decision is major decision for an organization. Under investment
decision process, the cost and benefit of prospective projects is analyzed and the
best alternative is selected on the basis of the result of analysis. The benchmark of
computing present value and comparing the profitability of different investment
alternatives is cost of capital. Cost of capital is also known as minimum required
rate of return, weighted average cost of capital, cut off rate, hurdle rate, standard
return etc. Cost of capital is determined on the basis of component cost of financing
and proportion of these sources in capital structure.

Meaning Of Cost Of Capital


Business firms raise the needed fund from internal sources and external sources.
Undistributed and retained profit is the main source of internal fund. External fund is
raised either by the issue of shares or by issue of debenture (debt) or by both
means. The fund collected by any means is not cost free. Interest is to be paid on
the fund obtained as debt and dividend is to be paid on the fund collected through
the issue of shares. The average cost rate of different sources of fund is known as
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.

Cost of Capital EXAMPLE


The difference in return between an investment one makes and another that one
chose not to make. This may occur in securities trading or in other decisions. For
example, if a person has $10,000 to invest and must choose between Stock A and
Stock B, the cost of capital is the difference in their returns. If that person invests
$10,000 in Stock A and receives a 5% return, while Stock B makes a 7% return, the
cost of capital is 2%. One way of conceptualizing the cost of capital is as the
amount of money one could have made by making a different investment decision.
Many companies calculate the cost of capital when deciding whether to issue stock
or a bond, to determine which would be cheaper.

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.

Investors frequently borrow money to make investments, and analysts commonly


make the mistake of equating cost of capital with the interest rate on that money. It
is important to remember that cost of capital is not dependent upon how and where
the capital was raised. Put another way, cost of capital is dependent on the use of
funds, not the source of funds.
Definition of Cost of Capital:

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.

Cost of CapitalPricing the Sources of Fund:

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.

Significance and Relevance of the


Cost of Capital:

Cost of capital is an important area in financial management and is referred to as


the minimum rate, breakeven rate or target rate used for making different
investment and financing decisions. The cost of capital, as an operational criterion,
is related to the firms objective of wealth maximization.

The significance and relevance of cost of capital has been discussed below:

Investment Evaluation:

The primary objective of determining the cost of capital is to evaluate a project.


Various methods used in investment decisions require the cost of capital as the cut-
off rate. Under net present value method, profitability index and benefit-cost ratio
method the cost of capital is used as the discounting rate to determine present
value of cash flows. Similarly a project is accepted if its internal rate of return is
higher than its cost of capital. Hence cost of capital provides a rational mechanism
for making the optimum investment decision.

Designing Debt Policy:

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.

Significant of the Cost of Capital

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:

Evaluating investment decisions.

Designing a firms debt policy.

Appraising the financial performance of top management.

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.

Designing debt policy

The debt policy of a firm is significantly influence by the cost consideration. In


designing the financing policy, that is, the proportion of debt and equity in the
capital structure, the firm aims at maximizing the overall 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.

Significance Of Cost Of Capital


Cost of capital is considered as a standard of comparison for making different
business decisions. Such importance of cost of capital has been presented below.

1. Making Investment Decision

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.

2. Designing Capital structure

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

Cost of capital is the benchmark of evaluating the performance of different


departments. The department is considered the best which can provide the highest
positive net present value to the firm. The activities of different departments are
expanded or dropped out on the basis of their performance.

4. Formulating Dividend Policy

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.

Importance of Cost Of Capital

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. It has such an importance
in financial decision making. It actually used in managerial decision making in
certain field such as-

1) Decision on capital budgeting- It is used to measure the investment proposal


to choose a project which satisfies return on investment.

2) Used in designing corporate financial structure- it is used to design the


market fluctuations and try to achieve the economical capital structure for firm.

3) Top management performance- It evaluates the financial performance of top


executives. It involves the comparison of actual profit of the projects and taken
projects overall cost.
IMPORTANCE
The cost of capital is very important concept in the financial decision making. Cost
of capital is the measurement of the sacrifice made by investors in order to invest
with a view to get a fair return in future on his investments as a reward for the
postponement of his present needs. On the other hand from the point of view of the
firm using the capital, cost of capital is the price paid to the investor for the use of
capital provided by him. Thus, cost of capital is reward for the use of capital. The
progressive management always likes to consider the importance cost of capital
while taking financial decisions as its very relevant in the following spheres:

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.

Comparative study of sources of financing: There are various sources of


financing a project. Out of these, which source should be used at a particular point
of time is to be decided by comparing costs of different sources of financing. The
source which bears the minimum cost of capital would be selected. Although cost of
capital is an important factor in such decisions, but equally important are the
considerations of retaining control and of avoiding risks.
Evaluations of financial performance: Cost of capital can be used to evaluate
the financial performance of the capital projects. Such as evaluations can be done
by comparing actual profitability of the project undertaken with the actual cost of
capital of funds raise to finance the project. If the actual profitability of the project is
more than the actual cost of capital, the performance can be evaluated as
satisfactory.

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.

Financing and Dividend Decisions: The concept of capital can be conveniently


employed as a tool in making other important financial decisions. On the basis,
decisions can be taken regarding dividend policy, capitalization of profits and
selections of sources of working capital.

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.

Deciding about the Method of Financing. An efficient financial manager has a


thorough knowledge of the capital market fluctuation. The ultimate aim of the
financial management is the wealth maximisation. In order to achieve these
objectives, the financial manager finds the financing sources. Apart from these,
comparing the specific cost of different sources of fmance, the finance manager can
select the most economical source of finance in a particular situation.

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.

Importance of Cost of Capital in


Decision Making
The concept of cost of capital is a very important concept in financial management
decision making. The concept, is however, a recent development and has relevance
in almost every financial decision making but prior to that development, 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 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.

(2) Designing the Corporate Financial Structure. The cost of capital is


significant in designing the firm's capital structure. The cost of capital is influenced
by the chances in capital structure. A capable financial executive always keeps an
eye on capital market fluctuations and tries to achieve the sound and economical
capital structure for the firm. He may try to substitute the various methods of
finance in an attempt to minimise the cost of capital so as to increase the market
price and the earning per share.
(3) Deciding about the Method of Financing. A capable financial executive
must have knowledge of the fluctuations in the capital market and should analyse
the rate of interest on loans and normal dividend rates in the market from time to
time. Whenever company requires additional finance, he may ave a better choice of
the source of finance which bears the minimum cost of capital. Although cost of
capital is an important factor in such decisions, but equally important are the
considerations of relating control and of avoiding risk.

(4) Performance of Top Management. The cost of capital can be used to


evaluate the financial performance of the top executives. Evaluation of the financial
performance will involve a comparison of actual profitabilities of the projects and
taken with the projected overall cost of capital and an appraisal of the actual cost
incurred in raising the required funds.

(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.