Cost of Capital

Concept of Cost of Capital

 Cost of Capital may be defined according to the following two terms:

 (a) Under operational terms and
 (b) Under economic terms.
 Under operational terms, it is defined as the minimum rate of return which a firm must earn on its
investment, i.e., it refers to the discount rate which is used while determining the present value of
estimated future cash flows. But, under economic terms, however, there are two formulations.
 First, it is the cost of raising funds required in order to finance the proposed project, i.e., it is the
borrowing rate of the firm. Secondly, it refers to the opportunity cost of the funds, in terms of the
lending rate, i.e., the expected earnings by investing funds outside.
 Here, we prefer to use the term “Cost of Capital” as a borrowing rate since it is impracticable on
the part of the firm which is going to take any capital budgeting decisions to invert outside. Thus,
this approach is very much realistic as well as practicable. Of course, under economic terms, the
cost of capital is defined as the weighted average cost of each type of capital.
Relevance, Significance and Importance
of Cost of Capital
 The cost of capital is the most significant concept in capital budgeting decisions since it is
used as a decision criterion. Under DCF techniques, if NPV method is followed as a
decision criterion, the cost of capital is used as a discount rate in evaluating the desirability
of the projects in order to calculate the NPV and if there is a positive (+) NPV the project
will be accepted and vice-versa.
 Similarly, if IRR method is adopted, the computed IRR is compared with the cost of capital,
i.e., if the project has a greater/higher rate of return (IRR) in comparison with the cost of
capital, the same will be accepted and vice-versa. At the same time, Profitability Index (B.
C. Ratio.) may be applied for the purpose while determining the present value of future
cash flows.
 Thus, it plays a significant role in investment decisions and supplies a yardstick to measure
the value of investment proposals. In short, it is referred to as the minimum required rate of
return, cut-off rate, hurdle or target rate, standard return etc., which implies the crucial
significance of the same.
 In this context, the accept-reject rules desire that if the rate of return is higher than
the cost of capital, a firm may undertake such investment opportunities.
 On the contrary, if the rate of return is lower than the cost of capital the firm is
advised not to undertake such investment proposals. In other words, if a project is
accepted which will yield a higher return than the cost of capital, the same will
increase the prices of shares along with the shareholders’ wealth and in the
opposite case, the prices of the shares will go down, i.e., shareholders’ wealth will
decline.
 Thus, the cost of capital presents a rational technique for the purpose of making
the optimum investment decisions.
it is important from the standpoint of both capital budgeting and
capital structure planning decisions which are:

 (i) Capital budgeting decisions:

 It has already been explained earlier that cost of capital is used as a discount rate and in order to find
out the present value, the firms’ cash flows are discounted by the rate, i.e., it is the most significant
basis for financial appraisal of the new capital expenditure decision.
 (ii) Capital structure decisions:
 The most of capital is, no doubt, an important consideration in designing the firm’s capital structure.
At the time of raising finance from different sources, the firm should optimize the risk and cost
factors. Needless to mention that the sources of funds which are less costly involve greater degree of
risk.
 Therefore, a firm should always aim at minimising the cost of capital and maximizing the market
value after con­sidering the risk factors.
 Moreover, the framework of cost of capital can be applied in order to evaluate financial performance
of top management. This evaluation depends on a comparison between the actual profitability of the
projects that are undertaken and the overall cost of capital including the cost of raising funds.
Aspects of Cost of Capital:

 There are three basic aspects about the concept of cost which are:
 (i) It is not a cost as such:
 Practically, the cost of capital of a firm is the rate of return which it requires on
the projects. That is why, it is a ‘hurdle’ rate. Although such rate may be computed
on the basis of actual cost of different components of capital.
 The term ‘component’ means the different sources from which funds are actually
raised since each sources of fund or each component of capital has its own cost,
e.g., equity capital has a cost followed by preference share capital and so on.
 (ii) It is the minimum rate of return:
 Cost of capital represents the minimum rate of return (already stated above) which is
required in order to maintain the market value of equity shares.
 (iii) It includes the following components:
 (a) The riskless cost of the particular type of financing or return at zero risk level,:
 It relates to the expected rate of return when a project involves no risk whether business or
financial, i.e., the firm’s business and financial risk are unaffected by the acceptance and
financing of the project.
 (b) The business risk premium, b; :
 Business risk measures the variability in operating profit (Earnings before interest and
taxes) as a result of changing sales. If the project which is accepted is found to be more
risky than the average or normal, the supplier of funds naturally, will expect a higher rate
of return than the normal or average rate, i.e., the cost of capital, in that case, will go up.
 Therefore, the business risk premium is deter­mined by the capital budgeting decisions for
investment proposals.
 (c) The financial risk premium, f; :
 Financial risk depends on the capital structure pattern of the firm, i.e., debt-equity mix. Because, if a firm
has higher debt-content (debt-equity ratio) in its capital structure in comparison with a firm where the said
content is low, the same is more risky simply because, the former must have a higher operating profit in
order to cover the periodic interest payment and repayment of principal at the time of maturity as well.
 In other words, possibility of cash insolvency exists in case of such firms. As a result, the suppliers will
expect a higher rate of return from such firm for carrying a higher degree of risk as compared to latter.
 Thus, the above three components of cost of capital may be written in the form of the following
equation:
 K0 =ro + b + f
 where,
 K0 = Cost of Capital;
 Ro = Return at zero risk level;
 b = Premium for business risk;
 f = Premium for financial risk.
 It should be noted that the business and financial risks are assumed to be constant, and, as such, the
changing cost of each type of capital over time should be affected by the demand and supply of each type
of funds as well.