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The concept of cost of capital

The term cost of capital refers to the minimum rate of return a firm must earn on its investments.
This is in consonance with the firms overall object of wealth maximization. Cost of capital is a
complex, controversial but significant concept in financial management.
The following definitions give clarity management.
Hamption J.: The cost of capital may be defined as the rate of return the firm requires from
investment in order to increase the value of the firm in the market place.
James C. Van Horne: The cost of capital is a cut-off rate for the allocation of capital to investments
of projects. It is the rate of return on a project that will leave unchanged the market price of the
stock.
Solomon Ezra:Cost of Capital is the minimum required rate of earnings or the cut-off rate of capital
expenditure.
It is clear from the above definitions that the cast of capital is that minimum rate of return which a
firm is expected to earn on its investments so that the market value of its share is maintained. We
can also conclude from the above definitions that there are three basic aspects of the concept of
cost of capital:
1) Not a cost as such: In fast the cost of capital is not a cost as such, it is the rate of return that
a firm requires to earn from its projects.
2) It is the minimum rate of return: A firms cost of capital is that minimum rate of return
which will at least maintain the market value of the share.
3) It comprises three components:
K= ro+b+f
Where, k=cost of capital;
ro= return at zero risk level:
b = premium for business risk, which refers to the variability in operating profit (EBIT) due to
change in sales.
f = premium for financial risk which is related to the pattern of capital structure.
IMPORTANCE OF COST OF CAPITAL:
The cost of capital is very important in financial management and plays a crucial role in the
following areas:
1) Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net
Present Value method for investment proposals. So, it is very useful in capital budgeting
decisions.
2) Capital structure decisions: An optimal capital is that structure at which the value of the
firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing
optimal capital structure.
3) Evaluation of final Performance: Cost of capital is used to evaluate the financial
performance of top management. The actual profitably is compared to the expected and
actual cost of capital of funds and if profit is greater than the cast of capital the
performance nay be said to be satisfactory.
4) Other financial decisions: Cost of capital is also useful in making such other financial
decisions as dividend policy, capitalization of profits, making the rights issue etc.
CLASSIFICATION OF COST OF CAPITAL:
Cost of capital can be classified as follows:
1) Historical Cost and future Cost: Historical costs are book costs relating to the past, while
future costs are estimated costs act as guide for estimation of future costs.
2) Specific Costs and Composite Costs: Specific accost is the cost if a specific source of capital,
while composite cost is combined cost of various sources of capital. Composite cost, also
known as the weighted average cost of capital, should be considered in capital and capital
budgeting decisions.
3) Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which
equates the present value of cash inflows with the present value of cash outflows. It is the
internal rate of return and is calculated with the following formula.

Implicit cost also known as the opportunity cost is of the opportunity foregone in order to
take up a particular project. For example, the implicit cast of retained earnings is the rate of
return available to shareholders by investing the funds elsewhere.
4) Average Cost and Marginal Cost: An average cost is the combined cost or weighted average
cost of various sources of capital. Marginal cost of refers to the average cost of capital of
new or additional funds required by a firm. It is the marginal cost which should be taken
into consideration in investment decisions.

DETERMINATION OF CAST OF CAPITAL:
It has already been stated that the cost of capital is one of the most crucial factors in most financial
management decisions. However, the determination of the cost of capital of a firm is not an easy
task. The finance manager is confronted with a large number of problems, both conceptual and
practical, while determining the cost of capital of a firm. These problems can briefly be summarized
as follows:
1. Controversy regarding the dependence of cost of capital upon the method and level of
financing: There is a, major controversy whether or not the cost of capital dependent upon
the method and level of financing by the company. According to the traditional theorists,
the cost of capital of a firm depends upon the method and level of financing. In other words,
according to them, a firm can change its overall cost of capital by changing its debt-equity
mix. On the other hand, the modern theorists such as Modigliani and Miller argue that the
firm's total cost of capital is independent of the method and level of financing. In other
words, the change in the debt-equity ratio does not affect the total cost of capital. An
important assumption underlying MM approach is that there is perfect capital market. Since
perfect capital market does not exist in practice, hence the approach is not of much
practical utility.

2. Computation of cost of equity: The determination of the cost of equity capital is another
problem. In theory, the cost of equity capital may be defined as the minimum rate of return
that accompany must earn on that portion of its capital employed, which is financed by
equity capital so that the market price of the shares of the company remains unchanged. In
other words, it is the rate of return which the equity shareholders expect from the shares of
the company which will maintain the present market price of the equity shares of the
company. This means that determination of the cost of equity capital will require
quantification of the expectations of the equity shareholders. This is a difficult task because
the equity shareholders value the equity shares of accompany on the basis of a large
number of factors, financial as well as psychological. Different authorities have tried in
different ways to quantify the expectations of the equity shareholders. Their methods and
calculations differ.

3. Computation of cost of retained earnings and depreciation funds: The cost of capital raised
through these sources will depend upon the approach adopted for computing the cost of
equity capital. Since there are different views, therefore, a finance manager has to face
difficult task in subscribing and selecting an appropriate approach.


4. Future costs versus historical costs: It is argued that for decision-making purposes, the
historical cost is not relevant. The future costs should be considered. It, therefore, creates
another problem whether to consider marginal cost of capital, i.e., cost of additional funds
or the average cost of capital, i.e., the cost of total funds.

5. Problem of weights: The assignment of weights to each type of funds is a complex issue.
The finance manager has to make a choice between the risk value of each source of funds
and the market value of each source of funds. The results would be different in each case. It
is clear from the above discussion that it is difficult to calculate the cost of capital with
precision. It can never be a single given figure. At the most it can be estimated with a
reasonable range of accuracy. Since the cost of capital is an important factor affecting
managerial decisions, it is imperative for the finance manager to identify the range within
which his cost of capital lies. Computation of weighted average cost of capital.

COMPUTATION OF COST OF CAPITAL:
Computation of cost capital of a firm involves the following steps:
1. Computation of cost of specific sources of a capital, viz., debt, preference capital, equity and
retained earnings, and

a) Cost of debt: A company may raise debt in a variety of ways. It may borrow funds from
financial institutions or public either in the form of public deposits or debentures for a
specified period of time at a certain rate of interest. A debenture or bond may be issued at
par or at a discount or premium. The contractual rate of interest forms the basis for the
calculating the cost of any form of debt
b) Cost of preference capital: The cost of preference capital is a function of the dividend
expected by investors. Preference capital is never issued with an intention not to pay
dividends. Although it is legally binding upon the firms to pay the dividends on preference
capital, yet it is generally paid when the firm makes sufficient profits. The failure to pay
dividends, although doesnt cause bankruptcy, yet it can be a serious matter from the
ordinary shareholders point of view. It will affect the fund raising capacity of the firm.
Hence, dividends are usually paid regularly on preference shares except when there are no
profits to pay dividends
c) Cost of equity capital : The cost of equity is the maximum rate of return that the company
must earn on equity financed portion of its investment in order to leave unchanged the
market price of its stock. The cost of equity capital is a function of the expected return by its
investors. The cost of equity is not the out-of-pocket cost of using equity capital as the
equity shareholders are not paid dividend at a fixed rate every year. Shareholders invest
money in equity shares on the expectations of getting dividend and the company must earn
this minimum rate so that the market price of the shares remains unchanged. Whenever
company wants to raise additional funds by the issue of new equity shares, the expectations
of the shareholders have to be evaluated.
d) Cost of retained earnings: It is sometimes argued that retained earnings do not involve any
cost because a firm is not required to pay dividends on retained earnings. However, the
shareholders expect the return on retained profits. The cost of retained earnings may be
considered as the rate of return which the existing shareholders can obtain by investing the
after tax dividends in the alternative opportunities of equal qualities. It is thus opportunity
cost of dividends foregone by the shareholders.

2. Computation of weighted average cost of capital.
Weighted average cost of capital: Weighted average cost of capital is the average cost of
capital of various sources of financing. Wt average cost of capital is also known as composite
cost of capital, overall cost of capital or average cost of capital. Once the specific cost of
individual source of finance its determined, we can compute the wt average cost of capital
by putting weights to the specific costs of capital in proportion of the various sources of
funds to the total. The weights may be giving either by using book value of the source or
market price of the source. The market value weights are preferred to book value weighs
because market value represents true value of the investors. However, the market value
weights suffer from the following limitations:
I. It is very difficult to determine market value because of frequent fluctuation
II. With the use of market value weights, equity capital gets greater importance.

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