Importance / Significance of cost of capital

1. Used in capital budgeting decisions: it serves as a yard stick against which the viability of an investment can be
measured. If an investment has a return less than the cost of capital, it is not viable.
2. Used as a discounting rate in evaluating capital budgeting decisions.
3. Used in capital structure decisions: an optimum capital structure is the one that results to the lowest overall cost
of capital.
4. Used in evaluating the managements decisions: the actual profitability of projects undertaken by the
management is compared with the overall cost of capital of the company. The management is assumed to be
efficient if the return from the project undertaken are higher than the companys cost of capital
5. Used in dividend policy decisions: a company with higher cost of capital will prefer to retain most of their
profits in terms of retained earnings which results in low dividend pay-out ratio.
6. Its a measure of the companys ability to raise additional financing. A company with high cost of capital is
assumed to be risky by investors hence will not supply funds to the firm.
Factors affecting the cost of capital
1. Period of financing: short term financing is associated with high cost of obtaining finances hence high cost of
capital. A company financed by long term funds is likely to have low cost of capital.
2. Age of the company / growth stage: young enterprises which are not well established are deemed risky hence
they will be charged high interest for the funds obtained which increases the cost of capital.
3. Economic conditions: when inflation rates are high, the cost of capital will be high.
4. Risk level of the project: companies venturing into risky projects will have high cost of capital to compensate
the providers of funds in case of failure of such projects.
5. Size of the business: small micro enterprises do not have established structures hence they obtain funds at high
costs. A well-established company will obtain funds at low cost due to the confidence the providers of funds
have in the company.
6. Availability of finance: where the providers of funds are few and the users of funds are many, the cost of
obtaining finance will be high and vice versa.
7. Taxation effects: debt financing is relatively cheaper than equity finance because interest is tax allowable while
dividend is not.
Limitations of market weights
(i) The market prices of securities keeps on changing from time to time hence the average weighted cost of capital
computed at a particular point in time is not relevant under different conditions at different periods.
(ii) Where the market values are over / under stated, the weighted cost of capital will not be accurate.
Limitations of weighted average cost of capital (WACC)
(a) Its historical its the cost of funds already committed by the company. It shows the cost of funds which were
obtained in the past, hence doesnt reflect the future cost of raising additional funds to finance future projects.
(b) It assumes as constant dividend growth rate which doesnt hold in practice.
(c) It assumes an optimum capital structure which is constant. However, capital structure composition changes over
time in practice.
(d) It assumes constant risk level of the companys projects. However, the risk level keeps changing, in practice.
(e) Its not applicable where there are complex changes in capital structure e.g. a company obtaining subsidized
loan.
(f) Its not relevant where the firm is operating in a complex tax regime.
(g) It assumes the cost of equity is more than the growth rate in dividend.
An optimum capital structure shows the various sources of funds obtained at the lowest cost hence it result into the
lowest WACC
Similarities of WACC and MCC
-

The computation of specific cost is the same

They are both weighted costs of capital

Differences between WACC and MCC

WACC

MCC

Historical shows the cost of committed funds

Cost of raising additional funds

Uses book weights or market weights

Uses marginal weights

Assumes constant risk levels of various projects

Realistic considers the aspects of changing risk of

various projects.