Cost of Capital Its Features and Significance
Introduction
The primary function of every financial manager is to arrange for adequate capital for the firm. A business firm can raise capital from various sources such as equity and or preference shares, debentures, retained earnings etc.
Company invests these capital in different projects of the firm for generating revenue. On the other hand, it is necessary for the firm to pay minimum rate of return on each source of capital. To pay minimum return to these sources or suppliers of capital each project must earn sufficient income paid. “Cost of Capital” is The concept of determining this minimum capital. The management evaluates various alternative sources of finance on this basis and selects the best one.
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 firm’s overall object of wealth maximization. Cost of capital is a complex, controversial but significant concept in financial management.
Definitions of Cost of Capital
“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”. – Hampton J.
“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”. – James C. Van Horn
“Cost of Capital is the minimum required rate of earnings or the cut off rate of capital expenditure”. – Soloman Ezra.
From the above definitions it is clear that the cost of capital is the minimum rate of return which a firm must earn on its investments, so that the market value of its share can be maintained.
FEATURES OF COST OF CAPITAL
- Not a cost as such:
The cost of capital is not a cost as such, it is the minimum rate of return that firm requires to earn from its projects. That is why, it is also known as “hurdle rate”. - It is the minimum rate of return:
A firm’s cost of capital is that minimum rate of return which will at least maintain the market value of the share. - It comprises three components: K=r0+b+f
- Where,
- k represents the overall Cost of Capital.
- r0 is the Return at zero risk level, also known as the Risk Free Rate of Return. This is the baseline/minimum return required for an investment with no risk.
- b is the Premium for business risk, which accounts for the variability in operating profit (EBIT) due to changes in sales. and
- f is the Premium for financial risk, which is related to the pattern of the company’s capital structure (how it uses debt and equity financing).
SIGNIFICANCE OF COST OF CAPITAL
The cost of capital helps management to consider minimum level of earnings which must be maintain for the survival of the company. It is very important in financial management and plays a crucial role in the following areas:
I) CAPITAL BUDGETING DECISIONS
The firm uses cost of capital for discounting cash flows under Net Present Value method for investment proposals. The 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 its cost of capital. So, it is very useful in capital budgeting decisions.
II) CAPITAL STRUCTURE DECISIONS
The cost of capital is a significant factor in designing a balanced capital structure of a firm. Financial managers consider the capital structure optimum when the firm’s value is at its maximum and the cost of capital is at its minimum. So, cost of capital is crucial in designing optimal capital structure.
III) EVALUATION OF FINANCIAL PERFORMANCE
Cost of capital is useful for evaluating the financial performance of top management. Analysts compare actual profitability to the expected and actual cost of capital; they deem performance satisfactory if profit is greater than the cost.
IV) COMPARATIVE STUDY OF SOURCES OF FINANCING
One can finance projects from various sources of finance. Out of these, which sources of finance should be used at a particular point of time is decided by comparing the cost of capital of various sources. Analyst selects sources in which cost of capital is minimum.
V) EXPECTED RETURN AND RISK
Investors can know the firms expected income and inherent risk by cost of capital. If the cost of capital of firm is high, it shows the firms present rate of earnings is less. There is more risk and capital structure is imbalanced too. In such situations, investors avoids investing in that firms and vice versa.
VI) Financing and Dividend Decisions
The concept of the cost of capital is a useful tool for making other important financial decisions. Based on this concept, companies can make determinations regarding their dividend policy, how they handle the capitalization of profits, and the selection of sources for their working capital.
CLASSIFICATION OF COST OF CAPITAL
- Historical Cost and Future Cost:
Historical costs are defined as past, recorded expenses found in accounting books. In contrast, future costs are estimations that help guide future financial planning and projections. - Specific Costs and Composite Costs:
A specific cost is the expense associated with a single, particular source of capital. The composite cost, known as the weighted average cost of capital (WACC), represents the combined cost from various capital sources. WACC is a crucial metric for making capital budgeting and investment decisions. - 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. Implicit cost also known as the opportunity cost is of the next best opportunity foregone in order to take up a particular project. For example, the implicit cost of retained earnings is the rate of return available to shareholders by investing the funds elsewhere. - Average Cost and Marginal Cost:
An average cost represents the total cost or the weighted mean cost of different capital sources. Marginal cost relates to the mean cost of obtaining new or extra capital needed by a business. The marginal cost is the figure that ought to be factored into investment choices.