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 viewpoints—acquisition 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.
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 company’s equity shareholders does not fall.
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 investor’s 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 investor’s 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.
- Investment Evaluation
- Designing Debt Policy
- Performance Appraisal
- Determining Component Cost of Capital
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 NPV method, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting its cash flows by the cost of capital. In this sense, ·the cost of capital is the discount rate used for evaluating the desirability of the investment project. In the IRR method, the investment project is accepted if it has an internal rate of return greater than the cost of capital. In this context, the cost of capital is the minimum required rate of return on the investment project. It is also known as the cutoff, or the target, or the hurdle rate.
An investment project that provides a positive NPV when its cash flows are discounted by the cost of capital makes a net contribution to the wealth of shareholders. If the project has zero NPV, it means that its cash flows have yielded a return just equal to the cost of capital, and the acceptance or rejection of the project will not affect the wealth of share-holders. The cost of capital is the minimum required rate of return on the investment project that keeps the present wealth of shareholders unchanged. It may be thus noted that the cost of capital represents a financial standard for allocating the firm’s funds, supplied by owners and creditors, to the various investment projects in the most efficient manner.
Designing Debt Policy
The debt policy of a firm is significantly influenced 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 minimizing 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. For example, cost may be com-pared in choosing between leasing and borrowing. Of course, equally important considerations are control and risk.
Performance Appraisal
Further, 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 profit abilities 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.\
Determining Component Cost of Capital
In the following pages you will know, the methods of computing the component costs of three major sources of capital: debt, preference shares and equity shares. Generally, the component cost of a specific source of capital is equal to the investors’ required rate of return. But the investors’ required rate of return should be adjusted for taxes in practice for calculating the cost of a specific source of capital to the firm. In Appraising the financial performance of top management. The investment analysis, net cash flows are computed on after-tax basis. Therefore, the component costs, used to determine the discount rate should also be expressed on an after-tax basis.
