INTRODUCTION
Cost of capital is an integral part of investment decision as it is used to measure the worth
of investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance manager must take
careful decision with regard to the cost of capital; because it is closely associated with the
value of the firm and the earning capacity of the firm.
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to
maintain its market value and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity,
debt and retained earnings. If a firm fails to earn return at the expected rate, the market
value of the shares will fall and it will result in the reduction of overall wealth of the
shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and
concept of the cost of capital.
According to the definition of John J. Hampton “ Cost of capital is the rate of return
the firm required from investment in order to increase the value of the firm in the market
place”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required
rate of earnings or the cut-off rate of capital expenditure”.
66 Financial Management
According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for
the allocation of capital to investment of projects. It is the rate of return on a project that
will leave unchanged the market price of the stock”.
According to the definition of William and Donaldson, “Cost of capital may be defined
as the rate that must be earned on the net proceeds to provide the cost elements of the
burden at the time they are due”.
Assumption of Cost of Capital
Cost of capital is based on certain assumptions which are closely associated while calculating
and measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consis of three important risks such as zero risk level, business risk and financial risk.
Cost of capital can be measured with the help of the following equation.
K = rj + b + f.
Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
CLASSIFICATION OF COST OF CAPITAL
Cost of capital may be classified into the following types on the basis of nature and usage:
• Explicit and Implicit Cost.
• Average and Marginal Cost.
• Historical and Future Cost.
• Specific and Combined Cost.
Explicit and Implicit Cost
The cost of capital may be explicit or implicit cost on the basis of the computation of cost
of capital.
Explicit cost is the rate that the firm pays to procure financing. This may be calculated
with the help of the following equation;
CIo =
= + Σn
t
t
t 1
CO
(t C)
Where,
CIo = initial cash inflow
C = outflow in the period concerned
Cost of Captial 67
N = duration for which the funds are provided
T = tax rate
Implicit cost is the rate of return associated with the best investment opportunity for
the firm and its shareholders that will be forgone if the projects presently under
consideration by the firm were accepted.
Average and Marginal Cost
Average cost of capital is the weighted average cost of each component of capital employed
by the company. It considers weighted average cost of all kinds of financing such as equity,
debt, retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is
the additional cost of capital when the company goes for further raising of finance.
Historical and Future Cost
Historical cost is the cost which as already been incurred for financing a particular project.
It is based on the actual cost incurred in the previous project.
Future cost is the expected cost of financing in the proposed project. Expected cost is
calculated on the basis of previous experience.
Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained earnings and loans is
called as specific cost of capital. It is very useful to determine the each and every specific
source of capital.
The composite or combined cost of capital is the combination of all sources of capital.
It is also called as overall cost of capital. It is used to understand the total cost associated
with the total finance of the firm.
IMPORTANCE OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to
decide the capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to
net present value method, present value of cash inflow must be more than the present
value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities.
A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital
helps to take decision regarding structure.
68 Financial Management
Importance to Evolution of Financial Performance
Cost of capital is one of the important determine which affects the capital budgeting, capital
structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market
value of share, earning capacity of securities etc. hence, it plays a major part in the financial
management.
COMPUTATION OF COST OF CAPITAL
Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Cost of Capital
It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return
that a firm must earn on the equity financed portion of an investment project in order to
leave unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.
Dividend Price Approach
The cost of equity capital will be that rate of expected dividend which will maintain the
present market price of equity shares.
Dividend price approach can be measured with the help of the following formula:
epDK =N
Cost of Captial 69
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Cost of capital is an integral part of investment decision as it is used to measure the worth
of investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance manager must take
careful decision with regard to the cost of capital; because it is closely associated with the
value of the firm and the earning capacity of the firm.
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to
maintain its market value and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity,
debt and retained earnings. If a firm fails to earn return at the expected rate, the market
value of the shares will fall and it will result in the reduction of overall wealth of the
shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and
concept of the cost of capital.
According to the definition of John J. Hampton “ Cost of capital is the rate of return
the firm required from investment in order to increase the value of the firm in the market
place”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required
rate of earnings or the cut-off rate of capital expenditure”.
66 Financial Management
According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for
the allocation of capital to investment of projects. It is the rate of return on a project that
will leave unchanged the market price of the stock”.
According to the definition of William and Donaldson, “Cost of capital may be defined
as the rate that must be earned on the net proceeds to provide the cost elements of the
burden at the time they are due”.
Assumption of Cost of Capital
Cost of capital is based on certain assumptions which are closely associated while calculating
and measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consis of three important risks such as zero risk level, business risk and financial risk.
Cost of capital can be measured with the help of the following equation.
K = rj + b + f.
Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
CLASSIFICATION OF COST OF CAPITAL
Cost of capital may be classified into the following types on the basis of nature and usage:
• Explicit and Implicit Cost.
• Average and Marginal Cost.
• Historical and Future Cost.
• Specific and Combined Cost.
Explicit and Implicit Cost
The cost of capital may be explicit or implicit cost on the basis of the computation of cost
of capital.
Explicit cost is the rate that the firm pays to procure financing. This may be calculated
with the help of the following equation;
CIo =
= + Σn
t
t
t 1
CO
(t C)
Where,
CIo = initial cash inflow
C = outflow in the period concerned
Cost of Captial 67
N = duration for which the funds are provided
T = tax rate
Implicit cost is the rate of return associated with the best investment opportunity for
the firm and its shareholders that will be forgone if the projects presently under
consideration by the firm were accepted.
Average and Marginal Cost
Average cost of capital is the weighted average cost of each component of capital employed
by the company. It considers weighted average cost of all kinds of financing such as equity,
debt, retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is
the additional cost of capital when the company goes for further raising of finance.
Historical and Future Cost
Historical cost is the cost which as already been incurred for financing a particular project.
It is based on the actual cost incurred in the previous project.
Future cost is the expected cost of financing in the proposed project. Expected cost is
calculated on the basis of previous experience.
Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained earnings and loans is
called as specific cost of capital. It is very useful to determine the each and every specific
source of capital.
The composite or combined cost of capital is the combination of all sources of capital.
It is also called as overall cost of capital. It is used to understand the total cost associated
with the total finance of the firm.
IMPORTANCE OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to
decide the capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to
net present value method, present value of cash inflow must be more than the present
value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities.
A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital
helps to take decision regarding structure.
68 Financial Management
Importance to Evolution of Financial Performance
Cost of capital is one of the important determine which affects the capital budgeting, capital
structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market
value of share, earning capacity of securities etc. hence, it plays a major part in the financial
management.
COMPUTATION OF COST OF CAPITAL
Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Cost of Capital
It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return
that a firm must earn on the equity financed portion of an investment project in order to
leave unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.
Dividend Price Approach
The cost of equity capital will be that rate of expected dividend which will maintain the
present market price of equity shares.
Dividend price approach can be measured with the help of the following formula:
epDK =N
Cost of Captial 69
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
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