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COST OF CAPITAL

Q1. Define cost of capital? Explain its significance in financial decision-making.

A1 The project's cost of capital is the minimum required rate of return on funds committedto the project, which depends on the riskiness of its cash flows. The firm's cost of capital will be

the overall, or average, required rate of return on the aggregate of investment projects It is a

concept of vital importance in the financial decision-making. It is useful as a standard for:

evaluating investment decisions, designing a firm's debt policy, and appraising the financial

performance of top management

Q2. What are the various concepts of cost of capital? Why should they be distinguished in

financial management?

A2 The opportunity cost is the rate of return foregone on the next best alternative investmentopportunity of comparable risk. Thus, the required rate of return on an investment project is an

opportunity cost.

In an all-equity financed firm, the equity capital of ordinary shareholders is the only source to

finance investment projects, the firm's cost of capital is equal to the opportunity cost of equity

capital, which will depend only on the business risk of the firm Viewed from all investors' point

of view, the firm's cost of capital is the rate of return required by them for supplying capital for

financing the firm's investment projects by purchasing various securities. It may be emphasised

that the rate of return required by all investors will be an overall rate of return - a weighted

rate of return. Thus, the firm's cost of capital is the 'average' of the opportunity costs (or

required rates of return) of various securities, which have claims on the firm's assets. This rate

reflects both the business (operating) risk and the financial risk resulting from debt capital.

Q4. 'The equity capital is cost free.' Do you agree? Give reasons.

A4 :-It is sometimes argued that the equity capital is free of cost. The reason for such argument

is that it is not legally binding for firms to pay dividends to ordinary shareholders. Further,

unlike the interest rate or preference dividend rate, the equity dividend rate is not fixed. It is

fallacious to assume equity capital to be free of cost. Equity capital involves an opportunity

cost. Ordinary shareholders supply funds to the firm in the expectation of dividends and capital

gains commensurate with their risk of investment. The market value of the shares, determined

by the demand and supply forces in a well functioning capital market, reflects the returnrequired by ordinary shareholders. Thus, the shareholders' required rate of return, which

equates the present value of the expected benefits with the current market value of the share,

is the cost of equity.

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Q5. Are retained earnings less expensive than the new issue of ordinary shares? Give your

views.

A5 The cost of external equity is greater than the cost of internal equity for one reason. The

selling price of the new shares may be less than the market price. In India, the new issues of

ordinary shares are generally sold at a price less than the market price prevailing at the time ofthe announcement of the share issue.

Q6. 'Debt is the cheapest source of funds.' Explain.

A6 Debt and equity are the two main sources of funds. Debt is cheap because of two prime

reasons:

Risk of the lenders is less as compared to equity holders so cost of debt is less,

Interest paid on debt is tax deductible.

Q7. How is the weighted average cost of capital calculated? What weights should be

used in its calculation?

A7 The following steps are involved for calculating the firm's WACC:

Calculate the cost of specific sources of funds Multiply the cost of each source by its proportion

in the capital structure. Add the weighted component costs to get the WACC.

In financial decision-making, the cost of capital should be calculated on an after tax basis.

Therefore, the component costs should be the after-tax costs.

Summary

Capital structure is the proportion of debt and preference and equity shares on a firms

balance sheet.

Optimum capital structure is the capital structure at which the weighted average cost of

capital is minimum and thereby maximum value of the firm.

Explicit cost is the rate of interest paid on debt.