Cost of Capital Cost of Capital

Meaning Meaning

Significance Significance

Classification of costs Classification of costs

Determination of cost of Determination of cost of capital capital

Computation of Cost of Computation of Cost of CapitalCapital

Meaning Meaning

The COC of a firm is the minimum rate of The COC of a firm is the minimum rate of return expected by its investors. It is return expected by its investors. It is the weighted average cost of various the weighted average cost of various sources of finance used by a firm. sources of finance used by a firm.

“ “ A Cut off rate for the allocation of A Cut off rate for the allocation of capital to investments of projects. It is capital to investments of projects. It is the rate of return on a project that will the rate of return on a project that will leave unchanged the market price of leave unchanged the market price of the stock”.-James C Van Hornethe stock”.-James C Van Horne

Basic aspects of the Basic aspects of the definitiondefinition

Cost of Capital is not a cost as such-it is the Cost of Capital is not a cost as such-it is the rate of return firm needs to earn from its rate of return firm needs to earn from its project project

It is the minimum rate of return- which will at It is the minimum rate of return- which will at least maintain the market value of sharesleast maintain the market value of shares

It comprises of three components- It comprises of three components-

The expected normal rate of return at zero-level The expected normal rate of return at zero-level riskrisk

Premium for Finance risk Premium for Finance risk

Premium for Business risk (K=rPremium for Business risk (K=roo+ b +f)+ b +f)

Significance of the cost of capitalSignificance of the cost of capital As an Acceptance criterion in Capital Budgeting – As an Acceptance criterion in Capital Budgeting –

the acceptance or rejection of the project is the acceptance or rejection of the project is decided by taking into consideration the cost of decided by taking into consideration the cost of capitalcapital

As a determinant of capital mix in capital structure As a determinant of capital mix in capital structure decision- the objective of maximising the value of decision- the objective of maximising the value of the firm and minimizing the cost of capital results the firm and minimizing the cost of capital results in optimal capital structurein optimal capital structure

As a basis for evaluating the financial As a basis for evaluating the financial performance- the profitability is compared to performance- the profitability is compared to projected overall cost of capital and the actual cost projected overall cost of capital and the actual cost of capital of funds raised to finance the project. of capital of funds raised to finance the project.

As a basis for taking other financial decisions- Like As a basis for taking other financial decisions- Like Dividend policy, capitalisation of profits, making Dividend policy, capitalisation of profits, making the rights issue, working capital.the rights issue, working capital.

Classification of cost Classification of cost Historical and future cost: HC are Book cost Historical and future cost: HC are Book cost

related to past. Future cost are the estimated related to past. Future cost are the estimated cost related to the future. cost related to the future.

Specific and composite cost: SC refers to cost of Specific and composite cost: SC refers to cost of a specific source of capital, while composite cost a specific source of capital, while composite cost is combined cost of various sources of capital. It is combined cost of various sources of capital. It is the WACC, in case of more than one form of is the WACC, in case of more than one form of source of capital composite cost is resorted to source of capital composite cost is resorted to

Explicit cost and implicit cost: EC is the discount Explicit cost and implicit cost: EC is the discount rate which equates the PV of cash inflows in rate which equates the PV of cash inflows in other words, it is IRR. Implicit cost is also known other words, it is IRR. Implicit cost is also known as opportunity cost, it is the cost foregone in as opportunity cost, it is the cost foregone in order to take up a particular project. order to take up a particular project.

Average cost and marginal cost: AC is the Average cost and marginal cost: AC is the combined cost of various sources of capital, MC combined cost of various sources of capital, MC is the average cost of capital which has to be is the average cost of capital which has to be incurred to obtain additional funds required by incurred to obtain additional funds required by the firm.the firm.

Problems in determination of COCProblems in determination of COC Conceptual controversies regarding the relationship Conceptual controversies regarding the relationship

between the cost of capital and the capital between the cost of capital and the capital structure: few are of the opinion that a firm can structure: few are of the opinion that a firm can minimise the WACC and increase the value of the minimise the WACC and increase the value of the firm by debt financing. Others believe that the cost firm by debt financing. Others believe that the cost of capital is uneffected by the changes in the of capital is uneffected by the changes in the capital structure.capital structure.

Problems with regard to considering the various Problems with regard to considering the various costscosts

Problems in computing the cost of equity: it is a Problems in computing the cost of equity: it is a difficult task to calculate the expected rate of difficult task to calculate the expected rate of return on equity.return on equity.

Problems in computing cost of retained earnings: Problems in computing cost of retained earnings: (Opportunity cost of dividends of shareholders is (Opportunity cost of dividends of shareholders is ignored often)ignored often)

Problems in assigning weightsProblems in assigning weights