This article throws light upon the five major problems in determination of cost of capital. The problems are: 1. Conceptual Controversies Regarding the Relationship between the Cost of Capital and the Capital Structure 2. Historic Cost and Future Cost 3. Problems in Computation of Cost of Equity 4. Problems in Computation of Cost of Retained Earnings 5. Problems in Assigning Weights.
Determination of Cost of Capital:
- Conceptual Controversies Regarding the Relationship between the Cost of Capital and the Capital Structure
- Historic Cost and Future Cost
- Problems in Computation of Cost of Equity
- Problems in Computation of Cost of Retained Earnings
- Problems in Assigning Weights
Problem # 1. Conceptual Controversies Regarding the Relationship between the Cost of Capital and the Capital Structure:
Different theories have been propounded by different authors explaining the relationship between capital structure, cost of capital and the value of the firm.
This has resulted into various conceptual difficulties. According to the Net Income Approach and the traditional theories both the cost of capital as well the value of the firm have a direct relationship with the method and level of financing. In their opinion, a firm can minimise the weighted average cost of capital and increase the value of the firm by using debt financing.
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On the other hand, Net Operating Income and Modigliani and Miller Approach prove that the cost of capital is not affected by changes in the capital structure or say that debt equity mix is irrelevant in determination of cost of capital and the value of a firm.
However, the M and M approach is based upon certain unrealistic assumptions such as, there is a perfect market or the expected earnings of all the firms have identical risk characteristic, etc.
Problem # 2. Historic Cost and Future Cost:
Another problem in the determination of cost of capital arises on account of the difference of opinion as regards the concept of cost itself. It is argued that historic costs are book costs which are related to the past and are irrelevant in the decision-making process.
In their opinion, future estimated costs are more relevant for decision-making. In the same manner, arguments are given in favour of specific cost and composite cost as well as explicit cost and implicit cost and the marginal cost.
Problem # 3. Problems in Computation of Cost of Equity:
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The computation of cost of equity capital depends upon the expected rate of return by its investors. But the quantification of the expectations of equity shareholders is a very difficult task because there are many factors which influence their valuation about a firm.
Problem # 4. Problems in Computation of Cost of Retained Earnings:
It is sometimes argued that retained earnings do not involve any cost. But in reality, it is the opportunity cost of dividends foregone by its shareholders. Since different shareholders may have different opportunities for investing their dividends, it becomes very difficult to compute the cost of retained earnings.
Problem # 5. Problems in Assigning Weights:
For determining the weighted average cost of capital, weights have to be assigned to the specific cost of individual sources of finance. The choice of using the book value of the source or the market value of the source poses another problem in the determination of cost of capital.