Cost of Capital: Definition, Importance and Aspects

After reading this article you will learn about Cost of Capital:- 1. Definitions and Concept of Cost of Capital 2. Relevance, Significance and Importance of Cost of Capital 3. Aspects.

Definitions and Concept of Cost of Capital:

Cost of Capital may be defined according to the following two terms:

(a) Under operational terms and

(b) Under economic terms.

Under operational terms, it is defined as the minimum rate of return which a firm must earn on its investment, i.e., it refers to the discount rate which is used while determining the present value of estimated future cash flows. But, under economic terms, however, there are two formulations.

First, it is the cost of raising funds required in order to finance the proposed project, i.e., it is the borrowing rate of the firm. Secondly, it refers to the opportunity cost of the funds, in terms of the lending rate, i.e., the expected earnings by investing funds outside.

Here, we prefer to use the term “Cost of Capital” as a borrowing rate since it is impracticable on the part of the firm which is going to take any capital budgeting decisions to invert outside. Thus, this approach is very much realistic as well as practicable. Of course, under economic terms, the cost of capital is defined as the weighted average cost of each type of capital.

Relevance, Significance and Importance of Cost of Capital:

The cost of capital is the most significant concept in capital budgeting decisions since it is used as a decision criterion. Under DGF techniques, if NPV method is followed as a decision criterion, the cost of capital is used as a discount rate in evaluating the desirability of the projects in order to calculate the NPV and if there is a positive (+) NPV the project will be accepted and vice-versa.

Similarly, if IRR method is adopted, the computed IRR is compared with the cost of capital, i.e., if the project has a greater/higher rate of return (IRR) in comparison with the cost of capital, the same will be accepted and vice-versa. At the same time, Profitability Index (B. C. Ratio.) may be applied for the purpose while determining the present value of future cash flows.

Thus, it plays a significant role in investment decisions and supplies a yardstick to measure the value of investment proposals. In short, it is referred to as the minimum required rate of return, cut-off rate, hurdle or target rate, standard return etc., which implies the crucial significance of the same.

In this context, the accept-reject rules desire that if the rate of return is higher than the cost of capital, a firm may undertake such investment opportunities.

On the contrary, if the rate of return is lower than the cost of capital the firm is advised not to undertake such investment proposals. In other words, if a project is accepted which will yield a higher return than the cost of capital, the same will increase the prices of shares along with the shareholders’ wealth and in the opposite case, the prices of the shares will go down, i.e., shareholders’ wealth will decline.

Thus, the cost of capital presents a rational technique for the purpose of making the optimum investment decisions.

Apart from the above, it is important from the standpoint of both capital budgeting and capital structure planning decisions which are:

(i) Capital budgeting decisions:

It has already been explained earlier that cost of capital is used as a discount rate and in order to find out the present value, the firms’ cash flows are discounted by the rate, i.e., it is the most significant basis for financial appraisal of the new capital expenditure decision.

(ii) Capital structure decisions:

The most of capital is, no doubt, an important consideration in designing the firm’s capital structure. At the time of raising finance from different sources, the firm should optimize the risk and cost factors. Needless to mention that the sources of funds which are less costly involve greater degree of risk.

Therefore, a firm should always aim at minimising the cost of capital and maximizing the market value after con­sidering the risk factors.

Moreover, the framework of cost of capital can be applied in order to evaluate financial performance of top management. This evaluation depends on a comparison between the actual profitability of the projects that are undertaken and the overall cost of capital including the cost of raising funds.

Aspects of Cost of Capital:

There are three basic aspects about the concept of cost which are:

(i) It is not a cost as such:

Practically, the cost of capital of a firm is the rate of return which it requires on the projects. That is why, it is a ‘hurdle’ rate. Although such rate may be computed on the basis of actual cost of different components of capital.

The term ‘component’ means the different sources from which funds are actually raised since each sources of fund or each component of capital has its own cost, e.g., equity capital has a cost followed by preference share capital and so on.

(ii) It is the minimum rate of return:

Cost of capital represents the minimum rate of return (already stated above) which is required in order to maintain the market value of equity shares.

(iii) It includes the following components:

(a) The riskless cost of the particular type of financing or return at zero risk level,:

It relates to the expected rate of return when a project involves no risk whether business or financial, i.e., the firm’s business and financial risk are unaffected by the acceptance and financing of the project.

(b) The business risk premium, b; :

Business risk measures the variability in operating profit (Earnings before interest and taxes) as a result of changing sales. If the project which is accepted is found to be more risky than the average or normal, the supplier of funds naturally, will expect a higher rate of return than the normal or average rate, i.e., the cost of capital, in that case, will go up.

Therefore, the business risk premium is deter­mined by the capital budgeting decisions for investment proposals.

(c) The financial risk premium, f; :

Financial risk depends on the capital structure pattern of the firm, i.e., debt-equity mix. Because, if a firm has higher debt-content (debt-equity ratio) in its capital structure in comparison with a firm where the said content is low, the same is more risky simply because, the former must have a higher operating profit in order to cover the periodic interest payment and repayment of principal at the time of maturity as well.

In other words, possibility of cash insolvency exists in case of such firms. As a result, the suppliers will expect a higher rate of return from such firm for carrying a higher degree of risk as compared to latter.

Thus, the above three components of cost of capital may be written in the form of the following equation:

K₀ =r_o + b + f

where,

K₀ = Cost of Capital;

R_o = Return at zero risk level;

b = Premium for business risk;

f = Premium for financial risk.

It should be noted that the business and financial risks are assumed to be constant, and, as such, the changing cost of each type of capital over time should be affected by the demand and supply of each type of funds as well.