COST OF CAPITAL
Cost of capital is one of the most important criteria used by the financial managers for evaluating the profitability of capital investment proposals. It is used as a technique to determine, whether a particular project is to be accepted or not. It is also used as a base for taking various investment decisions. The concept of cost of capital plays a significant role in financial management. The term cost of capital is also referred to as cut off rate, hurdle rate, discount rate, target rate etc.
Concept, Meaning and Definitions
Cost of capital is the minimum rate of return expected by the investors for their investment. It is the weighted average cost of various sources of finance used by an entity such as equity, preference or debt, for various investment proposals. It can also be called as the minimum rate of return that a project must yield to keep the value of the enterprise unchanged. The cost of capital is the rate of return, that must be received by the firm on its investment projects, to attract investors for investing capital in the firm and to maintain its market value. The main components of cost of capital are cost of debt, cost of preference capital, cost of equity and cost of retained earnings.
Cost of capital may be defined as, "the minimum rate of return that a firm must earn
on its investments to keep the market value of shares remain unchanged",
According to Solomon Ezra, "cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditures"
Basic aspects of Cost of Capital
The following are the basic aspects of cost of capital.
1. It is not a cost as such; it is the rate or return that a firm requires to earn fnm its projects.
2. It is the minimum rate of return: Cost of capital of a firm is that minimum rate of return which will atleast maintain the market value of the shares.
3. It comprises of three components:
a. Return at zero risk level: This refers to the expected rate of return at zero risk
level. Premium for business risk: The term business risk refers to the variability a b.
operating profit due to change in the nature of business. Premium for financial risk: It refers to risk on account of pattern of capital C.
structure (debt-equity mix).
Approaches to Cost of Capital
There are two important approaches to cost of capital.
1. Traditional Approach: According to the traditional approach, a firm's cost of capital depends upon the method and level of financing or capital structure. Hence, in this approach a firm can change its cost of capital by increasing or decreasing the debt equity mix.
2. Modigliani and Miller (MM) Approach: According to the MM approach, the organisation's cost of capital remains constant and is independent of the method and level of financing. In this approach, a change in the debt-equity mix does not at the total cost of capital.
Importance/ Significance of Cost of Capital
The concept of cost of capital is very significant in financial management. It plays a crucial role in capital budgeting as well as capital structure. It also plays a significant role in evaluating the performance of various projects and taking various financial decisions. The importance of cost of capital can be detailed as follows:
1. As an Acceptance Criterion in Capital Budgeting: Cost of capital is very important in capital budgeting. Capital budgeting decisions can be made by considering cost of capital. According to present value technique of capital budgeting, investment proposals are accepted only if the present value of cash inflows is equal or greater than the cost of capital. The present value of cash inflows are calculated by discounting cash inflows with appropriate discount or cut off rate. Hence in capital budgeting decisions, cost of capital play a significant role.
2. As a Basis for Designing Capital Structure: Cost of capital is very important in designing optimum capital structure. Capital structure refers to the proportion or mix of owners' funds or equity and borrowed funds or debts in the total capitalisation. Optimum capital structure is that capital structure that maximises the value of firm and minimises the overall cost of capital. Measurement of cost of capital from various sources of finance is very essential in planning and designing optimum capital structure. Hence, cost of capital plays a significant role designing capital structure.
3. Evaluating Financial Performance: The concept of cost of capital is very important in evaluating the financial performance of the management. For evaluating the financial performance, the actual profitability of the project is compared with the overall cost of capital of the project. If the actual profitability of the project is greater than the overall cost of raising funds for the projects, the performance is said to be good.
4. As a Basis for Making Various Financial Decisions: The concept of cost of capital is very useful in making various financial decisions such as dividend policy, working capital management, right issue and bonus issue.
5. Assisting Project Expansion: The cost of capital assists the finance manager in
taking correct decisions about the expansion of the project.