Sources of Finance and Cost of Capital

DEFINITION OF COST OF CAPITAL

The cost of capital is an integral part of investment decisions as it is used to
measure the worth of investment proposal. It is used as a discount rate in
determining the present value of future cash flow associated with capital
projects. Conceptually, it is the minimum rate of return that a firm must earn on
its investments so as to leave market price of its. It is also referred to as cut-off
rate, target rate, hurdle rate, required rate of return and so on.
According to James C. Van Horne, ‘Cost of capital is ‘a cut-off rate for the allocation
of capital to investments of projects. It is the rate of return on a project that will leave
unchanged the market price of the stock.’
Soloman Ezra stated that ‘Cost of capital is the minimum required rate of earnings or
the cut-off rate of capital expenditure.’
So, the cost of capital is the rate of return that a firm must earn on its project
investments to maintain its market value and attracts funds.

ASSUMPTIONS OF COST OF CAPITAL

The theory of cost of capital is based on certain assumptions. These are –
(a) A basic assumption of traditional cost of capital analysis is that the firm’s
business and financial risks are unaffected by the acceptance and financing
of projects.
(b) The capital budgeting decision determines the business risk complexion of
the firm. The financing decision determines financial risk. In general, the
greater the proportion of long-term debt in the capital structure of the firm,
the greater is the financial risk because there is a need for a larger amount of
periodic interest payment and principal repayment at the time of maturity.
(c) For the purpose of capital budgeting decisions, benefits from undertaking a
proposed project are evaluated on an after-tax basis. In fact, only the cost of
debt requires tax adjustment as interest paid on debt is deductible expense
from the point of view of determining taxable income whereas dividends paid
 Sources of Finance and Cost of Capital
either to preference shareholders or to equity-holders are not eligible items
as a source of deduction to determine taxable income.
Cost of capital (k) consists of the following three components:
(a) The riskless cost of the particular type of financing, rj
(b) The business risk premium, b; and
(c) The financial risk

Business risk is the risk to the firm of being unable to cover fixed operating costs. Financial risk is the risk of
being unable to cover required financial obligations such as interest and preference dividends.

premium, f Or,

k = rj + b + f

IMPORTANCE OR SIGNIFICANCE OF COST OF CAPITAL

The cost of capital is an important element, as basic input information for taking
decision in the field of capital budgeting, capital structure, dividend policy and
for appraisal of performance management, etc. The correct cost of capital helps
in the following areas:
(a) Capital Budgeting Decision or Investment Evaluation
Cost of capital is usually taken as the cut-off rate or minimum required rate
of return for an investment project. In the Net Present Value (NPV) method,
an investment is accepted if it has a positive NPV. The projects NPV are
calculated by discounting its cash flows by the cost of capital. The cost of
capital is the minimum required rate of return on the investment project that
keeps the present wealth of shareholders unchanged. So, for a profitable
investment project, the NPV should be greater than zero.
Again, when Internal Rate of Return (IRR) method is used, the computed IRR
is compared with the cost of capital and the investment proposal is accepted
if it has an IRR greater than cost of capital. So, it provides a benchmark to
measure the worth of investment proposal and perform the role of accept
reject criterion. That is why, cost of capital is also called as cut-off rate,
target rate, hurdle rate, minimum required rate of return, standard return,
 Sources of Finance and Cost of Capital
etc.
(b) Capital Structure Decision
Cost of capital plays an important role in designing the capital structure and
debt policy of a firm. The decision about debt equity mix in the capital
structure is taken with reference to the impact of the same on the average
cost of capital. Debt helps to save taxes, as interest on debt is a tax-
deductible expense. The interest tax shield as a result of use of debt in capital
reduces the overall cost of capital, but it also increases the financial risk of
the firm. On deciding the proportion of the debt and equity in the capital
structure, the firm aims at maximising the firm value by minimising the
overall cost of capital.
(c) Appraisal of Financial Performance
The financial performance of the top management can be appraised by using
the cost of capital. The performance of a project or business i.e., the return
from the business is compared against the cost of capital to evaluate the
profitability of the project investment. If the management has been able to
earn higher return over its cost of capital, the management will be treated as
an efficient one and vice-versa.
(d) Designing of Optimum Credit Policy
Credit sale is an integrated part of today’s business and the decision of credit
period to be allowed to the customers is an important one. To achieve the
optimum credit policy, the cost of allowing credit period is compared against
the benefits or profit earned by providing credit to customers. While doing
this, cost of capital is used to arrive at the present value of cost and benefits
received.
 Sources of Finance and Cost of Capital

(e) Inventory Management

While taking the decision regarding the inventory management cost of capital can
be used as a guide to evaluate financial cost of carrying inventory.
(f) Dividend Decision
The dividend policy of the firm can also be formulated after considering the
cost of capital. Here, internal rate of return (r) is compared with the cost of
capital (k) for fixing up the %age of dividend to be distributed to the
shareholders.

DETERMINING FACTORS OF COST OF CAPITAL

Cost of capital, like all other costs, is a variable term, subject to changes in a
number of factors. The various factors that play a part in determination of cost
of capital are described below:
(a) Risk Profile of the Project
Given a particular set of economic conditions, the cost of capital might vary
between industries and between firms in the same industry. This happens
because of variation in the risk profile of the firm. A project considered risky
would attract capital at a higher cost than a project in the same industry
having lesser risk.
(b) Market Conditions
If the security is not readily marketable when the investor wants to sell, or even if a
continuous demand for the security exists but the price varies significantly, an
investor will require a relatively high rate of return.
Conversely, if a security is readily marketable and its price is reasonably
stable, the investor will require a lower rate of return and the company’s cost
of capital will be lower.
(c) General Economic Conditions
The structure of interest rates is linked to the general economic conditions
prevalent in the economy. Cost of capital, in turn, is related to the interest
rate structure. Fluctuation in interest rates occurs as a result of changes in
the demand supply equilibrium of investible funds. When investment demand

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 Sources of Finance and Cost of Capital
is more than the supply, the rate of interest tends to rise and hence the cost of
capital is also more during these periods. On the other hand, during times of
slack investment demand, the cost of capital declines due to available supply
of funds being more than the demand. The fluctuation in the cost of capital
may not be as frequent as the changes in interest rates because the
deployment of funds in the debt component of capital is for a longer period of
time.
(d) Amount of Financing
As the financing requirements of the firm become larger, the weighted cost of
capital increases for several reasons. For instance, as more securities are
issued, additional flotation costs, or the cost incurred by the firm from
issuing securities, will affect the percentage of cost of the funds to the firm.
Also, as management approaches the market for large amounts of capital
relative to the firm’s size, the investors’ required rate of return may rise.
Suppliers of capital become hesitant to grant relatively large sums without
evidence of management’s capability to absorb this capital into the business.

CLASSIFICATION OF COSTS
Costs can be classified as follows:
A. Historical Cost and Future Cost: Historical cost is the cost which has
already been incurred for financing a particular project. It is based on the
actual cost incurred in the previous project. Historical cost is useful for
analyzing the existing capital structure of the firm.

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 Sources of Finance and Cost of Capital

Future cost is the estimated cost for the future. In financing decision, the future
cost is more important than the historical cost as most of the financing
decision are related with the future or proposed project that are taken in
future period. But at the same time, the future cost is estimated on the basis of
previous experience or historical data, so both are related.
B. Specific Cost and Composite Cost: The cost of each component or source of
capital is known as the specific cost or component cost. The cost of finance is
the minimum return expected by the investors which again depend on the
degree of risk involved in the investment.
When all the specific cost of individual source are combined together to get a
single cost of capital of the firm, it is known as overall or composite or
combined or weighted average cost of capital (WACC). Composite cost is
commonly referred as the firm’s cost of capital. It represents the minimum
return that a firm must earn on its existing investment or asset base to satisfy
its creditors, owners and other providers of capital.
C. Explicit and Implicit Cost: Explicit cost of any source of finance is the
discount rate which equates the present value of cash inflows with the present
value of cash outflows. Van Horne defined explicit cost as – ‘the discount
rate that equates the present value of the funds received by the firm, net of
underwriting and other cost, with the present value of expected outflows.’
These outflows are interest payment, repayment of principal or dividends,
etc.
Implicit cost, also known as the opportunity cost is the cost of the opportunity
foregone in order to take up a particular project. The implicit cost can be
defined as “the rate of return associated with the best investment opportunity
for the firm and its shareholders that would be foregone, if the projects
presently under consideration by the firm were accepted.” For example, the
implicit cost of retained earnings is an opportunity cost or implicit cost of
capital to the shareholders as they could have invested the fund in anywhere
else if the retained earnings were distributed to them as dividend.
Now, it can be said that explicit cost arises where funds are raised, whereas the
implicit cost arises when funds are used.
D. Average Cost and Marginal Cost: An average cost is the combined cost or
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 Sources of Finance and Cost of Capital
weighted average cost of various source of capital. When the aggregate of
the cost of capital of each such source is divided by the aggregate of the
weight of sources, the average cost of capital is obtained. The weight
represents the proportion of each source of in the capital structure.
Marginal cost refers to the average cost of new additional funds required by a
firm. It is simply the cost of additional fund raised. Marginal cost of capital is
an important tool for evaluating a new project. The return of the new project
is compared with the marginal cost of capital to decide on the acceptance or
rejection of the project.