Cost Of Capital

Cost Of Capital

• 1.
  Cost of Capital Meaning Significance Classification of costs Determination of cost of capital Computation of Cost of Capital
• 2.
  Meaning TheCOC of a firm is the minimum rate of return expected by its investors. It is the weighted average cost of various sources of finance used by a firm. “ 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”.-James C Van Horne
• 3.
  Basic aspects ofthe definition Cost of Capital is not a cost as such-it is the rate of return firm needs to earn from its project It is the minimum rate of return- which will at least maintain the market value of shares It comprises of three components- The expected normal rate of return at zero-level risk Premium for Finance risk Premium for Business risk (K=r o + b +f)
• 4.
  Significance of thecost of capital As an Acceptance criterion in Capital Budgeting – the acceptance or rejection of the project is decided by taking into consideration the cost of capital As a determinant of capital mix in capital structure decision- the objective of maximising the value of the firm and minimizing the cost of capital results in optimal capital structure As a basis for evaluating the financial performance- the profitability is compared to projected overall cost of capital and the actual cost of capital of funds raised to finance the project. As a basis for taking other financial decisions- Like Dividend policy, capitalisation of profits, making the rights issue, working capital.
• 5.
  Classification of cost Historical and future cost: HC are Book cost related to past. Future cost are the estimated cost related to the future. Specific and composite cost: SC refers to cost of a specific source of capital, while composite cost is combined cost of various sources of capital. It is the WACC, in case of more than one form of source of capital composite cost is resorted to Explicit cost and implicit cost: EC is the discount rate which equates the PV of cash inflows in other words, it is IRR. Implicit cost is also known as opportunity cost, it is the cost foregone in order to take up a particular project. Average cost and marginal cost: AC is the combined cost of various sources of capital, MC is the average cost of capital which has to be incurred to obtain additional funds required by the firm.
• 6.
  Problems in determinationof COC Conceptual controversies regarding the relationship between the cost of capital and the capital structure: few are of the opinion that a firm can minimise the WACC and increase the value of the firm by debt financing. Others believe that the cost of capital is uneffected by the changes in the capital structure. Problems with regard to considering the various costs Problems in computing the cost of equity: it is a difficult task to calculate the expected rate of return on equity. Problems in computing cost of retained earnings: (Opportunity cost of dividends of shareholders is ignored often) Problems in assigning weights