Concept of cost of capital


The cost of capital of a company is the average rate of return required by investors who provide long term funds (equity, preference, and long term debt). A central concept in financing decisions, the cost of capital is important for two reasons:

1. For evaluating capital investment proposals an estimate of the cost of capital is required. As we have seen, the cost of capital is the discount rate in NPV calculation and also the financial benchmark against which the internal rate of return is compared

2. To maximize the value of the firm, costs of all inputs (including the capital input) must be minimized. In the context the firm should what its cost of capital is and what are its key determinants.

Basic Concepts:

A firm’s cost of capital is the weighted arithmetic average of the cost of various sources of long term finance employed by it. Suppose that a firm uses equity costing 18%, preference costing 15%, and debt costing 11%. If the proportions in which equity, preference, and debt are used are respectively 40%, 10%, and 50%, the cost of capital of the firm will be:

Cost of Capital = {Proportion of equity}{Cost of equity} + {Proportion of preference}{Cost of preference} + {Proportion of debt}{Cost of debt)

From the above example, it is clear that three basic steps are involved in calculation a firm’s cost of capital:

1. Determine the cost of different components of capital.
2. Establish a set of weights (proportions).
3. Calculate the weighted average cost of capital.

Conditions for using the Cost of capital:

Two key conditions should be satisfied for using a firm’s cost of capital for evaluating new investments:

* The risk of new investment is the same as the average risk of existing investment. In other words, the adoption of new investment will not change the risk complexion of the firm.

* The capital structure of the firm will not be affected by the new investments. Put differently, the firm will continue to pursue the same financing policy.

Thus, strictly speaking the cost of capital is an appropriate discount rate for a project that is a carbon copy of the firm’s existing business. However, in practice, the cost of capital is used as a benchmark hurdle rate that is adjusted for variations in risk and financing patterns

Determination of the Component Costs:

Before you calculate the average cost of capital for a company, you should know the cost of specific sources of finances used by the company. How is the cost of a specific source of finance calculated? It is measured as the rate of discount that equates the present value of the expected post tax payments to that source of finance with the net funds received from that source of finance. In symbols, it is the value of k in the following equation:

P = Ct / (1+k)t

Where P= net funds received from the source
Ct= expected payment to the source at the end of year t

We measure costs at the margin since we are interested in using costs for analyzing investment decisions to be undertaken. Further, the explicit costs are measured on a post-tax basis because the cost of capital is used to evaluate post tax cash flows. Remember that the relevant cash flows for investment analysis are defined in post-tax terms.

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