Concept of Cost of Capital Capital refers to the funds invested in a business.

The capital can come from different sources such as equity shares, preference shares, and debt. All capital has a cost. However, it varies from one sources of capital to another, from one company to another and from one period of time to another. "Cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise." Cost of capital may be defined as the company's cost of collecting funds. This is equal to the average rate of return that an investor in a company will expect for providing funds. Cost of the capital is the rate of return which is minimum which has to be earned on investments in order to satisfy the investors of various types who are making investments in the company in the form of shares, debentures and loans. It is the minimum required rate of return which a firm must earn in order to break even. It refers to the cost that a firm must incur in retaining the funds obtained through different sources ( ie equity shares, preference shares, Debt and retained earnings). The cost of capital in always expressed in terms of percentage. Proper allowance is made for tax purposes to get a correct picture of the cost of capital. Basic aspects of the Concept of cost 1. It is not a cost as such: It is only a hurdle rate ie rate of return on projects available 2. It is the minimum required rate of return which a firm must earn in order to break even. It refers to the cost that a firm must incur in retaining the funds obtained through different sources ( ie equity shares, preference shares, Debt and retained earnings). 3. It comprises of three componenets: a. Risk-free Interest rate (Rf): It is interest rate on the risk free and default free securities. Eg securities issued by Govt. of India. Theoretically, Risk-free Interest rate consists of two components: i) Real interest rate- interest rate payable to the lender for supplying the funds. ii) Purchasing power risk premium-compensation for loss of purchasing power over the period of lending. Higher the expected rate of inflation greater would be Purchasing power risk premium and consequently higher would be Risk-free Interest rate. b. Premium for Business risk: Business risk is the variability of EBIT due to changes in sales. If the firm accepts a proposal which is more risky than the average present risk, the investor will expect a higher rate of return than the normal rate. This premium added for business risk is known as Business risk Premium.

c. Premium for Financial risk: Financial risk refers to the likelihood that firm would not be able to meet its fixed financial charges. It is the risk on account of capital structure (debt-equity mix) of the firm. Higher the proportion of fixed cost securities in the overall capital structure, greater would be the financial risk. Investors required to be compensated for this increased risk and therefore add financial risk premium over and above the business risk premium. In view of above, the cost of capital may be defined as: k = Rf + b + f where, k = cost of capital Rf = Risk free Interest Rate. b = Business risk Premium. f = Financial risk Premium.

Importance of Cost of Capital The importance of cost of capital is that it is used to evaluate new project of company and allows the calculations to be easy so that it has minimum return that investor expect for providing investment to the company. It has such an importance in financial decision making. The progressive management always takes notice of the cost of capital while taking a financial decision. It actually used in managerial decision making in certain field such as1) Decision on capital budgeting- It is used to measure the investment proposal to choose a project which satisfies return on investment. The concept of cost of capital is a major standard for comparison used in finance decisions. Acceptance or rejection of an investment project depends on the cost that the company has to pay for financing it. Good financial management calls for selection of such projects, which are expected to earn returns, which are higher than the cost of capital. It is therefore, important for the finance manager to calculate the cost of capital, which the company has to pay and compare it with the rate of return, which the project is expected to earn. 2) Used in designing corporate financial structure- The cost of capital is a guideline for determining the optimum capital structure of a company. The cost of capital is influenced by the changes in capital structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. He may try to substitute the various methods of finance in an attempt to minimise the cost of capital so as to increase the market price and the earning per share. (3) Deciding about the Method of Financing. A capable financial executive must have knowledge of the fluctuations in the capital market and should analyse the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, he may have a better choice of the source of finance which bears the

minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the considerations of relating control and of avoiding risk. 4) Performance of Top Management. The cost of capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitability of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. (5) Other Areas. The concept of cost of capital is also important in many others areas of decision making, such as dividend decisions, working capital policy etc. Calculation of Cost of Capital In order to calculate the overall cost of capital, a finance manager has to take the following steps:1. Determine the type of funds to be raised and their share in the capital structure. 2. Determine cost of each type of funds. 3. Calculate combined cost of capital of the company by giving weights to each type of funds in terms of proportion of funds raised to total funds. Classification of cost of capital 1. Explicit cost and implicit cost The explicit cost of any source of finance may be defined as the discount rate that equates the present value of the fund outflows with the present value of the fund inflows. It is the internal rate of return the firm pays for financing. This can be calculated by : I0 = C1 + C2 + _____ + Cn (1 + k)1 (1 + k)2 (1 + k)n where, I0 = Net amount of the fund inflows C = Outflow n = No. of years k = Explicit cost of capital The implicit cost of capital may be defined as the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted. Explicit costs arise when the funds are raised while implicit cost arises when they are used. 2. Future cost and historical cost Future cost refers to the expected cost of funds to finance the project while historical cost is the cost which has already been incurred for financing a particular project. In financial decision making, the relevant costs are future cost and not the historical costs. 3. Specific cost and combined cost

The cost of each component of capital ( i.e. equity shares, preference shares, Debt and retained earnings) is known as specific cost of capital. These specific costs are helpful in determining the average cost of capital of the firm. This concept of cost is useful in those cases where the profitability of a project is judged on the basis of the cost of the specific sources from where the project will be financed. Eg if k e is 11%, a project will be financed out of equity shareholders funds would be accepted only when it gives a rate of return of at least 11%. The composite or combined cost of capital is inclusive of all cost of capital from all sources i.e. equity shares, preference shares, Debt and retained earnings. It is used as a basis for accepting or rejecting the capital investment proposal. 4. Average cost and Marginal cost: The average cost of capital is the weighted average of the costs of each component of funds employed by the firm. The weights are in proportion of the share of each component of capital in the total capital structure. The computation of average cost of capital involves: a. Measurement of costs of each specific source of capital. b. Assignment of appropriate weights to each component. c. Finding out whether the average cost of capital is at all affected by changes in the composition of the capital. Marginal cost of capital is the weighted average cost of new funds raised by the firm. For capital budgeting and financing decisions, Marginal cost of capital is the most important factor to be considered. Determination of cost of capital Problems in Determination of Cost of Capital 1. Conceptual controversies regarding the relationship between the cost of capital and the capital structure: Traditional theorists are of the opinion that a firm can minimise the WACC and increase the value of the firm by debt financing. According to them, a firm can change its overall cost of capital by changing the debt-equity mix. On the other hand modern theorists believe that the cost of capital is unaffected by the changes in the level and method of financing the capital structure. According to them, by changing the debt-equity mix a firm cannot change its overall cost of capital. 2. Problems in computation of cost of equity: It is a difficult task to calculate the expected rate of return on equity as equity shareholders value the shares of a Co. on the basis of large number of factors financial as well as psychological. 3. Problems in computation of cost of retained earnings and depreciation funds: Opportunity cost of dividends of shareholders is ignored often. Problems in assigning weights in proportion of the share of retained earnings in the total capital structure of the firm. 4. Historic cost and future cost: HC are book costs related to past. Future costs are the estimated cost related to the future. It is argued that for decision-making purposes, the historical cost is not relevant. Again it is a problem whether to consider Average cost or marginal cost. AC is the combined cost of various sources of capital where as MC is the cost of capital which has to be incurred to obtain additional funds required by the firm.

5. Problem of weights: Assignment of appropriate weights to each component of capital is a complex issue. Two types of weights i.e. book value and market value of each source of funds is used. But results would be different in each case.