The cost of capital is very important factor in formulating firm’s capital structure. It is one of the cornerstones of the theory of financial management while deciding capital structure it is necessary to consider the cost of each source of capital and compare them to decide which source of capital is in the interest of the owner as well as to the shareholders.
The cost of capital of a firm is the minimum rate of return expected by its investors. In fact, the cost of capital is the minimum rate of return expected by its owner. The object of every firm is wealth maximization, a firm must earn a rate of return more than its cost of capital otherwise the capital investment is not worth accepting.
The cost of capital of a firm is associated with the return expected by its investors has a direct relation with the risk involved in the firm. Generally, a higher risk is associated with a higher cost of capital.
Definitions of Cost of Capital
The important definitions are as under:
1. Solemn Ezra. “The cost of capital is the minimum required rate of earnings or cut off rate for capital structure.”
2. James C. Van Horne. “The cost of capital represents a cut off rate for the allocation capital to the investment of projects. It is the area of return on a project that will leave unchanged the market price of stock.”
3. Halley and Schall. “The cost of capital is the minimum discount rate used to value each stream.”
4. Hunt, William and Donaldson. “The cost of capital may be defined as the rate of that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due.”
Cost of capital is the minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price. In economics there are two approaches to define the cost of capital:
According to first: It is the borrowing rate at which a firm acquires funds to finance the projects. The second is the lending rate which the firm could have earned if the firm would have invested it elsewhere. The cost of capital is the combined cost of each type of source by which a firm raises the funds for financing different capital investment proposals.
Importance of cost of capital
The concept is very relevant in the managerial decisions:
1. Useful in investment decision. The cost of capital is very useful in capital budgeting decisions. The firm chooses projects which give a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing. In various methods of Capital Budgeting cost of capital is the key factor in the selection of a project.
2. Useful in designing capital structure. The cost of capital is very useful factor in designing the firm’ s capital structure. A capable financial manager always keeps an eye on capital market fluctuations and try to achieve the sound and economical capital structure for the firm.
3. Useful in determining method of financing. A capable financial executive must have knowledge about the fluctuations in the capital market and should analyze the rate of interest on Loans and normal dividend rate in the market from time to time. Whenever the company requires additional finance, he may have a better choice of the source of finance which bears the minimum cost of capital.
4. Performance of top management. The cost of capital can be used to evaluate the financial performance of top management. Evaluation of financial performance will involve a comparison of actual profitability of projects undertaken with the projected over all cost of capital and an appraisal of the actual cost incurred in raising the required funds.
5. Optimum Resources Mobilisation. The cost of capital can be used as a medium of optimum resources mobilization. It might also help the government departments in deciding financial priorities on a sound basis. Both private and public sector can use this technique, it can identify such projects which are taken irrespective of profitability.
6. Useful in Evaluation of Expansion Projects. The cost of capital is a useful technique in the study of financial possibilities of a given expansion proposal there, a comparison is made on the marginal return on investment to the cost of financing the expansion, the excess return must be the criteria of selection of the project.
7. Other Uses. The cost of capital is important in many areas of decision making such as: Decision regarding payment of Dividend and retained earnings, capital structure, working capital management, capital expenditure control and profit maximization or wealth maximization.