The Importance of Cost of Capital

1.1    The Meaning of Cost of Capital

Cost of capital could be defined from many points of view (firm, investor, project/investment appraisal etc):

·         To a firm→►Cost of capital is the:

      price of obtaining fund/capital.

      rate which is paid for the use of capital.  

      cost of a company's fund.

      minimum rate of return a firm must earn on its investments

·         To an investor→► Cost of capital is the:

      reward for the amount the investor is investing which could have otherwise been used for consumption or for investment at some other places.

      required return on a portfolio of all the company's existing securities.

·         For project/investment appraisal (Capital budgeting)→ ►Cost of capital is the:

      minimum required rate of return, a project must earn in order to cover the cost of raising funds being used by the firm in financing of the project.

      minimum rate of return that similar risk class investment/project are providing in the market.

      minimum rate of returns that a project/investment must earn to justify investment of resources..

      cut-off rate for the allocation of capital to investments of projects.

Cost of capital has two aspects to it: → ► (a) cost of funds; (b) minimum return:

      i.        the cost of funds that a company raises and uses, and the returns that investors expect to be paid for putting funds into the company.

    ii.        the minimum return that a company should make on its own investments, to earn the cash flow out of which investors can be paid their returns.

Therefore → ►the cost of capital can be measured by studying the returns required by investors and then → ►used to derive a discount rate for the discounted cash flow (DCF) analysis and investment appraisal.

·         Cost of capital is an opportunity cost of finance→► it is the minimum returns that investors require. If they do not get this return, they will transfer some or all of their investment somewhere else. 

·         There is a cost of doing business that must serve as a benchmark for decisions on investment in long-term assets.

·         Majorly, cost of capital could be cost of equity, cost of preference shares and cost of debt capital.

1.2    Importance of Cost of Capital

Financial managers need a cost of capital in making decisions. Cost of capital is generally important in financial management decisions and risk analysis. Consequently, cost of capital is useful as a standard for:

      I.        capital budgeting/investment appraisal;

    II.        designing corporate capital structure and debt policy of a firm;

   III.        appraising the financial performance of top management;

  IV.        comparative analysis of various sources of finance

1.         Capital budgeting/investment appraisal:

v  Cost of capital is used as a tool for screening the investment proposals →►towards accepting/rejecting investment proposals.

v  It is used to measure the investment proposal so as to choose a project which satisfies return on investment.

v  Naturally, the firm will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing.

v  In various methods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management.

v  It helps in determining the acceptability of all investment opportunities.

v  If a firm’s actual rate of return exceeds its cost of capital and if this return is earned without of course, increasing the risk characteristics of the firm, then the wealth maximization goal will be achieved.

The net present value (NPV) method and the internal rate of return (IRR) methods are the two principal discounted cash flow (DCF) techniques of project/investment appraisal.

ü    In case of the NPV method →►the cost of capital is used as the discounting rate for discounting the future inflow of funds. Any project resulting into positive net present value only will be accepted. All other projects will be rejected.

ü    In case of the IRR method →►this approach calculates the discount rate at which the net present value (NPV) of the project would be zero →►indicating the maximum cost of capital at which is project would be viable and acceptable. The internal rate of return (IRR) is compared with the investing firm’s cost of capital. If a project is to be accepted, the cost of capital (serving as the yardstick, here) should be less than this internal rate of return (IRR), otherwise, the project should be rejected.

Hence→► the cost of capital when used as a discount rate in capital budgeting, helps accepting only those proposals whose rate of return is more than the cost of capital of the firm and hence results in increasing the value of the firm. Similarly, the firm’s value is reduced when the rate of return on the proposal falls below the cost of capital.

2.         Designing corporate capital structure and debt policy

v  Cost of capital is significant in designing the firm's capital structure.

v  In designing the financing policy (that is, the proportion of debt and equity in the capital structure), firms always aim at minimising the overall cost.

v  A capable financial manager 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.

v  Therefore, cost of capital provides useful guidelines for determining the optimal capital structure. (Optimal capital structure is the one where overall cost of capital is minimised, and the overall valuation of the firm is maximised).

v  It is useful in achieving the economical capital structure for firm.

v  Furthermore, the debt policy of a firm is significantly influence by the cost consideration. The higher the cost of debt, the lower volume of the firm’s debt and consequently, the lower the proportion of debt in the capital structure. It will be the other way round if the cost of debt is low.

3.         Appraising the financial performance of top management of a firm

v  Cost of capital assists in evaluating the financial performance and efficiency of top management.

v   Such evaluation of the financial performance of the top managers could involve a comparison of actual profitability of the projects against the actual overall cost incurred in raising the required funds, in consideration of the projected overall cost of capital.

4. Comparative analysis of various sources of fund:

v  The cost of capital is useful in making comparison between various sources of fund available to a firm so as to take decision on most cost-effective source of corporate financing at a point in time.

v  A cost-effective finance manager should be aware of the fluctuations in the money and capital markets and should analyse the rate of interest on overdrafts, loans and normal dividend rates in the financial market from time to time.  

v  Whenever the firm requires additional finance, cost-effective choice of the source of finance could be made by comparing those various costs of capital and agree on the one that bears the minimum cost of capital.