Introduction - Cost of Capital, Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download

Introduction
Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern. It is used as a discount rate in determining the present value of future cash flows associated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are using different sources of finance, the finance manager must take careful decision with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity of the firm.

Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.

Definitions
The following important definitions are commonly used to understand the meaning and concept of the cost of capital.
According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.
According to the definition of Solomon Ezra,“Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.
According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for the allocation of capital to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”.
According to the definition of William and Donaldson, “Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due”.

Assumption of Cost of Capital
Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consis of three important risks such as zero risk level, business risk and financial risk. Cost of capital can be measured with the help of the following equation.
K = r_j + b + f.
Where,
K = Cost of capital.
r_j=The riskless cost ofthe particular type of finance.
b=The business riskpremium.
f = The financial risk premium.

Significance of Cost of Capital:
The concept of cost of capital plays a vital role in decision-making process of financial management. The financial leverage, capital structure, dividend policy, working capital management, financial decision, appraisal of financial performance of top management etc. are greatly influenced by the cost of capital.
The significance or importance of cost of capital may be stated in the following ways:

1. Maximisation of the Value of the Firm:
For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital. There should be judicious mix of debt and equity in the capital structure of a firm so that the business does not to bear undue financial risk.

2. Capital Budgeting Decisions:
Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally cost of capital is the discount rate used in evaluating the desirability of the investment project. In the internal rate of return method, the project will be accepted if it has a rate of return greater than the cost of capital.
In calculating the net present value of the expected future cash flows from the project, the cost of capital is used as the rate of discounting. Therefore, cost of capital acts as a standard for allocating the firm’s investible funds in the most optimum manner. For this reason, cost of capital is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return etc.

3. Decisions Regarding Leasing:
Estimation of cost of capital is necessary in taking leasing decisions of business concern.

4. Management of Working Capital:
In management of working capital the cost of capital may be used to calculate the cost of carrying investment in receivables and to evaluate alternative policies regarding receivables. It is also used in inventory management also.

5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be formulated according to the nature of the firm— whether it is a growth firm, normal firm or declining firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth firm, normal firm and decline firm, respectively.

6. Determination of Capital Structure:
Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is the proportion of debt and equity, due importance is given to the overall or weighted average cost of capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimised.

7. Evaluation of Financial Performance:
The concept of cost of capital can be used to evaluate the financial performance of top management. This can be done by comparing the actual profitability of the investment project undertaken by the firm with the overall cost of capital.

Illustration 1:
A firm presents the following information relating to cost of capital:

The firm wants to raise a fund of Rs. 25,000 for the purpose of an investment proposal. It also decides to take the same from a financial institution at a cost of 10%.
Compute the marginal cost of capital and compare the same with average cost of capital before and after additional financing, assuming that the corporate rate of tax is 50%.
Solution:
It becomes clear from the above problem that the marginal cost is Rs. 25,000 which is 10% before tax and 5% after tax (i.e. 10% – 50% of 10%). The same is also known as specific or explicit cost of financing Rs. 25,000 since the source is only one, i.e. financial institution.
But the same also differs from the average cost calculated as:

Thus, it is evident from the above that the weighted average cost comes down from 8% to 7.4%. The cost of new debt is higher than the cost of old debt. Again, the cost of new debt is lower than the cost of equity capital. Therefore, the average cost of capital reduces since there is an increase in the proportion of debt capital to total capital invested.
While raising additional capital a firm must concentrate on the optimum capital structure and should use the different sources of financing proportionately for the purpose of main­taining the optimum capital structure. In the circumstance, the present book value may be considered as weight in order to compute the average cost of capital. If the capital is raised from different sources at a given proportion, it needs a computation of average cost of capital to know the cost of the total additional amount raised.’ So, in this case, marginal cost of capital may also be known as weighted average cost for the same. There will be no difference between the two provided there is no change in specific cost.

Illustration 2:
In Illustration 1, it is considered that the additional amount of Rs. 25,000 will be raised by the firm from equity and debt at the existing specific cost, there will be no difference between the weighted average cost and the marginal cost of capital as both of them will be one or the same as presented:
Solution.

Therefore, the cost of raising Rs. 25,000 is only 8%, which is the marginal cost. The same should, be measured with the help of weighted average cost for raising the additional fund of Rs. 25,000.
It has already been highlighted above that, if the specific cost changes, there will be a difference between the marginal cost of capital and the average cost of capital of a firm even if additional capital is procured at a given proportion. It should be remembered that the marginal cost of capital will continue to be the weighted average cost of new capital for a firm.

Illustration 3:
If it is assumed that cost of debt is 10% (before tax) and rate of tax is 50% and the firm prefers to raise Rs. 25,000 proportionately, compute the marginal cost of capital and the average cost of capital.
Solution.

It becomes clear from the above that overall cost of capital is raised upward as there is an increase in the cost of new debt capital. The same actually differs from the marginal cost of 8.5% for raising additional capital of Rs. 25,000 to 8.1%.