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Classification of Cost of Capital
Cost of capital may be classified into the following types on the basis of nature and usage:
- Explicit and Implicit Cost.
- Average and Marginal Cost.
- Historical and Future Cost.
- Specific and Combined Cost.
Explicit and Implicit Cost
The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital.
Explicit cost is the rate that the firm pays to procure financing. This may be calculated with the help of the following equation;
Where,
CIo=initialcashinflow
C = outflow in the period concerned
N=duration forwhich the funds are provided
T = tax rate
Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently under consideration by the firm were accepted.
Average and Marginal Cost
Average cost of capital is the weighted average cost of each component of capital employed by the company. It considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when the company goes for further raising of finance.
Historical and Future Cost
Historical cost is the cost which as already been incurred for financing a particular project. It is based on the actual cost incurred in the previous project.
Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of previous experience
Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of capital. It is very useful to determine the each and every specific source of capital.
The composite or combined cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. It is used to understand the total cost associated with the total finance of the firm.
Importance of Cost of Capital
Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.
Importance to Evolution of Financial Performance
Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.
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FAQs on Classification and Importance of Cost of Capital - Accountancy and Financial Management - Accountancy and Financial Management - B Com
| 1. What is the meaning of cost of capital in accountancy and financial management? |  |
Ans. The cost of capital refers to the rate of return that a company must earn on its investments in order to satisfy the expectations of its investors. It is the cost of funds used by a company to finance its operations and investments. The cost of capital is an important concept in accountancy and financial management as it helps in determining the feasibility of various investment projects and in making decisions regarding capital structure.
| 2. How is the cost of capital classified in accountancy and financial management? | |
Ans. The cost of capital is classified into two main categories:
1. Cost of Debt: This refers to the cost of borrowing funds from creditors or financial institutions. It includes the interest expense on debt and any other costs associated with borrowing, such as fees and commissions.
2. Cost of Equity: This refers to the cost of funds raised from shareholders or owners of the company. It is the return expected by shareholders in exchange for their investment in the company's stock. The cost of equity is usually higher than the cost of debt as it involves a higher level of risk.
| 3. Why is the cost of capital important in accountancy and financial management? | |
Ans. The cost of capital is important in accountancy and financial management for the following reasons:
1. Investment Decisions: It helps in evaluating the profitability and feasibility of various investment projects. By comparing the expected return from an investment project with the cost of capital, companies can determine whether the project will generate sufficient returns to meet the expectations of investors.
2. Capital Structure Decisions: It assists in determining the optimal mix of debt and equity in a company's capital structure. By considering the cost of debt and the cost of equity, companies can decide on the most cost-effective way to finance their operations and investments.
3. Valuation of Companies: The cost of capital is also used in valuing companies. It is used as a discount rate to calculate the present value of future cash flows, which helps in determining the intrinsic value of a company.
| 4. How is the cost of capital calculated in accountancy and financial management? | |
Ans. The cost of capital is calculated by taking into account the cost of debt and the cost of equity. The formula for calculating the cost of capital is as follows:
Cost of Capital = (Weight of Debt × Cost of Debt) + (Weight of Equity × Cost of Equity)
The weight of debt and the weight of equity are calculated by dividing the market value of debt and equity by the total market value of the company's capital structure. The cost of debt is the interest rate paid on debt, and the cost of equity is the expected return required by shareholders.
| 5. How does the cost of capital affect a company's financial performance? | |
Ans. The cost of capital directly affects a company's financial performance in the following ways:
1. Profitability: If the cost of capital is higher than the return generated by an investment project, it can lead to reduced profitability. Companies need to earn a return higher than the cost of capital in order to generate profits.
2. Investment Opportunities: The cost of capital also affects a company's ability to pursue new investment opportunities. If the cost of capital is high, it may deter companies from undertaking new projects as they may not generate sufficient returns to cover the cost of capital.
3. Capital Structure: The cost of capital influences a company's capital structure decisions. If the cost of debt is lower than the cost of equity, companies may choose to finance their operations and investments through debt to reduce their overall cost of capital.
4. Shareholder Expectations: The cost of capital is used as a benchmark to evaluate the performance of a company. Shareholders expect a return on their investment that is higher than the cost of capital. Failing to meet these expectations can lead to a decline in shareholder confidence and potential negative consequences for the company's stock price.
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