Cost of Capital: Meaning and Classification

Cost of capital refers to the weighted average cost of various capital components, i.e. sources of finance, employed by the firm such as equity, preference or debt. In finer terms, it is the rate of return that must be received by the firm on its investment projects, to attract investors for investing capital in the firm and to maintain its market value.

The factors which determine the cost of capital are:-

• Source of finance
• Corresponding payment for using finance.

On raising funds from the market, from various sources, the firm has to pay some additional amount, apart from the principal itself. The additional amount is nothing but the cost of using the capital, i.e. cost of capital which is either paid in lump sum or at periodic intervals.

Classification of Cost of Capital

1. Explicit cost of capital: It is the cost of capital in which firm’s cash outflow is oriented towards utilization of capital which is evident, such as payment of dividend to the shareholders, interest to the debenture holders, etc.
2. Implicit cost of capital: It does not involve any cash outflow, but it denotes the opportunity foregone while opting for another alternative opportunity.

To cover the cost of raising funds from the market, cost of capital must be obtained. It helps in assessing firm’s new projects because it is the minimum return expected by the shareholders, lenders and debtholders for supplying capital to the business, as a consideration for their share in the total capital. Hence, it establishes a benchmark, which must be met out by the project.

However, if a firm is incapable of reaping the expected rate of return, the value of shares in the market will tend to decline, which will lead to the reduction in the wealth of the shareholders as a whole.

Importance of Cost of Capital

• It helps in evaluating the investment options, by converting the future cash flows of the investment avenues into present value by discounting it.
• It is helpful in capital budgeting decisions regarding the sources of finance used by the company.
• It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is maximum, and the cost of capital is minimum.
• It can also be used to appraise the performance of specific projects by comparing the performance against the cost of capital.
• It is useful in framing optimum credit policy, i.e. at the time of deciding credit period to be allowed to the customers or debtors, it should be compared with the cost of allowing credit period.

Cost of capital is also termed as cut-off rate, the minimum rate of return, or hurdle rate.

Cost of Capital and Equity Financing

The cost of equity is more complicated, since the rate of return demanded by equity investors is not as clearly defined as it is by lenders. Theoretically, the cost of equity is approximated by the capital asset pricing model

(CAPM) = risk-free rate + (company’s beta x risk premium)

The firm’s overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and after-tax cost of debt is 7%. Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%. This is the cost of capital that would be used to discount future cash flows from potential projects and other opportunities to estimate their net present value (NPV) and ability to generate value.

Companies strive to attain the optimal financing mix based on the cost of capital for various funding sources. Debt financing has the advantage of being more tax efficient than equity financing, since interest expenses are tax deductible and dividends on common shares are paid with after-tax dollars. However, too much debt can result in dangerously high leverage, resulting in higher interest rates sought by lenders to offset the higher default risk.

Cost of Capital Examples

Every industry has its own prevailing cost of capital. For some companies, the cost of capital is lower than their discount rate. Some finance departments may lower their discount rate to attract capital or raise it incrementally to build in a cushion depending on how much risk they are comfortable with.

As of January 2018, diversified chemical companies have the highest cost of capital at 10.78%. The lowest cost of capital can be claimed by non-bank and insurance financial services companies at 2.99%. Cost of capital is also high among biotech and pharmaceutical drug companies, steel manufacturers, food wholesalers, internet (software) companies, and integrated oil and gas companies. Those industries tend to require significant capital investment in research, development, equipment and factories. Among the industries with lower capital costs are money center banks, hospitals and healthcare facilities, power companies, real estate investment trusts (REITs), reinsurers, retail grocery and food companies, and utilities (both general and water). Such companies may require less equipment or benefit from very steady cash flows.