Brief introduction of Cost of Capital
Investment decision is major decision for an organization. Under investment decision process, the cost and benefit of prospective projects is analyzed and the best alternative is selected on the basis of the result of analysis. The benchmark of computing present value and comparing the profitability of different investment alternatives is cost of capital. Cost of capital is also known as minimum required rate of return, weighted average cost of capital, cut off rate, hurdle rate, standard return etc. Cost of capital is determined on the basis of component cost of financing and proportion of these sources in capital structure.
Business firms raise the needed fund from internal sources and external sources. Undistributed and retained profit is the main source of internal fund. External fund is raised either by the issue of shares or by issue of debenture (debt) or by both means. The fund collected by any means is not cost free. Interest is to be paid on the fund obtained as debt and dividend is to be paid on the fund collected through the issue of shares. The average cost rate of different sources of fund is known as cost of capital.
From the view point of return, cost of capital is the minimum required rate of return to be earned on investment. In other words, the earning rate of a firm which is just sufficient to satisfy the expectation of the contributors of capital is called cost of capital. Shareholders and debenture holders are the contributors of the capital. For example, a firm needs $ 5,00,000 for investing in a new project. The firm can collect $3,00,000 from shares on which it must pay 12% dividend and $ 2,00,000 from debentures on which it must pay 7% interest. If the fund is raised and invested in the project, the firm must earn at least $50,000 which becomes sufficient to pay $36,000 dividend(12% of $3,00,000) and $14000 interest(7% of $2,00,000). The required earning $50,000 is 12% of the total fund raised. This 12% rate of return is called cost of capital.
In this way, cost of capital is only minimum required rate of return to earn on investment and it is not the actual earning rate of the firm. As per above example, if the firm is able to earn only 10%. all the earnings will go in the hands of contributors of capital and nothing will be left in the business. Therefore, any business firm should try to maximize the earning rate by investing in the projects that can provide the rate of return which is more than the cost of capital.
Significance Of Cost Of Capital
Cost of capital is considered as a standard of comparison for making different business decisions. Such importance of cost of capital has been presented below.
1. Making Investment Decision
Cost of capital is used as discount factor in determining the net present value. Similarly, the actual rate of return of a project is compared with the cost of capital of the firm. Thus, the cost of capital has a significant role in making investment decisions.
2. Designing Capital structure
The proportion of debt and equity is called capital structure. The proportion which can minimize the cost of capital and maximize the value of the firm is called optimal capital structure. Cost of capital helps to design the capital structure considering the cost of each sources of financing, investor’s expectation, effect of tax and potentiality of growth.
3. Evaluating The Performance
Cost of capital is the benchmark of evaluating the performance of different departments. The department is considered the best which can provide the highest positive net present value to the firm. The activities of different departments are expanded or dropped out on the basis of their performance.
4. Formulating Dividend Policy
Out of the total profit of the firm, a certain portion is paid to shareholders as dividend. However, the firm can retain all the profit in the business if it has the opportunity of investing in such projects which can provide higher rate of return in comparison of cost of capital. On the other hand, all the profit can be distributed as dividend if the firm has no opportunity investing the profit. Therefore, cost of capital plays a key role formulating the dividend policy.
Components Of Cost Of Capital
The individual cost of each source of financing is called component of cost of capital. The component of cost of capital is also known as the specific cost of capital which includes the individual cost of debt, preference shares, ordinary shares and retained earning. Such components of cost of capital have been presented below:
A. Cost Of Debt
- Cost of perpetual or irredeemable debt
- Cost of non-perpetual or redeemable debt
- Cost of debt issued on redeemable condition
- Cost of callable debt
B. Cost Of Preference Share
- Cost of perpetual preference Share
- Cost of redeemable preference Share
C. Cost of ordinary/equity shares or common stock
D. Cost of retained earning