Cost of Capital Critical Analysis

Cost of Capital Definition: cost of capital is the rate of return that a company must earn on its project investments to maintain its market value and attract funds. The cost of capital to a company is the minimum rate of return that is must earn on its investments in order to satisfy the various categories of investors, who have made investments in the form of shares , debentures and loans. The cost of capital in operational terms refers to the discount rate that would be used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not.

It is defined as “the minimum rate of return” that a firm must earn on its investment for the market value of the firm to remain unchanged. Basic Aspects of concept of Cost of capital : here are three basic aspects of concept of cost. They are: * It is not a cost as such. * It is the minimum rate of return. * It comprises the following 3 components: * Return at Zero risk level – This refers to the expected rate of return when a project involves no risk whether business or financial. Premium for business risk – The term business risk refers to the variability in operating profit due to change in sales. The concept is higher the risk, higher is the expected return. * Premium for financial risk – The term financial risk refers to the risk on account of pattern of capital structure. In general, it can be said that a firm having higher debt content in its capital structure is more risky as compared to a firm which has comparatively low debt content. Importance of Cost of capital: It is relevant in the field of managerial decision as this dynamic concept is affected by a company’s capital structure, its’ financing plans for the future and any changes in the rate of earnings. * When taking decisions based on Net Present Value method, the cost of capital is usually the discount rate that discounts the cash inflows. * It is important in designing the capital structure of a firm. * It is helpful in evaluation of expansion projects, evaluation of the financial performance of the top management through the comparison of the projected overall cost of capital and the actual cost incurred in raising the required funds. It is a vital factor in management decision about the method of financing at a given time. Costs of various sources of capital at a given time influence the management’s decision in favor of a certain capital. Cost of capital can be classified as follows: * Explicit cost of capital – It may be defined as the discount rate that equates the present value of funds received by the firm net of underwriting costs, with the present value of expected cash outflows. It is the rate of return of the cash flows of financing opportunity. It is, in other words, the internal rate of return the firm pays for financing. Implicit cost of capital – The implicit cost may be defined as the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm were accepted. * Future cost of capital – It is the projected cost of capital used in designing the capital structure to minimize the future cost of capital and to control it. * Historical cost of capital – It is the cost which has already been incurred for financing a particular project.

These costs are useful in projecting future costs. * Specific cost of capital – It is the cost associated with particular component of capital structure. * Average cost of capital – It is the average of various cost of the weighted average of the costs of each component of funds employed by the concern, the weights being the proportion of each component in the capital structure. * Combined cost of capital – It includes the cost of capital from all sources namely, debt, equity, preference capital and retained earnings. It is also called as the weighted cost of capital. Marginal cost of capital – Marginal cost of capital is the weighted average cost of new funds raised by the firm. For capital budgeting and financing decisions, the marginal cost of capital is the most important factor to be considered. Cost of debt : Cost of debt is the interest rate that the company pays on its debt content of the capital structure. It can be measured as before tax cost of debt or after tax cost of debt. Tax plays an important role as the debenture interest expense is allowed as an expense for tax purposes. Debt may be issued at par, at premium or at a discount.

It may be irredeemable or redeemable. Cost of Irredeemable debt: Irredeemable debentures are those debentures issuing by which the company has no obligations to pay back the value of the debenture on some fixed date or time and has the full authority to choose any time to pay back the debt until the company is a going entity and does not default in it’s interest payments. So we take into account only the sale value (SV) while evaluating the cost of irredeemable debentures. Cost of Redeemable debt: For redeemable debentures, the maturity date is fixed initially.

The meaning redeemable denotes that the debentures would be redeemed by the company at a fixed date or after a specified period of notice. So, we take the average of Sale Value and Redeemable value while calculating the cost of redeemable debentures. Cost of Preference Capital Preference shares represent a special type of ownership interest in the firm. They are entitled to a fixed dividend, but subject to availability of profit for distribution. The preference share holders have to be paid their fixed dividends before any distribution of dividends to the equity shareholders.

Their dividends are not allowed as an expense for the purpose of taxation. In fact, the preference dividend is a distribution of profits of the business. Because dividends are paid out of profits after taxes, the question of after tax or before tax cost of preference shares does not arise as in case of cost of debentures. Cost of Irredeemable preference shares : Irredeemable preference shares are those shares issuing by which the company has no obligation to pay back the principal amount of the shares during its lifetime. The only liability of the company is to pay the annual dividends.

The cost of irredeemable preference shares is: formula Cost of Redeemable preference shares: Redeemable preference shares are those shares which have a fixed maturity date at which they would be redeemed. Formula Cost of equity Capital : The cost of equity capital is the minimum rate of return that a company must earn on the equity financed portion of its investments in order to maintain the market price of the equity share at the current level. The cost of equity capital is rather difficult to estimate because there is no definite commitment on the part of the company to pay dividends.

However, there are various approaches for computing the cost of equity capital. They are: CAPM (Capital asset pricing model ) : this is a popular approach to estimate the cost of equity. According to the SML, the cost of equity capital is: Ke = rf + ? (Km – rf) Where: Ke = Cost of equity Krf = Risk-free return Km = Equity market required return (expected return on the market portfolio) ? = beta Dividend Method : Dividend Growth Method: Weighted Average Cost of Capital : The term Cost of Capital refers to the over-all composite cost of capital.

It is defined as the Weighted Average Cost of Capital (WACC). The percentage or proportion of various sources of finance used by a company is different. For example, not all companies would have 33. 33% of debt, 33. 33% of preference capital and 33. 33% of equity. This is not practical and hence we use the weighted average and not the simple average. Thus, the overall cost of capital should take into account the respective proportions of various sources of funds and hence the weighted average comes into question. The computation of the over-all cost of capital involves the following steps: 1.

Calculate the cost of specific source of funds such as the cost of debt, cost of preference capital, cost of equity and cost of retained earnings. 2. Multiplying the cost of each of the sources by its weight which is obtained by calculating its’ proportion to the total capital. 3. Add these weighted costs from all the sources of funds to arrive at weighted average cost of capital. Formula Factors affecting Weighted Average Cost of Capital: Factors outside a firm’s control: * Interest rate levels * Market risk premium * Tax rates Factors within a firm’s control: * Investment policy * Capital structure policy * Dividend policy