Introduction

The Cost of Capital is the most important and controversial area in Financial Management.
Capital Budgeting decisions have a major impact on the firm, and Cost of Capital is used as a
criterion to evaluate the capital Budgeting decisions i.e., whether to accept or reject a project.
Knowledge about cost of capital, and how it is influenced by financial leverage, is useful in
making capital structure decisions. The cost of capital is the most important concept in financial
decision making. The chief objective of measuring the cost of capital is its use as a decision
criterion in capital budgeting. The cost of capital is a term used in the field of financial
investment to refer to the cost of a company’s funds (both debt and equity), or, from an
investor’s point of view “the shareholder’s required return on a portfolio of all the company’s
existing securities”. It is used to evaluate new projects of a company as it is the minimum return
that investors expect for providing capital to the company, thus setting a benchmark that a new
project has to meet.

Meaning of cost of capital

Cost of Capital is the minimum rate of return that must be earned on investments, in order to
meet the rate of return required by the investors. It is the discount rate applied to evaluate the
firm’s capital projects.

According to Professor I.M.Pandy “Cost of Capital is the discount rate used in evaluating the
desirability of the investment project”. The cost of capital is the minimum rate of return required
for investment project.

In other words, it is the rate that suppliers of funds expect to get. It is determined by the cost of
the various sources of finance. It is also referred to as the weighted average cost of capital
(WACC) or composite/combined cost of capital

Classification of Cost of Capital

Cost of Capital can be classified as follows:

(i) Historical Cost and Future Cost: Historical costs are book costs relating to the past, while
future costs are estimated costs act as guide for estimation of future costs.

(ii) Specific Costs and Composite Costs: Specific cost is the cost of a specific source of capital,
while composite cost is combined cost of various sources of capital. Composite cost, also known
as the weighted average cost of capital, should be considered in capital and capital budgeting
decisions.

(iii) Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which
equates the present value of cash inflows with the present value of cash outflows. It is the
internal rate of return and is calculated with the following formula;

 K = Explicit cost of capital

 N = Duration of time period

Implicit cost also known as the opportunity cost is the opportunity foregone in order to take up a
particular project. For example, the implicit cast of retained earnings is the rate of return
available to shareholders by investing the funds elsewhere.

(iv) Average Cost and Marginal Cost: An average cost is the combined cost or weighted
average cost of various sources of capital. Marginal cost refers to the average cost of new or
additional funds required by a firm. It is the marginal cost which should be taken into
consideration in investment decisions.

 Market Value Added

  Capital Budgeting

How to calculate cost of capital

1. Cost of Debt

While debt can be detrimental to a business’s success, it’s essential to its capital structure. Cost
of debt refers to the pre-tax interest rate a company pays on its debts, such as loans, credit cards,
or invoice financing. When this kind of debt is kept at a manageable level, a company can retain
more of its profits through additional tax savings.

There are many ways to calculate cost of debt. One common method is adding your company’s
total interest expense for each debt for the year, then dividing it by the total amount of debt.

Another formula that businesses and investors can use to calculate cost of debt is:

Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)

2. Cost of Equity

Cost of equity is the rate of return a company must pay out to equity investors. It represents the
compensation that the market demands in exchange for owning an asset and bearing the risk
associated with owning it.

Cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which considers an
investment’s riskiness relative to the current market.To calculate CAPM, investors use the
following formula:

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return - Risk-Free Rate of
Return)
3. Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the most common method for calculating cost
of capital. It equally averages a company’s debt and equity from all sources.

WACC is calculated by multiplying the cost of each capital source (both equity and debt) by its
relevant weight by market value, then adding the products together to determine the total. The
formula is:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Importance of Cost of Capital

The Cost of Capital is very important in Financial Management and plays a crucial role in the
following areas:

 (i) Capital budgeting decisions: The cost of capital is used for discounting cash flows
under Net Present Value method for investment proposals. So, it is very useful in capital
budgeting decisions.

 (ii) Capital structure decisions: An optimal capital is that structure at which the value of
the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in
designing optimal capital structure.

 (iii) Evaluation of final Performance: Cost of capital is used to evaluate the financial
performance of top management. The actual profitably is compared with the actual cost
of capital of funds and if profit is greater than the cost of capital the performance nay be
said to be satisfactory.

 (iv) Other financial decisions: Cost of capital is also useful in making such other
financial decisions as dividend policy, capitalization of profits, making the rights issue,
etc.

Factors affecting cost of capital

(a) Dividend Policy:
The cost of equity is also influenced by a company’s dividend policy. When a company makes
profits, it can distribute them to the shareholders as dividends or reinvest them into the company
as retained earnings or it can do both by deciding the dividend pay-out ratio. The firm may use
retained earnings to retire costly debts, hence changing its overall cost of capital and debt equity
ratio. Although retained earnings have an implicit cost, yet they are considered to be a cheaper
source of finance.

(b) Amount of Financing:

The cost of funds also depends on the level of financing that the firm requires. As the financing
requirements of the firm become larger, the weighted cost of capital increases for several
reasons. For instance, as more securities are issued, additional floatation costs are incurred,
which in turn tend to cause a rise in the cost of capital.

(c) Economic Conditions:

The economic conditions in the form of demand and supply of capital as well as expectations
with respect to inflation also affect the cost of capital. If the demand for funds in the economy
increases, lenders will automatically increase the required rate of return and vice versa.

(d) Tax Considerations:

Corporate taxes as well as value added tax also exert an influence in determining the cost of
capital in a firm. A higher rate of corporate tax makes the debt funds cheaper because of the tax
shield enjoyed by interest. The tax rates affect the after-tax cost of debt. As tax rates increase, the
cost of debt decreases, thereby causing overall cost of capital to decline. A higher value added
tax increases the indirect tax burden and increases the amount of funds that are tied up with
credit customers