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Subject

Paper No and Title Paper No 8: Financial Management

Module No and Title Module No 13: Cost of capital –an overview

Module Tag COM_P8_M13

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Factors affecting Cost of Capital
4. Significance of cost of capital
5.Some other concepts
5.1 Opportunity cost of capital
5.2 Explicit and Implicit cost of capital
5.3 Marginal cost of capital
6. Summary

SUBJECT PAPER No. : FINANCIAL MANAGEMENT

MODULE No. : COST OF CAPITAL – AN OVERVIEW
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1. Learning Outcomes
After studying this module, we shall be able to learn:

· The meaning and general concept of cost of capital

· Factors affecting cost of capital
· Significance of cost of capital
· The concept of opportunity cost of capital
· The relationship between risk and return of securities
· The concept of explicit and implicit cost of capital
· Meaning of Marginal Cost of Capital

2. Introduction

Concept

While setting up a new project or installing new machinery, a company needs funds which can be
raised from a different type of alternative sources of finance which are subject to different costs,
such as:
a) Debentures or Bonds
b) Preference shares
c) Equity shares
d) Retained earnings

A company’s capital structure is a combination of debt and equity. Debt comes in the form of
long-term debentures, bonds and loans and specific short-term debt like working capital
requirements. On the contrary, equity is categorized as common stock, preferred stock and
retained earnings. The capital structure shows how a businesscapitalizes its overall operations and
growth by means of alternative sources of funds. Thus, the cost of capital refers to the cost of a
firm's funds (debt, preference and equity capital).Optimal capital structure refers to the best debt-
to-equity ratio for a company that enhances its value and decreases the company’s cost of capital.
Therefore, accompanyis neededto determine the overall cost of capital or weighted average cost
of capital while making the investment decisions. As we have noted in the previous modules on
capital budgeting, evaluation of an investment proposal requires two basic inputs:

a) The proposal’s expected cash flows

b) The discount rate

SUBJECT PAPER No. : FINANCIAL MANAGEMENT

MODULE No. : COST OF CAPITAL – AN OVERVIEW
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The discount rate or the weighted average cost of capital is the minimum required rate of
return or the hurdle rate which a company must earn on its investments so as to be profitable
and so that its market value does not fall. In other words, the cost of capital is the minimum
rate of return that a firm must earn in order to satisfy the expectations of its investors.
Acceptance or rejection of an investment project depends on the cost that the company has to
pay for financing it. Good financial management calls for selection of such projects, which
are expected to earn returns, which are higher than the cost of capital. It is therefore,
important for the finance manager to calculate the cost of capital, which the company has to
pay and compare it with the rate of return, which the project is expected to earn. The cost of
capital is also known as Hurdle rate, Cut off rate, Discount rate, Target rate, Standard return,
Inflation rate, Required rate of return and opportunity cost of capital.

3. Factors affecting Cost of Capital

Following are the elements influencing cost of capital:

a) Risk free rate
b) Business risk premium
c) Financial risk premium
d) Other factors like liquidity and profitability

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The minimum return necessitate by the investors for keeping their purchasing power intact is
called risk free rate (RF). It is basically the compensation associated with time value of money.
When a person bestows money to another person for some time, then he is sacrificing his present
purchasing power in favor of the borrower. When he gets his money back after sometime, he
wants the compensation of this lose in purchasing power because this same money which he lent
does not convey the same value when it is returned back. Hence, the lender necessitates the
borrower to recompenseat least the risk free return on the borrowed amount to reimburse for time
value of money.

Business risk or operating risk (b) is the dissimilitude in firm’s earnings before interest and taxes
(EBIT) due to changes in sales turnover. If a firm is likely to pickfor a project which has wide
fluctuations in sales, the suppliers of funds would start perceiving higher risk and demand higher
return on their capital contribution to the firm, which will raise the cost of capital.

The risk kindred with the change in firm’s capital structure i.e. the proportion of debt and equity
is called financial risk (f). It refers to variation in earning per share (EPS) to changes in EBIT. It
increases with an expansion of debt component in the capital structure as debt involves a fixed
financial cost or fixed interest obligation on the part of the company. As a consequence, both
equity shares and even debenture holders would start perceiving higher risk in the company as the
firm’s operating profit may not be enough to meet the fixed interest obligation. Therefore, they
would start demanding greater rate of return resulting in increased cost of capital.

SUBJECT PAPER No. : FINANCIAL MANAGEMENT

MODULE No. : COST OF CAPITAL – AN OVERVIEW
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Theoretically, debt financing is considered as the economical source of finance due to its tax
deductibility. However, it is rarely found that a firm has 100% debt in its capital structure
because it also increases a company's risk. A healthy proportion of equity capital, along with
debt capital, in a firm’s capital structure is an indication of financial fitness. Thus, greater the
proportion of fixed cost securities in the overall capital structure, more would be the financial
risk and hence, the cost of capital.

Other factors (e) like liquidity and profitability are also likely to have an effect on the cost of
capital. If the source of finance is highly liquid, for example, if equity shares are freely tradable in
the secondary market, the firm would be able to raise the equity at a lower cost as in contrastto
circumstances where shares are not freely tradable. Similarly, if the business is highly profitable,
it will not face much difficulty in increasing the capital without much floatation cost.

Some other factors affecting the cost of capital which are beyond the control of a company are:
1. Level of Interest rates
The level of interest rates affects the cost of debt and, potentially, the cost of equity. For
instance, the cost of debt increases with a rise in general level of interest rates, which
ultimately increases the cost of capital.

2. Tax rates
The rate of tax prevalent in the economy also affects the after-tax cost of debt. The cost of
debt reduces with rise in the tax rates, reducing the cost of capital.

For a given company, debt is more dangerous than preferred stock, which is less dangerous than
the common stock. Therefore, preferred shareholders require higher return than the debenture
holders and equity shareholders require higher return than the preference shareholders.

Estimating the cost of capital requires us to first calculate the cost of each source of capital we
anticipate the company to use, along with the relative amounts of each source of capital we
anticipate the company to raise. Then, we can determine the marginal cost of raising
additional capital. Finally, we calculate the overall cost of capital which is also called
weighted average cost of capital by multiplying the cost of each source of capital with their
respective proportion in the total capital structure of the company.

4. Significance of Cost of capital

It is very necessary for the firms to compute the cost of its capital because of its significance in
financial management decisions of capital budgeting, capital structure, dividend decisions and so
on. Therefore, the consequence of cost of capital is briefly given as follows:

a) Evaluating investment proposals/ Capital budgeting decisions

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MODULE No. : COST OF CAPITAL – AN OVERVIEW
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One of the primary purposes of cost of capital is its use as a discount rate in evaluating the
desirability of investment proposals. The firm, naturally, will choose the project which gives a
satisfactory return on investment which would in no case be less than the cost of capital
incurred for its financing. In various methods of capital budgeting, cost of capital is the key
factor in deciding the project out of various proposals pending before the management. It
measures the financial performance and determines the acceptability of all investment
opportunities. Under Net present value (NPV) technique of Capital budgeting, the cash flows
are discounted at a rate equal

to the firm’s cost of capital and the project is accepted only if the discounted cash flows are
greater than the cost of project so as to generate a positive NPV. Similarly, under IRR
technique of capital budgeting, the project is accepted only if it has an IRR greater than the
cost of capital. A positive NPV or an IRR greater than the cost of capital makes a net
contribution to the wealth of shareholders, and thus, the concept of cost of capital is consistent
with the goal of maximization of shareholders wealth and it works as a tool to achieve this
goal. Hence, the cost of capital is the minimum required rate of return on the investment
project that keeps the present wealth of shareholders unchanged.
b) Designing the debt policy or the firm’s capital structure

The capital structure of a company comprises of different sources of funds such as debt, equity,
preference shares and retained earnings. Each source has different cost associated with it. The
cost of capital is a supreme factor in constructing a company’s capital structure. The cost of
capital is influenced by the changes in capital structure. In determining the capital structure of a
business, it is necessary toevaluate the cost of each source of capital and differentiate them so as
to determine which source of capital is in the interest of owners as well as of the contributors, i.e.,
creditors, etc. Though debt is the economical source of finance, but it involves financial risk as
well because of fixed interest payments attached to it. Further, debt helps to save taxes, as interest
on debt is a tax deductible expense. Thus, the firm should have such a combination of distinct
sources of funds which causes least risk and provides maximum return for that level of risk.An
efficient finance manager always has a watch on fluctuations of capital market and endeavor to
maintain the sound and cheapest capital structure for the company. He mayendeavorto use as a
replacement ofdivergenttechniques of finance in an expectation to lessen the cost of capital so as
to raise the market price and the earning per share.

c) Performance appraisal of top management

The cost of capital can be caste- off toassess the fiscalbehavior of the top management executives.
Evaluation involves a distinction of actual profitability of the projects assumed with the projected
overall cost of capital and an appraisal of the actual cost incurred in increasing the required funds.

d) Other areas

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MODULE No. : COST OF CAPITAL – AN OVERVIEW
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The technique of cost of capital is also necessary in many

others aspects of decision making, such as dividend decisions,
working capital policy etc.

5. Other related concepts

5.1 Opportunity cost of capital

The rate of return foregone on the next best alternative investment opportunity of similar or
comparable risk is called Opportunity cost of capital. For instance, suppose you have Rs. 10,000
to devote and there are two alternative investment options available before you. First alternative
is investment in a nationalized bank Fixed deposit that will fetch 9% p.a. rate of interest, and the
second option is to devote in Government bonds offering 10% p.a. rate of interest. Now, if you
select second option i.e. investment in government bonds, you are foregoing the chance of
investing in fixed deposit which is equivalent to 9% p.a.
For an investment to be worthwhile, the expected return on capital must be greater than the
cost of capital. The cost of capital is the rate of return that capital could be expected to earn in
an alternative investment of equivalent risk. It is the opportunity cost of capital.
The opportunity cost of capital of the investors varies with the nature and type of security
being offered by the firm. As the risk increases, the investors require a higher rate of return as
a compensation for bearing higher risk. “Higher the risk, higher the return demanded by the
investors” is the rule.

Return

Equity shares
Risk premium

Preference shares

Corporate Bonds

Govt. Bonds/ Public sector bonds

Risk Free rate Risk Free security

Risk

Figure 1: Risk Return relationship between different types of securities

SUBJECT PAPER No. : FINANCIAL MANAGEMENT

MODULE No. : COST OF CAPITAL – AN OVERVIEW
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The above diagram shows the risk return tradeoff between different types of securities. The
required return on any security is composed of two components:
a) Risk free rate and the
b) Risk premium
Risk free rate is the compensation for time value of money and risk premium is the
compensation for undertaking additional risk. For instance, a risk free security such as
Treasury bills issued by the Government of India just offers a risk free rate, as the risk
premium is zero because there is no additional risk. The payment is hundred percent secured
as they are issued by the government. On the other hand, equity shares are the most risky
form of security and thus investors demand a higher required rate of return on them. Henc
higher the risk of a security, the higher will be its risk premium and therefore, higher the
required rate of return.

5.2 Explicit and Implicit cost of capital

The cost of capital iscategorized as explicit and implicit cost of capital. Explicit cost of capital to
a company involves an explicit payment made by the business to the suppliers of funds such as
interest payments to debenture holders and dividend payments to preference and equity
shareholders. On the contrary, implicit costs of capital do not require any cash outflow to the
providers of funds. This is related with retained earnings. The profits earned by the company but
are not distributed to the equity shareholders in the form of dividendsare called retained earnings
Rather; these profits are cultivated back and put in power again within the company.Therefore,
implicit cost is like opportunity cost because had these profits been diffused to equity
shareholders, they could have infused these funds elsewhere and would have earned some return
on them. Thus, if the company does not distribute dividends and keep retained earnings, it
becomes obligatory on the part of the firm to generate enough return on these retained earnings
which should compensate the return generated by the shareholders had the dividend been paid to
them. Hence, retained earnings have implicit cost.

The explicit cost include only the cost of capital to be paid and ignores the other factors such
as risk involved, flexibility and leverage characteristics which are adversely affected with an
increase in debt contents in its capital structure and these changes imply additional but hidden
costs.

5.3 Marginal cost of capital

Marginal cost of capital is the average cost of new or incremental funds raised by the firm. It
tends to increase proportionately as the amount of debt increases. The overall marginal cost of
additional funds is calculated on the basis of market value weights because the new funds are
to be raised at the market values.

6. Summary

· The cost of capital refers to the cost of a firm’s funds (debt, preference and equity
capital).
· Strictly speaking, the cost of capital is the minimum rate of return that a company must
obtain money ina condition to satisfy the expectations of its investors. Acceptance or
SUBJECT PAPER No. : FINANCIAL MANAGEMENT
MODULE No. : COST OF CAPITAL – AN OVERVIEW
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rejection of an investment project is dependent on the

cost that the business has to pay for capitalizing it.
Good financial management requiresthe option of such projects, which are expected to
earn returns, which are higher than the cost of capital.
· Theelementsinfluencing cost of capital comprises ofrisk free rate, business risk
premium, financial risk premium, other factors like liquidity and profitability, interest rates
and tax rates.
· It is very necessary for the firms to determine the cost of its capital because of its
significance in financial management decisions of capital budgeting, capital structure,
dividend decisions and so on.
· The rate of return foregone on the next best alternative investment opportunity of similar
or comparable risk is called Opportunity cost of capital.
· The cost of capital can also be categorized as explicit and implicit cost of capital. Explicit
cost of capital to a company involves an explicit payment made by the company to the
suppliers of funds such as interest payments to debenture holders and dividend payments
to preference and equity shareholders. On the contrary, implicit cost of capital does not
include any cash outflow to the providers of funds. This is related with retained earnings.
· The average cost of new or incremental funds raised by the company is called Marginal
cost of capital.

SUBJECT PAPER No. : FINANCIAL MANAGEMENT

MODULE No. : COST OF CAPITAL – AN OVERVIEW