Cost of Capital Meaning, Definitions, Components, Significance and Problems

[Cost of Capital Meaning, Definitions, WACC meaning, How cost of capital is determined?, Components of cost of capital, Significance, Problems in Determination of the cost of capital]

Cost of Capital Meaning

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.

Cost of Capital Definitions

According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.

According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.

Weighted average cost of capital (WACC) Meaning

Weighted average cost of capital (WACC) is the average of the minimum after-tax required rate of return which a company must earn for all of its security holders (i.e. common stock-holders, preferred stock-holders and debt-holders). It is calculated by finding out cost of each component of a company’s capital structure, multiplying it with the relevant proportion of the component to total capital and then summing up the proportionate cost of components. WACC is a very useful tool because it tells whether a particular project is increasing shareholders’ wealth or just compensating the cost.

Weighted average cost of capital (WACC) Formula

For a company which has two sources of finance, namely equity and debt, WACC is calculated using the following formula: WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)

👉Cost of equity: In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common stock of the company. It is the minimum rate of return which a company must earn to keep its common stock price from falling. Cost of equity is estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).

👉Weights: w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market value of the company’s equity by sum of the market values of equity and debt. w(D) is the weight of debt component in the company’s capital structure. It is calculated by dividing the market value of the company’s debt by sum of the market values of equity and debt.

How cost of capital is determined?

Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts:

1. It is not a cost as such. It is merely a hurdle rate.

2. It is the minimum rate of return.

3. It consists of three important risks such as zero risk level, business risk and financial risk.

Cost of capital can be measured with the help of the following equation.

K = rj + b + f.

Where,

K = Cost of capital.

rj = The riskless cost of the particular type of finance.

b = The business risk premium.

f = The financial risk premium.

Various components of cost of capital

Capital structure of a company mainly consists of debt and equity. Debt includes debentures, loans and bonds and equity include both equity and preference shares and retained earnings. 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 earnings. Such components of cost of capital have been presented below:

1. Cost of debt

a) Cost of irredeemable debt

b) Cost of redeemable debt (before tax and after tax)

c) Cost of debt redeemable in installments

d) Cost of existing debt

e) Cost of zero coupon bonds

2. Cost of Preference Share

a) Cost of irredeemable preference Share

b) Cost of redeemable preference Share

3. Cost of ordinary/equity shares or common stock

4. Cost of retained earning

Significance of Cost of Capital

Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.

a)      Importance to Capital Budgeting Decision: Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.

b)      Importance to Structure Decision: Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.

c)       Importance to Evolution of Financial Performance: Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.

d)      Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.

Problems in Determination of the cost of capital

The determination of the cost of capital of a firm is not an easy task. The finance manager is confronted with a large number of problems, both conceptual and practical, while determining the cost of capital of a firm. These problems in determination of cost of capital can briefly be summarized as follows:

1.       Controversy regarding the dependence of cost of capital upon the method and level of financing: There is a, major controversy whether or not the cost of capital dependent upon the method and level of financing by the company. According to the traditional authors, the cost of capital of a firm depends upon the method and level of financing. On the other hand, the modern authors such as Modigliani and Miller the firm’s total cost of capital argue that is independent of the method and level of financing. An important assumption underlying MM approach is that there is perfect capital market. Since perfect capital market does not exist in practice, hence the approach is not of much practical utility.

2.       Computation of cost of equity: The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged. This means that determination of the cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares on the basis of a large number of factors, financial as well as psychological.

3.       Computation of cost of retained earnings and depreciation funds: The cost of capital raised through retained earnings and depreciation funds will depend upon the approach adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager has to face difficult task in subscribing and selecting an appropriate approach.

4.       Future costs versus historical costs: It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total funds.

5.       Problem of weights: The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. The results would be different in each case.