Cost of capital

Cost of capital is the return expected by the providers of capital to the business as compensation for their contribution to the capital.

Content

1.What is the meaning of cost of capital?

2.What is the significance of cost of capital?

3.How to determine cost of capital?

1.What is the meaning of cost of capital?

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the debt-holders) to the business as a compensation for their contribution to the total capital.

Further, when entity procured finances from either sources as listed above , it has to pay some additional amount of money besides the principal amount. The additional money paid to these financiers may be either one off or regular payment at specified intervals .

This additional amount money paid is said to be the cost of using the capital and it is called the cost of capital.

Moreover, this is expressed in rate is used to discount/ compound the cashflow or stream of cashflows. Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc. It is used as a benchmark for:

• Framing debt policy of firm

• Taking capital budgeting decisions

2.What is the significance of cost of capital?

The COC is important to determine correct amount and helps the management or an investor to take an appropriate decisions.

The correct COC helps in the following decision making:

a) Evaluation of investment options:

The estimated benefits from available investments opportunities are converted into the present value of benefits by discounting them with the relevant coc.

Here it is pertinent to mention that every investment option may have different coc. Hence it is very important to use coc which is relevant to the options available.

b) Financing Decisions:

When a finance manager has to choose one of the two sources of finance, he can simply compare their cost and choose the source which has lower cost. Besides cost , he also considers financial risk and control.

c) Designing of Optimum credit policy

While apprising the credit period to be allowed to the customers , cost of allowing credit period is compared against the benefit / profit earned by providing credit to customer of segment of customers. Here, coc is used to arrive at the present value of cost and benefits received.

3.How to determine cost of capital?

Cost is not the amount which the company plans to pay or actually pays, rather than it is the expectation of stakeholders. Here, stakeholders includes providers of capital i.e. shareholders, debenture holder, money lenders and intermediaries like brokers, underwriters, merchant bankers etc., and Government.

Example

If the company issues 9% coupon debentures but expectation of investors is 9% then investors will subscribe it at discount and not at par. Hence cost to the company will not be 9% , rather than it will be 10%. Besides giving return to investors, company will also have to give commission, brokerage, fees etc. to intermediaries for issue of debentures. It will increase cost of capital above 10%.

On other hand, payment of interest is a deductible expenses under the income Income Tax Act. Hence it will reduce the cost of capital to the company. Cost of any sources of finances is expressed in terms of percentage per annum. To calculate cost first of all we should identify various cash flows like:

i) Inflow amount received at the beginning.

ii) Outflow of payment of interest, dividend, redemption amount etc.

iii) Inflow of tax benefit on interest or outflow of payment of dividend tax.

Thereafter, we can use trial & error method to arrive at a rate where present value of outflows. That rate is basically IRR. In investment decisions, IRR indicates income because there we have initial outflow followed by series of inflows. In cost of capital , this IRR represents cost, because here we have initial outflow followed by series of net outflows.