Cost of Capital - Definitions, Classifications & Formulas

Cost of Capital

The cost of capital is an important financial concept. It links the company's long-term decisions with the wealth of the shareholders as determined in the market place. Whenever, a business organization raises funds, it has to keep in mind its cost. Hence, computation of cost of capital is very important and finance managers must have a close look on it. The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects.

It is a concept of vital importance in the financial decision-making. It is useful as a standard for:

1. Evaluating investment decisions,

2. Designing a firm’s debt policy, and

3. Appraising the financial performance of top management

The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk. Thus, the required rate of return on an investment project is an opportunity cost. In an all-equity financed firm, the equity capital of ordinary shareholders is the only source to finance investment projects, the firm’s cost of capital is equal to the opportunity cost of equity capital, which will depend only on the business risk of the firm. Viewed from all investors’ point of view, the firm’s cost of capital is the rate of return required by them for supplying capital for financing the firm’s investment projects by purchasing various securities. It may be emphasised that the rate of return required by all investors will be an overall rate of return - a weighted rate of return. Thus, the firm’s cost of capital is the ‘average’ of the opportunity costs (or required rates of return) of various securities, which have claims on the firm’s assets. This rate reflects both the business (operating) risk and the financial risk resulting from debt capital.

Classification of Cost of Capital

There is no fixed base of classification of cost of capital. It varies according to need, process and purpose. It may be classified as follows:

Explicit Cost and Implicit Cost:

Explicit cost is the discount rate that equates the present value of the funds received by the firm net of underwriting costs, with the present value of expected cash outflows. Thus, it is `the rate of return of the cash flows of financing opportunity’. On the other hand, the implicit cost is 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. In the other words, explicit cost relate to raising of funds and implicit costs relate to usage of funds.

Average Cost and Marginal Cost:

The average cost is the weighted average of the costs of each components of funds. After ascertaining costs of each source of capital, appropriate weights are assigned to each component of capital. Marginal cost of capital is the weighted average cost of new funds raised by the firms.

Future Cost and Historical Cost:

In financial decision-making, the relevant costs are future costs. Future cost i.e expected cost of funds to finance the projects is ascertained with the help of historical costs.

Specific Cost and Combined Cost:

The costs of individual components of capital are specific costs of capital. The combined cost of capital is the average cost of capital as it is inclusive of cost of capital from all sources. In capital budgeting decisions, combined cost of capital is used for accepting /rejecting the proposals.

The following are the basic characteristics of cost of capital:

i) Cost of capital is a rate of return; it is not a cost as such.

ii) This return, however, is calculated on the basis of actual cost of different components of capital.

iii) A firm's cost of capital represents minimum rate of return that will result in at least maintaining (If not increasing) the value of its equity shares.

iv) It is related to long-term capital funds.

v) Cost of capital consists of three components:

a) Return at Zero Risk Level. (r0)

b) Premium for Business Risk (b)

c) Premium for Financial Risk (f)

vi) The cost of capital may be put in the form of the following equation :

K = ro + b + f

Where

K = Cost of Capital

ro = Return at Zero Risk Level

b = Premium for Business Risk

f = Premium for Financial Risk

A firm's cost of capital has mainly three risks:

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:

Business risk is possibility where in the firm will not be able to operate successfully in the market. Greater the business risk, the higher will be the cost of capital.

Premium for Financial Risk:

It refers to the risk on account of pattern of capital structure. In other words, a firm having a higher debt content in its capital structure is more risky as compared to a firm, which has a comparatively low debt content.