UNIT-III

COST OF CAPITAL

Q.GIVE THE MEANING AND CONCEPT OF COST OF CAPITAL.

The cost of capital of a firm is the minimum rate of return expected by its investors. It is the
weighted average cost of various sources of finance used by a firm. The capital used by a firm may be in the
form of debt, preference capital, retained earnings and equity shares.
A decision to invest in a particular project depends upon the cost of capital of the firm or the cut off rate
which is the minimum rate of return expected by the investors. In case a firm is not able to achieve even the cut
off rate, the market value of its shares will fall. In fact, cost of capital is the minimum rate of return expected
by its investors which will maintain the market value of shares at its present level. Hence to achieve the
objective of wealth maximization, a firm must earn a rate of return more than its cost of capital.
Further, optimal capital structure maximized the value of a firm and hence the wealth of its owners and
minimizes the firms cost of capital.
Cost of capital for a firm may be defined as the cost of obtaining funds, ie., the average rate of return
that the investors in a firm would expect for supplying funds to the firm.

CONCEPT OF COST OF CAPITAL

There are three basic aspects of concept of cost of capital.
1 It is not a cost as such-A firms cost of capital is really the rate of return that it requires on the projects
available. It is merely a hurdle rate. Of course, such rate may be calculated on the basis of actual cost of
different components of capital.
2 It is the minimum rate of return-A firms cost of capital represents the minimum rate of return that will
result in at least maintaining(if not necessary) the value of the equity shares.
3 It comprises of three components-A firms cost of capital comprises three components.
a Return at zero risk level-This refers to the expected rate of return when a project involves no
risk whether business or financial.
b Premium for business risk-The term business risk refers to the variability in operating profit
(EBIT) due to change in sales. In case a firm selects a project having more than the normal or
average risk, the suppliers of funds for the project will expect a higher rate of return than the
normal rate.
The cost of capital will thus go up. The business risk is generally determined by the capital
budgeting decisions.
c Premium for financial risk-The term financial risk refers to the risk on account of pattern of
capital structure(or debt-equity mix).in general, it may be aid that a firm having a higher debt
content in its capita structure is more risky as compared to a firm which has a comparatively low
debt content.
This is because in the former case the firm requires higher operating profit to cover periodic interest
payment & repayment of principal at the time of maturity as compared to the latter. Thus, the chances of cash
insolvency are greater in case of such firms. The supplier of funds would therefore expect a higher rate of return
from such firms as compensation for higher risk.
ro
Symbolically cost of capital may be represented as: k= +b+F
Where k = cost of capital
ro
= normal rate of return at zero risk level
b=premium for business risk
f=premium for financial risk

Q.DEFINE COST OF CAPITAL

A cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that
will leave unchanged the market price of the stock.
According to Solomon Ezra, Cost of capital is the minimum required rate of earnings or the cut off rate of
capital expenditure.

1
Hampton, John J defines cost of capital as, the rate of return the firm requires from investment in order to
increase the value of the firm in the market place.

Q.EXPLAIN THE SIGNIFICANCE OF THE COST OF CAPITAL

As an acceptance criterion in capital budgeting:
Capital budgeting decisions can be made by considering the cost of capital. According to the present
value method of capital budgeting, if the present value of expected returns from investment is greater than or
equal to the cost of investment, the project may be accepted; otherwise, the project may be rejected. The
present value of expected returns is calculated by discounting the expected cash inflows as cut off rate (which is
the cost of capital). Hence the concept of cost of capital is very useful in capital budgeting decision.
As a determinant of capital mix in capital structure decisions:
Financing the firms assets is a very crucial problem in every business and as a general rule there should
be a proper mix of debt and equity capital in financing a firms assets. While designing an optimal capital
structure, the management has to keep in mind the objective of maximizing the value of the firm and
minimizing the cost of capital. Measurement of cost of capital from various sources is very essential in
planning the capital structure of any firm.
As a basis for evaluating the financial performance:
The actual profitability of the project is compared to the projected overall cost of capital and the actual
cost of capital of funds raised to finance the project if the actual profitability of the project is more than the
projected and the actual cost of capital, the performance may be said to be satisfactory.
As a basis for taking other financial decisions:
The cost of capital is also used in making other financial decisions such as dividend policy,
capitalization of profits, making the rights issue and working capital.