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Cost of Capital
Cost of Capital
Cost of capital is the minimum rate of return expected by its investors. 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. Generally
higher the risk involved in a firm higher is the cost of capital.
Cost of capital for a firm may be defined as the cost of obtaining funds, i.e the average rate
of return that the investors ins firm would expect for supplying funds to the firm.
Cost of capital is the minimum required rate of earnings or the cutoff rate of capital
expenditures. COC is acutoff for the allocation of capital to investments of projects.
Three basic aspects of the concept of cost of capital:
1. Cost of capital is not a cost as such but it is the rate of return that a firm requires to earn
from its projects.
2. It is the minimum rate of returnwhich will at least maintain the market value of the
shares.
3. It comprises of three components :
a. The expected normal rate of return at zero risk level
b. The premium for business risk
c. The premium for financial risk on account of pattern of capital structure.
Cost of capital (k) is represented as
k=r0+b+f
Where k – cost of capital
r0 – Normal rate of return at zero risk level
b premium for business risk
f – premium for financial risk
Significance of the cost of capital
1. As an acceptance criterion in capital budgeting: Capital budgeting decisions can be made
by considering the cost of capital.
2. As a determinant of capital mix in capital structure decisions : Measurement of cost of
capital is very useful in capital budgeting decisions.
3. As a basis for evaluating the financial performance: Cost of capital can be used to
evaluate th financial performace of top management.
4. As a basis for taking other financial decisions: It helps in financial decisions like dividend
policy, capitalisation of profits , making the rights issue and working capital.