The cost of capital is very important concept in the financial decision making.

Cost of capital
is the measurement of the sacrifice made by investors in order to invest with a view to get a
fair return in future on his investments as a reward for the postponement of his present needs.
On the other hand, from the point of view of the firm using capital, cost of capital is the price
paid to the investor for the use of capital provided by him. Thus, cost of capital is reward for
the use of capital.
Cost of capital is the rate applied by firms in deciding which investments to accept and which
to reject. As the weighted average cost of capital is the relative mix of various sources of
capital financing, in order to maximize shareholders wealth, this rate serves as the benchmark
for investment decisions. An investment that yields a return higher than cost of capital
resulting in positive Net Present Value, and hence should be accepted.
In case where the weighted average cost of capital is underestimated, the firm could end up
accepting a non-profitable investment project and resulting in reduction of shareholders
wealth. In case where the weighted average cost of capital is overestimated, the firm could
end up rejecting an actually profitable investment project, forgoing the opportunity to
increase shareholders wealth.

The effect of taxes on the firm’s cost of capital is observed in computing the cost of debt.
Since interest is a tax-deductible expense, the use of debt indirectly decreases the firm’s
taxes. Therefore, since we have computed the internal rate of return on an after-tax basis, we
also compute the cost of debt on an after-tax basis. In completing a security offering,
investment bankers and other involved individuals receive a commission for their services.
As a result, the amount of capital net of these flotation costs is less than the funds invested by
the individual purchasing the security. Consequently, the firm must earn more than the
investors’ required rate of return to compensate for this leakage of capital.

Equity capital can be raised by either retaining profits within the firm or by issuing new
common stock. Either route represents funds invested by the common stockholders.
The first avenue simply indicates that the common stockholder permits management to retain
capital that could be remitted to these investors. In essence, even though no explicit out-of-
pocket cost results from retaining the capital, the cost in measuring a firm’s cost of capital is
actually the opportunity cost associated with these funds for the investors. Management
should satisfy the investors’ required rate of return when retaining profits to reinvest.
Many factors influence the operating leverage of a firm:
- The variability of sales volume over business cycle – turnover highly sensitive to
changes in economic conditions (boom or recession)
- Level of competition which depends on existence of market power (monopoly,
oligopoly, perfect competition) and barriers to entry
- The variability of selling price – certain industries suffer from price instability
- The variability of costs – usually relates to input costs
- The extent of product diversification – multiple product lines can yield economies of
scope and facilitate price bundling strategy
- Degree of operating leverage – a firm with higher fixed operating costs will
experience more volatile operating income when sales change
Business risk is the uncertainty that envelops the firm’s stream of EBIT. One possible
measure of business risk is the coefficient of variation in the firm’s expected level of EBIT.
Business risk is the residual effect of the:
1. Company’s cost structure
2. Product demand characteristics
3. Intra-industry competitive position.
The firm’s asset structure is the primary determinant of its business risk.
Financial risk can be identified by its two key attributes:
1. The added risk of insolvency assumed by the common stockholder when the firm
chooses to use financial leverage.
2. The increased variability in the stream of earnings available to the firm’s common
stockholders.

Business risk is the risk that the firm will be unable to cover its operating costs. Three factors
affecting business risk are:
1. The use of fixed operating costs (operating leverage)
2. Revenue stability
o Refers to the relative variability of the firm’s sales revenues, which is a
function of the demand for the firm’s product.
3. Cost stability
o Refers to the relative predictability of the input prices such as labour and
materials.
The greater the revenue and cost stability, the lower the business risk. The capital structure
decision is influenced by the level of business risk. Firms with high business risk tend toward
less highly leveraged capital structures, and vice versa.
Financial risk is the risk that the firm will be unable to meet required financial obligations.
The more fixed-cost components in a firm’s capital structure (debt, leases, and preferred
stock), the greater its financial leverage and financial risk. Therefore, financial risk is affected
by management’s capital structure decision, and t hat is affected by business risk.