Cost of capital

Meaning of Capital:
Capital refers to cash or goods used to generate income either by
investing in a business or any other property.
Cost of capital
 Investor's point of view: Cost of capital is the return expected by the
providers of capital (i.e.... shareholders, lenders and debt holders)
 Company's point of view: When an entity (Corporate or others)
procures finance from equity or debt capital it has to pay a certain
amount as an additional amount besides their principal amount
 The additional money paid can be a lump sum amount or in
instalments.
 This additional money is said to be the cost of using the capital is
known as the cost of capital.
 Cost of capital is also known as cut-off rate, hurdle rate, minimum
rate of return etc.
 It is used in framing the debt policy of the firm AND TAKING
CAPITAL BUDGETING DECISIONS.
Definitions Of Cost Of Capital
1. According to John J. Hampton:”
Cost of Capital Is the Rate of Return the Firm Required from
Investment in Order To Increase The Value Of The Firm In The
marketplace Place”
2. According to Solomon Ezra” - Cost of capital is the minimum
required rate of earnings or the cut-off rate of capital
expenditure “
Publicly-listed companies can raise capital by borrowing money or selling
ownership shares.
Debt investors and equity investors require a return on their money, either
through interest payments or capital gains/dividends.
The cost of capital takes into account both the cost of debt and the cost of
equity.
The cost of equity tends to be higher than the cost of debt. This is because
equity investors can receive (potentially) higher gains.
Significance of Cost of Capital:
The concept of cost of capital is very relevant in the following fields of
Financial management:
1. Capital budgeting decision:
 The cost of capital may be used as the measuring road for adopting
an investment proposal. The firm, naturally will choose the project
which gives a satisfactory return on investment which would in no
case less than the cost of capital incurred for its financing. In
various methods of capital budgeting, the cost of capital Is the
key factor in deciding the project out of various proposals
pending before management. it measures the financial
performance and determines the acceptability of all investment
opportunities.
2. Designing the corporate financial structure:
A capable finance executive always keeps an eye on capital market
fluctuations and tries to achieve a sound and economical capital structure
for the firm. he may try to substitute various methods of finance in an
attempt to minimise the cost of capital so as to increase the market price
and the earnings per share.

3. Deciding about the method of financing: A capable Financial

executive must have knowledge of the fluctuations in the capital
market and should analyse the rate of interest on loans and normal
dividend rates in the market from time to time. Whenever a company
requires additional finance, he may have a better choice of the
source of finance which bears the minimum cost of capital. Although
the cost of capital is an important factor in such decisions equally
important are the considerations of relating control and of avoiding
risk
4. Performance of top management:
The cost of capital can be used to evaluate the financial performance of
the top executives. Evaluation of the financial performance will involve a
comparison of the actual profitability of the projects taken with the
projected overall cost of capital and an appraisal of the actual cost
incurred in raising the required funds.
5. Other areas:
The concept of cost of capital is also important in many other areas of
decision making such as dividend decisions, working capital policy etc.,

Classification of capital:
1. Historical and future cost:
Historical costs are book costs which are related to the past.
Future costs are estimated costs for the future.
 In financial decision making future costs are more relevant than
historical costs. However, historical costs act as a guide for the
estimation of future costs.
2. Specific cost and composite cost:
Specific cost refers to the cost of a specific source of capital
While composite cost is the combined cost of various sources of capital or
it is the weighted average cost of capital.
3. Explicit cost and Implicit cost:
An Explicit cost is the discount rate which equates the present value of
cash inflows with the present value of cash outflows. In other words, it is
the internal rate of return.
Implicit costs also known as the opportunity cost, is the cost of opportunity
foregone in order to take up a particular project.
4. Average cost and marginal cost:
Average cost refers to the combined cost of various sources of capital
such as debenture, preference shares, and equity shares, it is the
weighted average cost of various sources of finance.
Marginal cost refers to the average cost of capital which has to be incurred
to obtain additional funds required by the firm.

Cost of Equity:
Dividend yield method: Ke =D/MP or NP
Where Ke = cost of capital
D= dividend
MP/NP = market price / net proceeds
Dividend yield plus growth in dividend method:
Ke = D/ NP or MP+G