Cost of Capital

In Nutshell, Cost of Capital is the minimum rate of return required by

the investor.

The cost of capital is the rate of return that a firm must earn on the
projects in which it invests to maintain the market value of its stock. It
can also be thought of as the rate of return required by the market
suppliers of capital to attract their funds to the firm.
Cost of Capital also referred cut-off rate, target rate, hurdle rate,
standard return, minimum required rate of return.
Importance of Cost of capital
 
To Maximize Wealth : One of the goals of Financial management is to
maximize the firm’s goal. To achieve this goal expenses for inputs are needed to be
kept low. Capital is one type of input whose cost must be kept low and for this we need
to know how to measure it.
 
Investment Decision : We need to know the Cost of Capital for the
feasibility of the Long-term Investment Projects.
 
Capital Structure Decision : Cost of Capital is important for the
Optimum Capital Structure.
 
Other Financial Decisions : There are many types of decisions we take
such as the decisions regarding lease, short-term assets or working capital expenses etc.
It is necessary to have knowledge about Cost of Capital for taking those decisions.
 
Some Related Issues
Opportunity Cost: Opportunity costs are cash flows that could be realized from the best alternative
use of an owned asset. They therefore represent cash flows that will not be realized as a result of employing
that asset in the proposed project. Because of this, any opportunity costs should be included as cash outflows
when one is determining a project’s incremental cash flows.
 
Flotation Costs: The total costs of issuing and selling a security. It reduces the net proceeds from the
sale. Flotation Costs include two components:
 
1.Underwriting Costs- Pay to investment bankers.
2.Administrative Costs-Legal, accounting, printing, and other expenses.
 
Percentage of Floatation cost will be charged on Face Value if nothing is
mentioned.
 
Net Proceeds: The net proceeds from the sale of a bond, or any security, are the funds that are actually
received from the sale. Net Proceeds mean Net Sale Value (NSV).
 
Net Proceeds (NSV) = Selling Price of Securities (S.P) - Flotation cost (F.C)
Different Sources of Capital
 

Our concern is only with the long-term sources of funds available to a

business firm. There are four basic sources of long-term funds for the
business firm:
 

1.Long-Term Debt

2.Preferred Stock

3.Common Stock

4.Retained Earnings
 
 Factors that affect the WACC
 
Factors that the firm can not control:
 
1. Level of interest rate: An increase in Interest rate increases the cost of debt
capital. It also increases the cost of preferred stock and the cost of common stock.
So, bond holders pay higher interest rate as expectation for income increases due
to increase in interest rate. In this way, interest rate affects the cost of capital
which the firm can not control.
 
1. Market risk Premium: Market risk premium is determined by the intrinsic risk
of share and the tendency of avoiding the risk by the investors. Firm has no
control on this factor but it affects the cost of capital
 
1. Tax Rate: Tax rate affects the cost of capital greatly specially; it affects the cost
of debt capital as tax shield is gain on the interest payment on debt capital. So,
the cost of debt capital depends on the tax rate. Apart from this decrease in capital
gain tax decreases the cost of equity capital.
 
 Components of Cost of Capital

• Cost of Debt
• Cost of Preferred Stock
• Cost of Retained Earnings
• Cost of New Common Stock