Cost of capital:meaning and significance

Cost of capital

Meaning of Cost of Capital:

An investor provides long-term funds (i.e., Equity shares, Preference Shares, Retained earnings, Debentures etc.) to a company and quite naturally he expects a good return on his investment.

In order to satisfy the investor’s expectations the company should be able to earn enough revenue.

Thus, to the company, the cost of capital is the minimum rate of return that the company must earn on its investments to fulfill the expectations of the investors.

If a company can raise long-term funds from the market at 10%, then 10% can be used as cut-off rate as the management gains only when the project gives return higher than 10%. Hence 10% is the discount rate or cut-off rate. In other words, it is the minimum rate of return required on the investment project to keep the market value per share unchanged.

In order to maximise the shareholders’ wealth through increased price of shares, a company has to earn more than the cost of capital. The firm’s cost of capital can be determined by working out weighted average of the different costs of raising different sources of capital.

Some definitions of financial experts are given below for the clear conception of cost of capital:

Ezra Solomon defines “Cost of capital is the minimum required rate of earnings or cut­off rate of capital expenditure”.

According to Mittal and Agarwal “the cost of capital is the minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price”.

According to Khan and Jain, cost of capital means “the minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged”.

Cost of capital depends upon:

(a) Demand and supply of capital,

(b) Expected rate of inflation,

(c) Various risk involved, and

(d) Debt-equity ratio of the firm etc.

Significance of or Importance of Cost of Capital:

The concept of cost of capital plays a vital role in decision-making process of financial management. The financial leverage, capital structure, dividend policy, working capital management, financial decision, appraisal of financial performance of top management etc. are greatly influenced by the cost of capital.

The significance or importance of cost of capital may be stated in the following ways:

1. Maximisation of the Value of the Firm:

For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital. There should be judicious mix of debt and equity in the capital structure of a firm so that the business does not to bear undue financial risk.

2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally cost of capital is the discount rate used in evaluating the desirability of the investment project. In the internal rate of return method, the project will be accepted if it has a rate of return greater than the cost of capital.

In calculating the net present value of the expected future cash flows from the project, the cost of capital is used as the rate of discounting. Therefore, cost of capital acts as a standard for allocating the firm’s investible funds in the most optimum manner. For this reason, cost of capital is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return etc.

3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions of business concern.

4. Management of Working Capital:

In management of working capital the cost of capital may be used to calculate the cost of carrying investment in receivables and to evaluate alternative policies regarding receivables. It is also used in inventory management also.

5. Dividend Decisions:

Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be formulated according to the nature of the firm— whether it is a growth firm, normal firm or declining firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth firm, normal firm and decline firm, respectively.

6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is the proportion of debt and equity, due importance is given to the overall or weighted average cost of capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimised.

7. Evaluation of Financial Performance:

The concept of cost of capital can be used to evaluate the financial performance of top management. This can be done by comparing the actual profitability of the investment project undertaken by the firm with the overall cost of capital.