Cost of Capital: Definition, Types, Elements, Classification, and Importance

What is Cost of Capital?

The cost of capital is the rate of return the company has to pay to various suppliers of funds in the company. If we have to explain briefly, The cost of capital is an expected return that the provider of capital plans to earn on their investment. It determines how a company can raise money (through a stock issue, borrowing or a mix of the two).

The cost of capital includes the cost of debt and the cost of equity.

The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default).

For companies with similar risk or credit ratings, the interest rate is largely exogenous.

The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown.

Definition of Cost of Capital

The following definitions give clarity about the cost of capital.

Hampton J.: The cost of capital may be defined as “the rate of return the firm requires from investment in order to increase the value of the firm in the market place.”

James C. Van Horne: The cost of capital is “a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.”

Solomon Ezra: “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure. “

Types of Cost of Capital

Followings are the types of cost of capital which are given below:

  1. Cost of Equity Capital
  2. Cost of Debt Capital
  3. Weighted Average Cost of Capital (WACC)

Cost of Equity Capital

The cost of equity capital is the cost of using the capital of equity shareholders in the operations. This cost is paid in the form of dividends and capital appreciation (increase in stock price).

Most commonly, the cost of equity is calculated using the following formula: The formula for Cost of Equity Capital = Risk-Free Rate + Beta * (Market Risk Premium – Risk-Free Rate)

Cost of Debt Capital

The cost of debt capital is the cost of using a bank’s or financial institution’s money in the business. The banks are compensated in the form of interest on their capital. The cost of debt capital is calculated using the following formula: Cost of Debt Capital = Interest Rate * (1 – Tax Rate)

Weighted Average Cost of Capital (WACC)

Most of the time, WACC is referred to as a cost of capital because of its frequent and vast utilization especially when evaluating existing or new projects. The weighted average cost of capital, as the term itself suggests, is the weighted average of all types of capital present in the capital structure of a company.

Assuming these two types of capital in the capital structure i.e. equity and debt, the WACC can be calculated by the following formula: WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt.

Elements of Cost of Capital

Followings are the elements of cost of capital:

  1. Cost of Equity
  2. Cost of Retained Earnings
  3. Cost of Preferred Capital
  4. Cost of Debt

Cost of Equity

The funds required for the project are raised from the equity share holders which are of permanent nature. These funds need not be repayable during the lifetime of the organization. Hence it is a permanent source of funds. The equity share holders are the owners of the company.

The main objective of the firm is to maximize the wealth of equity share holders. Equity share capital is the risk capital of the company. If the company’s business is doing well the ultimate and worst sufferers are the equity share holders who will get the return in the form of ends from the company and the capital appreciation from their investment.

Cost of Retained Earnings

The retained earnings are one of the major sources of finance available for the established companies to finance their expansion and diversification programmes. These are the funds accumulated over the years by the company by keeping part of the funds generated without distribution.

But so long as the retained profits are not distributed to the share holders, the company can use the funds within the company for further profitable investment opportunities.

Cost of Preferred Capital

The cost of preference share capital is the dividend expected by its investors. Moreover, preference share holders have a priority in dividend over the equity share holders. In case dividends are not paid to preference share holders, it will affect the fund raising capacity of the firm.

Hence dividends are usually paid regularly on preference shares except when there are no profits to pay dividends.

Cost of Debt

The cost of debt is the rate of interest payable on debt capital obtained through the issue of debentures. The issue of debentures involves a number of floatation charges, such as printing of prospectus, advertisement, underwriting, brokerage etc. Again, debentures can be issued at par or at times below par (at discount) or at times above par (at a premium).

Classification of Cost of Capital

There is no fixed basis for the classification of cost of capital. It varies according to need, process and purpose. It may be classified as follows:

  1. Explicit Cost and Implicit Cost
  2. Average Cost and Marginal Cost
  3. Future Cost and Historical Cost
  4. Specific Cost and Combined Cost

Explicit Cost and Implicit Cost

Explicit cost is the discount rate that equates the present value of the funds received by the firm net of underwriting costs, with the present value of expected cash outflows. Thus, it is `the rate of return of the cash flows of financing opportunity’.

On the other hand, the implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm were accepted. In the other words, explicit costs relate to the raising of funds and implicit costs related to the usage of funds.

Average Cost and Marginal Cost

The average cost is the weighted average of the costs of each component of funds. After ascertaining the costs of each source of capital, appropriate weights are assigned to each component of capital. The marginal cost of capital is the weighted average cost of new funds raised by the firms.

Future Cost and Historical Cost

In financial decision making, the relevant costs are future costs. Future cost i.e expected cost of funds to finance the projects is ascertained with the help of historical costs.

Specific Cost and Combined Cost

The costs of individual components of capital are specific costs of capital. The combined cost of capital is the average cost of capital as it is inclusive of the cost of capital from all sources. In capital budgeting decisions, the combined cost of capital is used for accepting or rejecting the proposals.

Importance of Cost of Capital

The following points describe the importance of cost of capital:

  1. Capital Budgeting Decisions
  2. Capital Structure Decisions
  3. Evaluation of Financial Performance
  4. Other Financial Decisions

Capital Budgeting Decisions

The cost of capital is used for discounting cash flows under the Net Present Value method for evaluating investment proposals. So, it is very useful in capital budgeting decisions.

Capital Structure Decisions

An optimal capital structure is that structure at which the value of the firm is maximum and the cost of capital is the lowest. So, the cost of capital is crucial in designing the optimal capital structure.

Evaluation of Financial Performance

The cost of capital is used to evaluate the financial performance of top management. The actual profitability is compared to the expected and actual cost of capital of funds and if profit is greater than the cost of capital the performance may be said to be satisfactory.

Other Financial Decisions

Cost of capital is also useful in making such other financial decisions as dividend policy, capitalisation of profits, making the rights issue, etc.

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