Cost of capital is an important factor that influences a firm’s capital structure. It is one of the cornerstones of the theory of financial management.
When formulating a company’s capital structure, it is necessary to consider and compare the cost of each source of capital to decide on which sources of capital are in the interest of the owners and shareholders.
The cost of capital of a firm is the minimum rate of return expected by its investors. In fact, the cost of capital is the minimum rate of return expected by its owner.
The objective of every company is wealth maximization. This means that a firm must earn a rate of return that exceeds its cost of capital; otherwise, the capital investment is not worth accepting.
A firm’s cost of capital is associated with the return expected by its investors, and it has a direct relation with the risk associated with the firm. Generally, a higher cost of capital is associated with greater risk.
Definitions of Cost of Capital
Several definitions of cost of capital have been proposed in the literature. Several of the most important and influential definitions are stated below:
1. Solemn Ezra: “The cost of capital is the minimum required rate of earnings or cut-off rate for capital structure.”
2. James C. Van Horne: “The cost of capital represents a cut-off rate for the allocation of capital to the investment of projects. It is the area of return on a project that will leave unchanged the market price of stock.”
3. Halley and Schall: “The cost of capital is the minimum discount rate used to value each stream.”
4. Hunt, William, and Donaldson: “The cost of capital may be defined as the rate of that which must be earned on the net proceeds to provide the cost elements of the burden at the time they are due.”
Importance of Cost of Capital
The concept of cost of capital is highly relevant when it comes to making managerial decisions. Key areas of utility include:
1. Useful in investment decisions: The cost of capital is useful in capital budgeting decisions. Firms choose projects that give a satisfactory return on investment, which would in no case be less than the cost of capital incurred for financing.
In various methods of capital budgeting, the cost of capital is the key factor used to select projects.
2. Useful in designing capital structure: The cost of capital is a useful factor when designing a firm’s capital structure.
A capable financial manager always considers capital market fluctuations and tries to achieve a sound and economical capital structure for the firm.
3. Useful in determining financing method: A capable financial executive must understand fluctuations in the capital market. They should also analyze the rate of interest on loans and the normal dividend rate in the market from time to time.
Whenever the company requires additional funding, the financial executive in the firm may be able to find a suitable choice in terms of a source of finance that bears the minimum cost of capital.
4. Performance of top management: Companies can use the cost of capital to evaluate the financial performance of top management.
Evaluation of financial performance usually involves a comparison of the actual profitability of projects undertaken to the projected overall cost of capital, along with an appraisal of the actual cost incurred in raising the required funds.
5. Optimal resource mobilization: The cost of capital can also be used as a medium for optimal resources mobilization. It can also help government departments establish reasonable financial priorities.
Both the private and public sectors can use this technique to identify projects that are taken irrespective of profitability.
6. Useful in evaluating expansion projects: The cost of capital is a useful technique to study the financial implications of potential expansion plans.
In these cases, a comparison is made between the marginal return on investment and the cost of financing the expansion, and the excess return is used as one of the criteria for project selection.
7. Other Uses: The cost of capital is important in many decision-making areas, including dividend and retained earnings payments, capital structure, working capital management, capital expenditure control, and profit maximization.
Cost of capital is the minimum rate of return that a company expects to earn from a proposed project so as to safeguard against a reduction in the earnings per share to equity shareholders and the share market price.
In economics, there are two approaches to define the cost of capital.
According to the first approach, the cost of capital is defined as the borrowing rate at which a firm acquires funds to finance its projects.
The second approach is that cost of capital is defined as the lending rate that the firm could have earned if it had invested its funds elsewhere.
The cost of capital is the combined cost of each type of source by which a firm raises funds to finance different capital investment proposals.