Cost of capital which is used as a financial standard plays a crucial role in capital budgeting

decisions. It is the discount rate applied for evaluating the desirability of investment projects. An
investment project can be accepted if it has a positive net present value. Besides, financial
decisions taken by the management of a firm are appropriately evaluated using the weighted
average cost of capital. The cost of capital influences debt policy of a firm.
Some thoughts on the cost of capital
Progress
There have been a number of significant advances in theory and in practice over the last forty
years. No longer do most forms use the current interest rate. It is generally accepted that a
weighted average of the costs of all the sources of finance is to be used. It is also accepted that
the weights are to be based on market values rather than book values, as market values relate
more closely to the opportunity cost of the finance providers. Furthermore, it is possible that the
WACC may be lowered and shareholder value raised by shifting the debt/equity ratio. Even
before the development of modern finance it was obvious that projects that had a risk higher than
that of investing in government securities require a higher rate of return. A risk premium must be
added to the risk-free rate determine the required return. However, modern portfolio theory has
refined the definition of risk, so the analyst need only consider compensation for systematic risk.
The Fama and French Three-factor Model
Since its appearance in 1964, the validity and testability of the CAPM has been the subject of
intense debate in the academic literature. Fama and French found that after accounting for other
variables. Specifically firm size and book-to-market equity ratio, beta has no power to explain
the cross-sectional dispersion in average returns of stocks. Based on the evidence in 1992, Fama
and French developed an alternative model for expected returns of stocks. They suggested a 3
factor model of the expected return premium required on a risky security. The three factors are:
 The expected premium on the market portfolio at date t, (rmt-rft)
 The difference between the expected returns on portfolios of stocks of small and large
firms denoted as SMBt
 The difference between the expected returns on portfolios of stocks that exhibit high and
low book-to-market equity ratios, denoted as HML. According to FF Three-factor model,
 as it is known, the expected return on security i is -

Where bit, sit, hit are the sensitives of rfeturns on stock i .

Critics argue that Farma and French model is without theoretical foundation. But authors
argued that both the book-to-market factor and the firm size factor are risk proxies. The
risk interpretation is that a firm with a high book-to-market equity ratio is likely to be
distressed. Such film may have sustained losses recently and consequently has a
substantial risk of bankruptcy.

Some thoughts of calculating cost of equity

At present we find several methods for calculating cost of equity. From the inception of the idea
of calculating cost of equity the method of finding out the cost has undergone different distinct
changes. New methods evolved and those replaced the formers. Starting from the fundamental
work in this area by F.Modigliani and M.Miller in 1958 the evolution process of the methods to
calculate cost of equity is still continuing. The entire evolution process has three distinct phases.
‘Phase 1 ’ started with the pioneering work of F.Modigliani and M.Miller in 1958 and continued
till late 1970's, in this stage the simple cost of capital model (Modigliani & Miller, 1958) laid the
foundation. Then it is refined by 'dividend policy’, ‘growth’ and ‘value of shares’ (Modigliani
& Miller, 1961) and corrected for ‘tax factor’ (Modigliani & Miller, 1963) and upgraded by
introduction of the ideas of ‘Overall Cost of Capital (OCC)’. Refinement of the OCC gave us the
concept of ‘Weighted Average Cost of apital (WACC)’ and ‘Phase T finally experienced
different models for finding out cost of equity capital like ‘earnings growth model’, ‘dividend
growth model’, etc. the ‘Phase 2’ started from late 1970’s with the publications of Michael C.
The ‘Phase 3’ started from the early 1990’s. Identification of “Long Run Performance” of a
company marked the beginning of this stage where direct use of “market efficiency” was
dropped. This stage is characterized by NPV, EVA, etc. The third phase of capital structure
research dropped the assumption of market efficiency,many papers have examined corporate
financial decisions where existing shareholders can create value for themselves not only by
having the firm undertake positive NPV projects, but also by timing external financing decisions
to take advantage of time varying relative costs of debt and equity caused by market
inefficiencies.