Chapter: Cost of capital

Q. Definition:

Cost of capital is a borrowing rate and generally it refers the payable of interests and dividends. For
capital investment decision, cast of Capital can be better termed as explicit cost of capital. Explicit
cost of capital means the rate of return which makes the present value of cash inflows equal to
present value of cash onflows/outflows. It is a minimum standard rate below which no investment
decisions are acceptable. So, the term cost of Capital can be defined as the minimum rate of return
which the company is required to earn in order to keep the market value of its shares. unchanged.
But if the term cost of capital is used in terms of lending money, it is called opportunity cost or
implicit cost i.e., the state of return which the company could have earned if the funds are invested
outside the business. Cost of retained earnings is an example of implicit cost and is arise only when
funds are invested. On the other hand, explicit costs arise only when funds have been raised. Each
source of fund has its own cost which is called specific cost and when all these specific costs are
combined or find out the overall cost of capital it is termed as combined cost of capital or Composite
cost of capital on weighted cost of capital. Any way cost of capital is also referred to as cut-off rate,
target rate, bundle rate, minimum required rate of return, standard return hurdle rate and so on.

Q. Flotation Cost:

when business firms sell new securities, they generally engage an investment banking firm.
Investment bankers may underwrite a large amount of issues; they buy issues from the company and
sell them to investors. The fee they receive for their services is the flotation cost. Flotation costs also
include legal fees and other expenses associated with the new issue of security. So, the flotation
costs are the costs of issuing and selling a security. Flotation cost includes are:

(a) Underwriting cost: publicity, commission, selling expenses.

(b) Administrative cost: issuing, legal, printing accounting & others.

Q. significance of the cost of Capital:

we should recognise that the cost of capital is one of the most difficult and disputed topics in the
finance theory. Financial experts express conflicting opinions as to the correct way in which the cost
of capital can be measured. Irrespective of the measurement problems, it is a concept of vital
importance in the financial decision-making. It is useful as a standard for:

1. Evaluating investment decisions: The primary purpose of measuring the cost of capital is its use as
a financial standard for evaluating the investment projects. It represents a financial standard for
allocating the firm's funds, supplied by owners and creditors to the various investment projects in
the most efficient manner. It plays a very vital role in investment decisions. It helps the management
to ascertain the acceptance/rejection decision for any new investment proposals. With the help of
acceptance-rejection rule management can determine the profitability of the new proposals and can
select the most profitable proposals out of so many alternatives.

2. Formulating Capital structure: The concept of cost of capital is very important in formulating the
capital structures of the company. This is an e useful concept as it helps the management in deciding
the future capital structure of the company. The capital structure includes both borrowed capital and
own capital. Every source of capitals on funds has its own cost.

3. Designing debt policy: The debt policy of a firm is significantly influenced by the cost
consideration. Debt helps to save taxes, as interest on debt is a tax-deductible expense. The interest
tax shield reduces the overall cost of capital, though it also increases the financial sick of the firm. In
designing the financing policy, that is, the proportion of debt and equity in the capital structure, the
firms aim at maximising the firm value by minimising the overall cost of capital. The cast of capital
can also be useful in deciding about the methods of financing at a point of time. For example, Cost
may be compared in choosing between leasing and borrowing. Of course, equally important
considerations are control and risk.

4. Performance Appraisal: The cost of capital framework can be used to evaluate the financial
performance of top management. Such an evaluation will involve a comparison of actual profitability
of the investment projects undertaken by the firm with the projected overall cost of capital, and the
appraisal of the actual costs incurred by management in raising the sequined funds.

The cost of capital also plays а veгу useful role in dividend decision and Investment in current assets.

Q. Factors Influencing cost of Capital Determination

The factors influencing the determination of cost of Capital are discussed as follows:

1. Business Risk: Business risk is that which Occurs from operating business of a firm. It is influenced
among others, largely by fixed costs incurred. The higher the fixed costs, the greater will be the
business risk and vice-versa. It is one of the important factors that influence the determination of
cost of capital. The more the business risk, the higher will be the cost of Capital.

2. Financial Risk: Financial risk is one that an enterprise will be unable to satisfy its financial.
obligations. The risk that will reduce the financial resources of a firm is known as financial-risk. The
more the financial risk the more. will be the cost of capital.

3. Sources of Finance: There are various sources of finance namely internal sources and external
sources. Cost of capital is largely dependent on these sources of finance. There are some Sources
which are relatively costly and again, there are some sources which relatively are e A cheaper from
the viewpoint of cost of capital.

4. Tax Aspect: Tax aspect, income tax as well as VAT also influences the determination of cost of
capital of a firm.

5. Relative Return: Relative return of a firm from its investment also influences the determination of
Cost of capital of that firm.

6.Capital Structure Composition: Capital S.C. i.e., debt. equity mix also affects the determination of
cost of Capital of a firm.

7. Dividend Policy: Dividend policy & Dividend payout and profit retention policies of a firm also
influence the determination of cost of capital.

Q. Problems of computation of Cost of Capital: The major problems involved are:

a: Lack of price stability.

b. Determination of future dividend

c. Indifference of capital market

d. Difficulties in calculations.

e: Effective rate of interest.

f Interest-free short-term loans' cost and

g. Determination of rate of dividend.

Q. Explicit cost vs Implicit cost:

The explicit cost arises when funds, are raised, whereas the implicit costs arise when funds are used.
Viewed in this perspective implicit costs are Ubiquitous. They arise whenever funds are used no
matter what the source.

Q. cost of Equity Capital

The cost equity capital is by far, conceptually speaking, the most difficult and controversial cost to
measure. It is sometimes argued that the equity Capital is free of cost. The reason for such argument-
is that it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the
interest rate and preference dividend rate, the equity dividend rate is not fixed. Apart from the
absence of any definite commitment to receive dividend, the equity shareholders rank at the bottom
as claimants on the assets of the company at the time of liquidation. It may, therefore, appear that
equity capital does not carry any cost. But this is not true. Equity capital, like other sources of funds,
does certainly involve a cost to the firm. When equity-holders invest their funds, they also expect
returns in the form of dividends. The market value of shares is a function of the return that the
shareholders expect and get. If the company does not meet the requirements of its shareholders and
pay dividends, it will have an adverse effect on the market price of shares. A policy of not paying
dividends by a firm would be in conflict, in other words, with its basic objective, namely net present
value maximisation. The equity shares, thus, implicitly involve a return in terms of the dividend
expected by the investors and therefore, Carry a cost. In fact, the cost of equity capital is relatively
the highest among all the sources of funds. The equity shares involve the highest degree The
Investors purchase the shares, in the expectation of a certain rate of return. The quantum of the
state of return, depends on the business risk and financial risk of a company. The equity shares
involve the highest degree of financial risk since they are entitled to receive dividend and return of
principal after all other obligations of the firm are met. As a Compensation to the highest risk
exposure, holdens of such securities expect a higher return and therefore, higher cost is associated-
with them.

Q. External equity will cost more:

Firms may raise equity capital internally by retaining-earnings. Alternatively, they could distribute the
entire earnings to equity shareholders and raise equity capital externally by issuing new shares. In
both cases, shareholders are providing funds to the firms to finance their capital expenditures.
Therefore, the equity shareholders' required rate of return would be the same whether they supply
funds by purchasing new shares on by foregoing dividends, which could have been distributed to
them. There is, however, a difference between retained earnings and issue of equity shares from the
firm's point of view. The firm may have to issue new shares at a price lower than the comment
market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the
firm than the internal equity.

Q. Risk- Differences:

In practice both shareholders and creditors (i.e, debt-holders) supply funds to finance a firm's
investment projects. Investors hold different claims on the firm's assets and cash flows, and thus,
they are exposed to different degrees of risk. Creditors have a priority claim over the firm's assets
and cash flows. The firm is under a legal obligation to pay interest and repay principal. Preference
shareholders hold claim prior to ordinary shareholders but after debt-holders. Preference dividend is
fixed and known, and the firm will pay it after paying interest but before paying any ordinary
dividend. Because preference dividend is sub- ordinated to interest, preference capital is more risky
than debt. Unlike creditors, ordinary shareholders are owners of the firm and retain its control. They
delegate powers to the management to make investment decisions. However, ordinary Shareholders
have claim on the residual assets and cash flows. The payment of ordinary dividend is discretionary.
They may be paid dividends from cash remaining after interest and preference dividends have been
paid. Also, the market price of ordinary share fluctuates more widely than that of the preference
share and debt. Thus, Ordinary share is more risky than both preference share and debt.

Q. Components of cost of Capital:

The cost of capital represents the minimum reward that investors demand for investing their money
in the firm. A firm collects funds from different sources in order to invest them in profitable channels.
The following m represent measures of different cost of capital.

1. Cost of Bond Or, Debt capital, 2: Cost of preferred stock, 3: Cost of common stock, 4: cost of
retained earnings:

The cost of capital of each source of capital is known as component.