Cost of Capital: Concept, Nature, Classification & Computation | All Important Numerical
Cost of Capital: Concept & Nature
Cost of Capital is a central concept in financial management.1 It acts as the bridge between investment decisions (where to put money) and financing decisions (where to get money).2
Definition:
It is the minimum rate of return that a firm must earn on its investments to maintain the market value of its shares.
Three Perspectives on Cost of Capital:
-
Investor’s View: It is the measurement of the sacrifice made by the investor.3 (e.g., If an investor puts money in your company instead of a bank offering 7%, their cost is that 7% opportunity loss).
-
Firm’s View: It is the minimum required rate of return needed to justify the use of funds.4
-
Capital Expenditure View: It is the hurdle rate or cut-off rate used to discount future cash flows in capital budgeting.
The Equation of Cost:
Symbolically, Cost of Capital ($K_o$) comprises three components:
-
$r_j$: The risk-free cost of the specific type of financing.5
-
$b$: The business risk premium.
-
$f$: The financial risk premium.
🎯 Significance of Cost of Capital
Why is this calculation so critical?
-
Designing Optimal Capital Structure: It helps managers determine the most economical mix of Debt and Equity.6 The goal is to minimize the overall cost of capital ($K_o$) to maximize the firm’s value.
-
Investment Evaluation (Capital Budgeting): It serves as the financial standard.
-
In Net Present Value (NPV), cash flows are discounted using the Cost of Capital.7
-
In Internal Rate of Return (IRR), a project is accepted only if $IRR > Cost of Capital$.
-
-
Financial Performance Appraisal: It is used to judge top management. If the actual profitability of a project is higher than the Cost of Capital, performance is satisfactory.
📊 Classification of Costs
Financial management distinguishes between several types of costs:
-
Marginal Cost: The additional cost incurred to raise an additional unit of capital. This is crucial for new investment decisions.
-
Average Cost (WACC): The weighted average of the costs of various sources (Equity, Debt, etc.). This is the acceptance criteria for the firm as a whole.
-
Specific Cost: The cost associated with a specific source (e.g., $K_e$ for Equity, $K_d$ for Debt).
-
Historic vs. Future Cost: Historic costs are based on past book values, while Future costs are estimated for upcoming fund-raising.
-
Explicit Cost: The discount rate that equates the present value of cash inflows (funds raised) with cash outflows (interest/dividends).
-
Implicit Cost (Opportunity Cost): The cost of the opportunity foregone.8
-
Example: Retained Earnings. The cost is not zero; it is the return shareholders could have earned if the money had been distributed to them instead of retained.
-
🧮 Computation of Specific Costs
A firm raises capital from different sources, and each has a different “price tag.”9
1. Cost of Debt ($K_d$)
Debt is generally the cheapest source of finance because interest is tax-deductible.10
A. Cost of Irredeemable (Perpetual) Debt:
-
Pre-Tax Cost:
$$K_{di} = \frac{I}{NP}$$ -
Post-Tax Cost:
$$K_d = \frac{I (1 – t)}{NP}$$(Where $I$ = Interest, $t$ = Tax Rate, $NP$ = Net Proceeds from issue)
B. Cost of Redeemable Debt:
If the debt must be repaid after ‘N’ years, we use a formula that considers interest payments plus the repayment of principal.
(Where $RV$ = Redeemable Value, $N$ = Number of years)
2. Cost of Preference Shares ($K_p$)
Preference shareholders receive a fixed dividend.11 Unlike debt interest, these dividends are not tax-deductible.
A. Cost of Irredeemable Preference Shares:
(Where $D$ = Annual Dividend, $NP$ = Net Proceeds)
If Dividend Tax applies: $K_p = \frac{D(1 + D_t)}{NP}$
B. Cost of Redeemable Preference Shares:
Similar to redeemable debt, this formula accounts for the repayment of capital.
3. Cost of Equity ($K_e$)
This is the most difficult to measure because equity shareholders are not promised a fixed return. It is the minimum return they expect to keep the share price unchanged.
Approaches to Calculate $K_e$:
A. Dividend Capitalization Approach (D/P):
Appropriate when investors primarily look for dividends.
(Where $MP$ = Current Market Price)
B. Earnings Capitalization Approach (E/P):
Appropriate when investors focus on the company’s earning power (EPS), regardless of whether it is distributed or retained.
C. Dividend + Growth Approach (Gordon Model):
Most widely used. It assumes dividends will grow at a constant rate ($g$).
(Where $D_1$ = Expected Dividend next year)
D. Bond Yield + Risk Premium Approach:
Since equity is riskier than debt, investors demand a premium.
E. Cost of Retained Earnings ($K_{re}$):
Often considered the same as Cost of Equity ($K_e$), but adjusted for personal taxes and brokerage if applicable.
⚖️ Weighted Average Cost of Capital (WACC)
A firm rarely uses just one source. WACC is the composite cost of all sources combined.12
The Calculation Process:
-
Calculate Specific Costs: Find 13$K_e, K_d, K_p$.14
-
Assign Weights: Determine the proportion of each source in the total capital.
-
Book Value Weights: Based on the balance sheet values. (Easy to calculate but may not reflect economic reality).
-
Market Value Weights: Based on current trading prices.15 (Theoretically superior as it reflects the current economic value).
-
-
Multiply & Sum: Multiply each specific cost by its weight and sum them up.
Formula:
Factors Affecting WACC
-
Controllable Factors:
-
Capital Structure: Changing the Debt/Equity ratio changes the risk and cost.16
-
Dividend Policy: Retaining earnings is cheaper than issuing new shares (no floatation costs).17
-
-
Uncontrollable Factors:
-
Tax Rates: Higher corporate tax makes debt cheaper (due to tax shield).
-
Interest Rates: Market rate fluctuations affect the cost of debt.
-
Market Risk Premium: Investor sentiment affects the cost of equity
-
