Cost of Capital Meaning
The cost of capital refers to the minimum rate of return that a company must achieve on its investments to ensure that the market value of its equity shares either increases or remains at the same level. This statement aligns with every company’s objective of maximizing wealth for its shareholders.
Wealth Maximisation for the shareholders of a company is feasible only when the projects financed by the company (shareholders’ money) generate revenues at a rate equal to or more than the rate expected by the shareholders. In case the company is unable to earn the expected rate of return, the possibility of a decrease in the market value of the company’s shares cannot be ruled out, which ultimately may result in the erosion of the shareholders’ wealth.
What is cost of capital?
Some of the eminent authorities on the subject have defined ‘Cost of Capital’ as described below:
According to James C Van Horne, “A cut-off rate for the allocation of capital to investments of project. It is the rate of return on a project that will leave unchanged the market price of the stock”.
According to Solomon Ezra, “Cost of Capital is the minimum required rate of earning or the cut-off rate of capital expenditures”.
According to Hampton, John J., “The rate of return the firm requires from investment to increase the value of the firm in the marketplace”.
In simple terms, the cost of capital refers to the minimum rate of return that investors expect from a business’s projects. This metric is important for determining the financial viability of investments.
The term “Cost of Capital” for an investment is also referred to as the “Minimum Required Rate of Return,” “Opportunity Cost,” or “Discount Rate” (also known as the “Interest Rate”).
Characteristics of Cost of Capital
The cost of capital is characterised by the following fundamental features:
1) Minimum Rate of Return: Cost of capital indicates the minimum rate of return, which is needed for maintaining the market value of a company’s equity shares.
2) Consideration of Risk Premium: The risk factor is taken care of during the computation of ‘Cost of Capital’, which is likely to be high if the numbers and degree of risks increase. In other words, the Cost of Capital is directly proportional to the number/degree of risks involved. The concept would be more clear from the following formula:
Where, K = Cost of a required return,
R = Risk-free rate, and
F = Risk premium rate.
3) Not Necessarily a Cash Cost: The cost of capital, which a company is required to pay, may not be in the form of cash every time. Factually, it is indicative of the expectation of the company’s shareholders about returns from their investment.
In brief, the cost of capital to a company is equal to the equilibrium rate of return demanded by investors in the capital market for securities at a given degree of risk. The equilibrium Rate of Return is an interest rate at which the demand for money and supply of money is equal.
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Importance of Cost of Capital
The cost of capital is very important for a company, as it plays a pivotal role in facilitating various decision making processes.
This can be observed by considering the following points:
1) Capital Structure Decisions: The objective of minimising the cost of capital needs to be kept in mind when planning an appropriate capital structure for a company. This would ensure a better market value for the company. The cost of financing is the determinant of the source of financing.
2) Evaluating Profitability: The profitability of a project depends upon the projected cost of the capital funds and the actual cost of the capital fund raised to finance the project. The performance of a project may be considered satisfactory if the project’s profitability is more than the projected and actual cost of capital.
3) Other Decisions: Decisions about the level of dividend distribution, working capital requirements etc., are affected directly by the cost of capital. Furthermore, the profitability of a project depends upon the cost of capital. The success or failure of the projects undertaken by a company is one of the bases of appraisal of the top management’s performance.
4) Capital Budgeting Decisions: ‘Cost of Capital’ may be considered one of the most essential basis on which capital budgeting is done. It is used as a rate for discounting cash inflows to assess the profitability of a project (under the DCF method). Furthermore, the minimum desired rate of return (projected) is compared with the actual rate of return under the Internal Rate of Return (IRR) method. This comparison allows for a comprehensive evaluation of investment performance.