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Importance and measurement of cost of capital

Importance of cost of capital

(1) Capital Budgeting Decision. Cost of capital may be used as the measuring road for adopting an

investment proposal. The firm, naturally, will choose the project which gives a satisfactory return oninvestment which would in no case be less than the cost of capital incurred for its financing. In

various methods of capital budgeting, cost of capital is the key factor in deciding the project out of

various proposals pending before the management. It measures the financial performance and

determines the acceptability of all investment opportunities.

(2) Designing the Corporate Financial Structure. The cost of capital is significant in designing the

firm's capital structure. The cost of capital is influenced by the chances in capital structure. A capable

financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound

and economical capital structure for the firm. He may try to substitute the various methods of

finance in an attempt to minimise the cost of capital so as to increase the market price and the

earning per share.

(3) Deciding about the Method of Financing. A capable financial executive must have knowledge of

the fluctuations in the capital market and should analyse the rate of interest on loans and normal

dividend rates in the market from time to time. Whenever company requires additional finance, he

may ave a better choice of the source of finance which bears the minimum cost of capital. Although

cost of capital is an important factor in such decisions, but equally important are the considerations

of relating control and of avoiding risk.

(4) Performance of Top Management. The cost of capital can be used to evaluate the financial

performance of the top executives. Evaluation of the financial performance will involve a

comparison of actual profitabilities of the projects and taken with the projected overall cost ofcapital and an appraisal of the actual cost incurred in raising the required funds.

(5) Other Areas. The concept of cost of capital is also important in many others areas of decision

making, such as dividend decisions, working capital policy etc.

Measurement of cost of capital

a. Cost of debt: the debts may be either short term debts or long term debts. Very naturally,

the cost of capital in the form of debt is the interest which the company has to pay. But this is

not the real cost attached with debt capital. The real cost is something less than the rate of

interest which the company has to pay. This is due to the fact that the interest on debt is a tax

deductible expenditure. If the amount of interest is considered as a part of expenses, the tax

liability of the company reduces proportionately. As such, while computing the cost of debt,

adjustments are required to made for its tax impact. E.G. Suppose a company issues the

debentures having the face value of $ 100 and bearing the rate of interest of 10% p.a. If the

rate applicable to the company is 50% of 10%, hence the cost of debentures is only 5%.

Further the interest payable on the debentures has to be viewed from the angle of the amount

actually received on their issue. E.g. A company issues 10,000, thus the company will have to

pay the annual interest of $ 8000 on the net amount received to the extent of only $ 90,000.

Cost of debentures in this case works out to around 8.89% and assuming that the tax rateapplicable is 50%, the tax benefit makes the cost of debentures equal to 4.45%. However, the

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debt capital has a hidden cost also. If the debt content in the capital structure of a company

exceeds the optimum level, the investors start considering company as too risky and their

expectations from equity shares increase. This is the hidden cost of debt.

b. Cost of preference shares: the cost of capital preference shares is the dividend rtepayable on them. As in case of debentures, the cost of capital is adjusted for the amount

excess or less received on the issue of preference shares.

E.g. Suppose a company issues 1000 preference shares of $ 100 each at the value of $ 105

each. Rate of dividend is 10% and the expenses involved with the issue of preference shares

amount to $ 10,000. Thus the net amount received works out to $ 95,000 whereas the amount

of the dividend is $ 100000. Here the cost of capital works out to

$ 10000 100 = 10.52%

$ 95,000

As the amount of dividend payable on preference shares is not a tax deductible expenditure,

there is no question of further adjustment for the tax benefit.