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What is Cost of Capital?
Cost of the capital is the cost which the organization pays for the purpose of usage of funds being borrowed by it. This is the minimum rate which is required to be earned by the organization so that, it could recover the funds being invested by it. There are twin applications of the cost of capital. The applications of the cost of capital include required rate of earnings or cut off rate for the expenditure. This means the expected rate of new investment proposals is being less in comparison to the average cost of capital or the cut off rate. If it is lower then, the organization should not accept the investment proposals being given to it in the area of doing the tasks being assigned.
The importance and relevance of each kind of capital funds of the company and the same can be understood in the context of implications of the same on income, risk factors, and control factors. If the business suffers by way of wide and frequent income fluctuations, there is involvement higher level of financial risk which results in lowering the market valuations and increase the cost of capital. The organization should also ensure that defective project planning should be avoided for ensuring that, correct projects are being identified by it in the area of doing the tasks.
Types of Cost of Capital
a. Historical and future cost.
b. Explicit and implicit cost or opportunity cost.
c. Average or marginal cost
d. Specific or composite cost
Importance of Cost of Capital
The importance of cost of capital is crucial for the organization and in this particular area, it is going to be essential for the organization to make sure that, cost of capital is being identified in a proper and appropriate way without any kind of trouble or issue arising in the area of doing the working.
a. Capital Budgeting Decisions: Cost of capital is being identified as the cut off rate which is being considered to be the minimum rate. In the course of the cost of capital, it is being identified that, if the cost of capital is higher then, investment option should not be accepted by the organization. This is being used for the purpose of ensuring that, net present value method is being adopted by the organization for the purpose of ensuring that, proper results are being generated. In case NPV is zero or negative then, the project should not be accepted by the organization as it would be detrimental to the interest of owners of the organization. The organization can also ensure that, it makes capital budgeting decisions on the basis of comparison of the internal rate of return. The organization should accept the project only at the time when, IRR is being higher in comparison to the weighted average cost of capital of the firm. The organization should not accept the same, in the case; IRR is being lower in comparison to overall cost of capital of the firm.
b. Capital structure planning decisions: An organization wishes to make sure that, it is being planning and designing the capital structure which is likely to prove an optimal capital structure. This is going to be helpful for the organization in the course of making sure that, there is an ideal mix of debt and equity capital for the purpose of achievement of proper results. This is going to help in ensuring that, the market value of shares of the organization is being enhanced.
c. Evaluation of financial performance: At the time when, a particular project is being implemented by the organization then, comparison of the project with the actual cost is to be carried out for ensuring that, capital budgeting decisions are being taken in a proper and appropriate way. Comparison of results with the profits being generated by the organization are going to help in making sure that, best results are being generated by the organization at a particular point wherein, best results are being generated in the area of doing the tasks.
d. Allocation of national resources: Cost of capital can also help in the allocation of resources to various kinds of projects of national importance which is being important for the growth of any kind of economy.
e. Other Miscellaneous financial decisions: Top management is also going to get help and assistance in the area of ensuring that, it works towards the area of making various kinds of decisions in the course of working out the tasks without any kind of trouble or issue arising.
Cost of Equity
In case of equity capital, the organization would be in the position to make sure that, it provides dividends to the investors, but the point is that, dividends being provided by the organization are not fixed. There is no legal binding on the organization to make payment of dividend to the shareholders. Therefore, there is an impression in the mind of the people that, there is no legal obligation in the course of doing the tasks at a particular point of time. There are definite cost implications in the course of the cost of capital. The management of the organization has to ensure that, it works in a particular way wherein, it makes payment of dividend to the investors as the investors expect receiving the dividends from the organization at a particular point of time. The expectations from the management of the organization are regarding the following things:
a. Regular stream of earning per share
b. Regular dividend being provided by the organization
c. Growth in future EPS and DPS
The expectation of the investors is to ensure that, they are being receiving dividends at all the times. With the help of availability of dividends, it becomes easier for the organization to make sure that, best tasks are being carried out. The organization has to ensure that, it works towards doing the tasks in the best way for ensuring proper results being generated by them at a particular point.
Formula for Cost of Capital
There are certain formulas which are being used for the purpose of identifying the cost of equity capital for the organization in the area of doing the tasks.
1. Dividend / Price Ratio Method: This method is being termed as dividend yield method. This approach is being used for the purpose of answering the question regarding the rate of return would the equity shareholders would expect on the market value of their investment being made on share capital. The formula is being provided as under.
Cost of Equity = DPSMPS ×100
DPS: dividend per share
MPS: market price per share
2. Earnings / Price Ratio method: This method is being termed as earnings yield method or E/ P approach. It is being based on the assumption that the shareholders should make capitalization of a certain amount for future portable earnings on the basis of existing earnings / price ratio. The formula for calculation is EPS / MPS * 100.
3. Dividend / Price + Growth Method: this method is also being termed as dividend yield and growth in dividend method. This method is being considered as a better method for computation of cost of equity. This method is being considered as an element of growth as it is being observed that in most of the cases dividend per share also grows.
4. Cost of newly issued equity shares: When the organization, issues new shares then, there is a definite case of incurring the expenses by the organization. The expenses being incurred by the organization would include the expenses in the name of underwriting, brokerage and commission. The cost of new cost of capital is being computed on the basis of the following formula.
Cost of Equity = (DPS*100)/NP
Or
Cost of Equity = (EPS*100)/NP
Or
Cost of Equity = ((DPS*100)/NP)+G
Cost of Debt
Cost of debt is the burden in relation to net proceeds of the organization. In this particular area, the burden is likely to be defined as the annual rate of interest is being agreed to be paid by the organization. It is a usual practice for the organization for procurement of borrowed funds by way of issuance of debentures and bonds. This occurs as a result of the fact that, an organization has to ensure that; it incurs certain categories of costs. In the course of the cost being incurred by it, the organization incurs costs in the form of floatation costs and other expenses. Therefore, it is being mentioned that, the cost is being computed as the percentage of interest has a burden on the net cost being incurred by the organization at a particular point of time.
Formula for Cost of Debt
Cost of debt of the organization is being divided into two different parts at a particular point.
a. Cost of perpetual debt.
b. Cost of redeemable debt.
At the time when, there is perpetual debt or non-redeemable then, the cost of such debts would be calculated as follows:
Cost of Debts (Before Tax) = (Interest Payable *100)/ Net Proceeds
Where,
Also,
|
Cost of Debt (After Tax) = I (1 - Tax Rate) |
Where,
I = Cost of debt (before tax)
When there are redeemable debentures or bonds then cost of such debts can be calculated by following formula:
Cost of Debt (Before Tax = ((IP+(MV-NP)/N)/((MV+NP)/2))*100
Where,
Note: Here, debentures are issued at par.
Also, we have,
Cost of debt (after tax) = I (1 - tax rate)
Where,
I = Cost of debt (before tax)
Cost of Retained Earnings
The management of the organizations follow a particular practice wherein, they make payment of only a part of profits after tax as dividends and remaining part of the profit is being kept by the organization as retained earnings. This helps the organization to make sure that, retained earnings are being accumulated by it over the years and this helps in ensuring that, the earnings per share of the organization on the basis of retained earnings increase to a considerable extent.
Formula for calculation of the cost of retained earnings
Cost of retained earnings of the organization can be computed by the help of following formula being used.
Cost of Retained Earnings (After Tax) =( (D*(1-Tj))/(MPS*(1-Tc)))*100
Where,
Also,
Cost of Retained Earnings (Before Tax) = 1/ (1-Tax rate)
Where,
I = Cost of retained earnings (after tax)
Concept of Marginal Cost of Capital
Marginal cost of capital of the organization is nothing but, weighted average cost of capital to the last capital rose. If the organization continues to raise capital then, there is a particular point of time wherein, marginal cost of capital of the organization would be higher in comparison to the weighted average cost of capital. It is being identified that the firms will try to prefer to have the capital being raised by it. Marginal cost of capital has been proven to be a yardstick for making various kinds of decisions at a particular point of time in the area of ensuring that, best results are being generated by the organization without any kind of trouble or issue arising.
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