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Management of Cost of Capital

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The concept of cost of capital
The term cost of capital refers to the minimum rate of return a firm must earn on its investments.
This is in consonance with the firm’s overall object of wealth maximization. Cost of capital is a
complex, controversial but significant concept in financial management.
The following definitions give clarity management.
Hamption J.: The cost of capital may be defined as “the rate of return the firm requires from
investment in order to increase the value of the firm in the market place”.
James C. Van Horne: The cost of capital is “a cut-off rate for the allocation of capital to investments
of projects. It is the rate of return on a project that will leave unchanged the market price of the
stock”.
Solomon Ezra:”Cost of Capital is the minimum required rate of earnings or the cut-off rate of capital
expenditure”.
It is clear from the above definitions that the cast of capital is that minimum rate of return which a
firm is expected to earn on its investments so that the market value of its share is maintained. We
can also conclude from the above definitions that there are three basic aspects of the concept of
cost of capital:
1) Not a cost as such: In fast the cost of capital is not a cost as such, it is the rate of return that
a firm requires to earn from its projects.
2) It is the minimum rate of return: A firm’s cost of capital is that minimum rate of return
which will at least maintain the market value of the share.
3) It comprises three components:
K= ro+b+f
Where, k=cost of capital;
ro= return at zero risk level:
b = premium for business risk, which refers to the variability in operating profit (EBIT) due to
change in sales.
f = premium for financial risk which is related to the pattern of capital structure.
IMPORTANCE OF COST OF CAPITAL:
The cost of capital is very important in financial management and plays a crucial role in the
following areas:
1) Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net
Present Value method for investment proposals. So, it is very useful in capital budgeting
decisions.
2) Capital structure decisions: An optimal capital is that structure at which the value of the
firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing
optimal capital structure.
3) Evaluation of final Performance: Cost of capital is used to evaluate the financial
performance of top management. The actual profitably is compared to the expected and

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actual cost of capital of funds and if profit is greater than the cast of capital the
performance nay be said to be satisfactory.
4) Other financial decisions: Cost of capital is also useful in making such other financial
decisions as dividend policy, capitalization of profits, making the rights issue etc.
CLASSIFICATION OF COST OF CAPITAL:
Cost of capital can be classified as follows:
1) Historical Cost and future Cost: Historical costs are book costs relating to the past, while
future costs are estimated costs act as guide for estimation of future costs.
2) Specific Costs and Composite Costs: Specific accost is the cost if a specific source of capital,
while composite cost is combined cost of various sources of capital. Composite cost, also
known as the weighted average cost of capital, should be considered in capital and capital
budgeting decisions.
3) Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which
equates the present value of cash inflows with the present value of cash outflows. It is the
internal rate of return and is calculated with the following formula.
Implicit cost also known as the opportunity cost is of the opportunity foregone in order to
take up a particular project. For example, the implicit cast of retained earnings is the rate of
return available to shareholders by investing the funds elsewhere.
4) Average Cost and Marginal Cost: An average cost is the combined cost or weighted average
cost of various sources of capital. Marginal cost of refers to the average cost of capital of
new or additional funds required by a firm. It is the marginal cost which should be taken
into consideration in investment decisions.
DETERMINATION OF CAST OF CAPITAL:
It has already been stated that the cost of capital is one of the most crucial factors in most financial
management decisions. However, the determination of the cost of capital of a firm is not an easy
task. The finance manager is confronted with a large number of problems, both conceptual and
practical, while determining the cost of capital of a firm. These problems can briefly be summarized
as follows:
1. Controversy regarding the dependence of cost of capital upon the method and level of
financing: There is a, major controversy whether or not the cost of capital dependent upon
the method and level of financing by the company. According to the traditional theorists,
the cost of capital of a firm depends upon the method and level of financing. In other words,
according to them, a firm can change its overall cost of capital by changing its debt-equity
mix. On the other hand, the modern theorists such as Modigliani and Miller argue that the
firm's total cost of capital is independent of the method and level of financing. In other
words, the change in the debt-equity ratio does not affect the total cost of capital. An
important assumption underlying MM approach is that there is perfect capital market. Since
perfect capital market does not exist in practice, hence the approach is not of much
practical utility.

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The concept of cost of capital The term cost of capital refers to the minimum rate of return a firm must earn on its investments. This is in consonance with the firm’s overall object of wealth maximization. Cost of capital is a complex, controversial but significant concept in financial management. The following definitions give clarity management. Hamption J.: The cost of capital may be defined as “the rate of return the firm requires from investment in order to increase the value of the firm in the market place”. James C. Van Horne: The cost of capital is “a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”. Solomon Ezra:”Cost of Capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”. It is clear from the above definitions that the cast of capital is that minimum rate of return which a firm is expected to earn on its investments so that the market value of its share is maintained. We can also conclude from the above definitions that there are three basic aspects of the concept of cost of capital: 1) ...
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