Cost of Capital^25Chapter-
Cost of Capital
Cost of Capital is the rate that must be earned in order to satisfy the required rate of
return of the firm's investors. It can also be defined as the rate of return on investments
at which the price of a firm's equity share will remain unchanged.
Each type of capital used by the firm (debt, preference shares and equity) should be
incorporated into the cost of capital, with the relative importance of a particular source
being based on the percentage of the financing provided by each source of capital.
Using of the cost a single source of capital as the hurdle rate is tempting to management,
particularly when an investment is financed entirely by debt. However, doing so is a
mistake in logic and can cause problems.
Future Cost and Historical Cost
Future cost of capital refers to the expected cost of funds to be raised to finance a
project. In contrast, historical cost represents cost incurred in the past in acquiring
funds. In financial decisions future cost of capital is relatively more relevant and
significant. While evaluating viability of a project, the finance manager compares
expected earnings from the project with expected cost of funds to finance the project.
Likewise, in taking financing decisions, attempt of the finance manager is to minimise
future cost of capital and not the costs already defrayed. This does not imply that
historical cost is not relevant at all. In fact, it may serve as a guideline in predicting
future costs and in evaluating the past performance of the company.
Component Cost and Composite Cost
A company may contemplate to raise desired amount of funds by means of different
sources including debentures, preferred stock, and common stocks. These sources
constitute components of funds. Each of these components of funds involves cost to
the company. Cost of each component of funds is designated as component or specific
cost of capital. When these component costs are combined to determine the overall
cost of capital, it is regarded as composite cost of capital, combined cost of capital or
weighted cost of capital, The composite cost of capital, thus, represents the average
of the costs of each sources of funds employed by the company. For capital budgeting
decision, composite cost of capital is relatively more relevant even though the firm may
finance one proposal with only one source of funds and another proposal with another
source. This is for the fact that it is the overall mix of financing over time which is
materially significant in valuing firm as an ongoing overall entity.