Cost of Capital^27
Similarly, explicit cost of retained earnings which involve no future flows to or from the
firm is minus 100 per cent. This should not tempt one to infer that the retained earnings
is cost free. As we shall discuss in the subsequent paragraphs, retained earnings do
cost the firm. The cost of retained earnings is the opportunity cost of earning on
investment elsewhere or in the company itself. Opportunity cost is technically termed
as implicit cost of capital. It is the rate of return on other investments available to the
firm or the shareholders in addition to that currently being considered. Thus, the implicit
cost of capital may be defined as the rate of return associated with the best investment
opportunity for the firm and its Shareholders that will be foregone if the project
presently under consideration by the firm were accepted. In this connection it may be
mentioned that explicit costs arise when the firm raises funds for financing the project.
It is in this sense that retained earnings has implicit cost. Other forms of capital also
have implicit costs once they are invested, Thus in a sense, explicit costs may also be
viewed as opportunity costs. This implies that a project should be rejected if it has a
negative present value when its cash flows are discounted by the explicit cost of
capital.
It is clear thus that the cost of capital is the rate of return a firm must earn on its
investments for the market value of the firm to remain unchanged. Acceptance of
projects with a rate of return below the cost of capital will decrease the value of the
firm; acceptance of projects with a rate of return above the cost of capital will increase
the value of the firm. The objective of the financial manager is to maximize the wealth
of the firmís owners. Using the cost of capital as a basis for accepting or rejecting
investments is consistent with this goal.
Risk
A basic assumption of traditional cost of capital analysis is that the firmís business
and financial risk are unaffected by the acceptance and financing of projects.
Business risk is related to the response of the firmís earnings before interest and
taxes, or operating profits, to changes in sales. When the cost of capital is used to
evaluate investment alternatives, it is assumed that acceptance of the proposed projects
will not affect the firmís business risk. The types of projects accepted by a firm can
greatly affect its business risk.
If a firm accepts a project that is considerably more risky than average, suppliers of
funds to the firm are quite likely to raise the cost of funds. This is because of the
decreased probability of the fund suppliersí receiving the expected returns on their
money. A long-term lender will charge higher interest on loans if the probability of
receiving periodic interest from the firm and ultimately regaining the principal is
decreased. Common stockholders will require the firm to increase earnings as
compensation for increases in the uncertainty of receiving dividend payments or ably
appreciation in the value of their stock.
In analyzing the cost of capital it is assumed that the business risk of the firm remains
unchanged (i.e., that the projects accepted do not affect the variability of the firmís
sales revenues). This assumption eliminates the need to consider changes in the cost
of specific sources of financing resulting from changes in business risk. The definition