- Implicit Cost
2.1 When retained earnings are used as source of funding, there will be no
explicit cost. The undistributed profits to share holders are the retained
earnings. What will be the return, if these retained earnings are invested
elsewhere? Such earnings will be taken as opportunity cost. This is
known as the Implicit Cost of capital. Opportunity cost is based on the
opportunity foregone by the firm in committing itself to a selected project,
and that is also a dividend foregone by the shareholders.2.2 Explicit or implicit costs are used as discount factors to calculate the
present value of the cash flows to take investment decisions.- Capital will be financed from one or more of the following sources.
- Debt financing
- Preference share capital
- Equity capital
- Rights shares
- Retained earnings
- Convertible securities
In the following sections we will look at ways to measure the cost of the capital by taking
into account the cost of funding capital.
- Debt Financing
4.1 In case of debt issued at par, the interest on debt i.e., before-tax shall be taken as
cost of debt. This will be taken as cost of capital. But the use of debt finance
shall not reduce the dividends to share holders. The operational efficiency must
go up along with the use of debt finance, so that the dividends to share holders
will go up. That means earnings must certainly exceed the interest. Therefore the
estimation of the project must be based upon the present values calculated on the
base interest on debt as cost of capital.
4.2 The other important point is while floating debt, a firm has to incur cost towards
floating charges. Therefore the cost of the capital is taken as interest on debt plus
floating charges.
4.3 Since interest on debt is deductible from payment of corporate tax, after-tax cost
of debt should be used.