Cost of Capital including CAP-M
(Source:- From the book on Financial Management by Prof. I.M. Pandey)Cost of capital can be used to evaluate a capital expenditure decision. The cost of capital
will be used as discount factor to determine NPV or IRR of the capital invested projects.
The focus will be on the measurement techniques of cost of capital.
The cost of capital is related to the objective of wealth-maximization of an organization.
Decisions is meant to raise the wealth of the owners i.e., the share holders. For this
purpose returns must be higher than the cost of the capital. The cost of the capital serves
the purpose of acceptance or rejection of an investment proposal.
The cost of the capital has to be measured correctly. Otherwise, under-valuation of cost
of capital may result in wrong acceptance and expectations may receive a setback.
Similarly, overestimation of cost of capital may also result wrong decisions in the form of
rejection of investment proposal. The following will be taken as base for the cost of
capital:-
- The existing rate of interest will be used as discount factor for calculation of NPV
or IRR - Using an opportunity cost as cost of capital or the lending rate
- Interest rate on borrowing
Among the above, the interest rate on borrowing is commonly used as cost of capital.
Capital Finance may be obtained from a number of sources. The cost of obtaining funds
from each source differs from each other. The total cost of these costs is called weighted
cost of capital. There are two categories of costs, viz. (i) Explicit cost, and (ii) Implicit
cost.
- Explicit Cost
1.1 When a firm starts to raise funds for its capital requirement, a series of
cash inflow takes place. If we focus on a particular type of fund raising
and the consequent cash inflow arising from it, there will be consequent
cash out flow on account of repayment towards principal, payment of
interest, payment dividend etc. In this situation, the rate of return should
be identified at the point at which PV of cash inflow is equal to PV of cash
outflow. Such rate of return is the Explicit Cost. The company which
borrows funds has to pay IRR to the suppliers of the funds.