Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.
According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.
Significance of Cost of Capital
Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.
1. Importance to Capital Budgeting Decision: Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
2. Importance to Structure Decision: Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.
3. Importance to Evolution of Financial Performance: Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
4. Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.
Problems in Determination of the Cost of Capital
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 in determination of cost of capital 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 authors, the cost of capital of a firm depends upon the method and level of financing. On the other hand, the modern authors such as Modigliani and Miller the firm’s total cost of capital argue that is independent of the method and level of financing. 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.
2. Computation of Cost of Equity: The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged.
This means that determination of the cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares on the basis of a large number of factors, financial as well as psychological.
3. Computation of Cost of Retained Earnings and Depreciation Funds: The cost of capital raised through retained earnings and depreciation funds will depend upon the approach adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager has to face difficult task in subscribing and selecting an appropriate approach.
4. Future Costs Versus Historical Costs: It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total funds.
5. Problem of Weights: The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. The results would be different in each case.
