Page 93 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

Cost of capital is still largely an academic term and the problem of measuring it in operational Notes
terms is a recent phenomena. Prior to this development, the problem was either ignored or by
passed. In modern times, it is widely used as basis of investment projects and evaluating the
alternative sources of finance.

6.1 Cost of Capital – Concept

The term cost of capital is a concept having many different meanings. The three viewpoints,
regarding the cost of capital is given below:
1. From Investors’ View Point: Investor may define it as “the measurement of the sacrifice
made by him in capital formation.”

Example: Mr. A an investor invested in a company’s equity shares, amount 1,00,000,
instead of investing in a bank at the rate of 7 per cent interest. Here he had sacrificed
7 per cent interest for not having invested in the bank.
2. Firms Point: It is the minimum required rate of return needed to justify the use of capital.

Example: A firm raised 50 lakhs through the issues of 10 per cent debentures, for
justifying this issue, a minimum rate of return it has to earn is 10 per cent.
3. Capital Expenditure Point: The cost of capital is the minimum required rate of return, the
hurdle or target rate or the cut off rate or any discounting rate used to value cash flows.

Example: Firm ‘A’ is planning to invest in a project, that requires 20 lakh as initial
investment and provides cash flows for a period of 5 years. So for the conversion of
future 5 years cash flows into present value, cost of capital is needed.

Cost of capital represents the rate of return that the firm must pay to the fund suppliers, who
have provided the capital. In other words, cost of capital is the weighted average cost of various
sources of finance used by the firm. The sources are, equity, preference, long-term debt and
short-term debt.
“The rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they
are due.”
—Hunt, William and Donaldson
“Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditures.”

—Solomon Ezra
“A cut-off rate for the allocation of capital to investments of projects. It is the rate of return
on a project that will leave unchanged the market price of the stock.”

—James C. Van Horne
“The rate of return the firm requires, from investment in order to increase the value of the firm in the market
place.”

—Hampton, John J
Thus, as defined above, we can say, that cost of capital is that minimum rate of return, which a
firm must and is expected to earn on its investments so as to maintain the market value of its
shares. It is also known as Weighted Average Cost of Capital (WACC), composite cost of capital
or combined cost of capital. It is expressed in terms of percentage.

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