Page 94 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Basic Aspects on the Concept of Cost of Capital

The above definitions indicates, that the following are the three basic aspects of the concept of
cost of capital:
1. Rate of Return: Cost of capital is not a cost as such, infact it is the rate of return that a firm
requires to earn from its investment projects.
2. Minimum Rate of Return: Cost of capital of any firm is that minimum rate of return that
will at least maintain the market value of the shares.
3. Cost of capital comprises three components:
(a) The risk less cost of the particular type of financing (r )
j
(b) The business risk premium, (b) and

(c) The financial risk premium (f)
Symbolically cost of capital may be represented as: K = r + b + f
o j
Self Assessment
Fill in the blanks:

1. Cost of capital represents the ……………………that the firm must pay to the fund suppliers,
who have provided the capital.
2. Cost of capital is expressed in terms of ………………….

3. Investor defines Cost of capital as “the measurement of the sacrifice made by him
in……………………..”

6.2 Importance/Significance of Cost of Capital

The concept of cost of capital is very important and the central concept in financial management
decisions. The decisions in which it is useful are as follows:

1. Designing Optimal Corporate Capital Structure: This concept is helpful in formulating a
sound and economical capital structure for a firm. The debt policy of a firm is significantly
influenced by the cost consideration. Capital structure involves determination of proportion
of debt and equity in capital structure that provides less cost of capital.

!

Caution While designing a firm’s capital structure, the financial executives always keep
in mind minimisation of the over all cost of capital and to maximise value of the firm.
The measurement of specific costs of each source of funds and calculation of weighted
average cost of capital help to form a balanced capital structure. By comparing various
(sources of finance) specific costs, he/she can choose the best and most economical source
of finance and can succeed in designing a sound and viable capital structure.
2. Investment Evaluation/Capital Budgeting: Wilson R.M.S., states that the Cost of Capital
is a concept, which should be expressed in quantitative terms, if it is to be useful as a cut-
off rate for capital expenses. Capital expenditure means investment in long-term projects
like investment on new machinery. It is also known as Capital budgeting expenditure.
Capital budgeting decisions require a financial standard (cost of capita) for evaluation.
The financial standard is Cost of Capital. In the Net Present Value (NPV) method, an
investment project is accepted, if the present value of cash inflows are greater than the

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