Page 60 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

4.1 Cost of Capital – Concept Notes

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 sacrifi ce
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 fi rm 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 fl ows.

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.

Meaning and Definition of Cost of Capital
“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

The above definitions indicate that the following are the three basic aspects of the concept of cost
of capital.
1. Rates of Return: Cost of Capital is not a Cost as such, infact it is the rate of return that a fi rm
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 fi nancing (r )
j
(b) The business risk premium, (b) and

(c) The financial risk premium (f)

Note Symbolically cost of capital may be represented as: K = r + b + f
o j

LOVELY PROFESSIONAL UNIVERSITY 53