Page 61 - DMGT409Basic Financial Management

Basic Financial Management

Notes 4.2 Significance of Cost of Capital
The concept of cost of capital is very important and the central concept in fi nancial 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 signifi cantly

influenced by the cost consideration.
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Did u know? What is capital structure?
Capital structure involves determination of proportion of debt and equity in capital
structure that provides less cost of capital.

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 fi rm. 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

fi nance) specific costs, he/she can choose the best and most economical source of fi nance
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.

3. Financial Performance Appraisal: Cost of capital framework can be used to evaluate the
financial performance of top management. Financial performance evaluation involves a

comparison of actual profitability of the investment project with the project overall cost

of capital of funds raised to finance the project. If the actual profitability is more than the
projected cost of capital, then the financial performance may said to be satisfactory and vice

versa.
4.3 Measurement of Cost of Capital
Computation of cost of capital for various sources of finance, viz., equity, preference shares,

debentures, retained earnings, public deposits is discussed below:
4.3.1 Cost of Equity

Firms may obtain equity capital in two ways (a) retention of earnings and (b) issue of additional
equity shares to the public. The cost of equity or the returns required by the equity shareholders
is the same in both the cases, since in both cases, the shareholders are providing funds to the fi rm
to finance their investment proposals.

In the following cost of equity is computed in both sources point of view (i.e., retained earnings
and issue of equity shares to the public).

Cost of Retained Earnings (K )
re

Retained earnings are one of the internal sources to raise equity finance. Retained earnings are
those part of (amount) earnings that are retained by the form of investing in capital budgeting
proposals instead of paying them as dividends to shareholders.

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