Page 69 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Fundamentals of Project Management

Notes 4.5 Cost of Capital

Till now we have learnt that the cash flows of a capital investment may be viewed from various
points of view and the discount rate applied to the cash flows must be consistent with the point
of view adopted. We also mentioned that the standard practice in capital budgeting is to look at
the cash flows from the point of view of explicit cost funds (referred to also as investor claims)
and apply the weighted average cost of capital of the firm as the discount rate.
The items on the financing side of the balance sheet are called capital components. The major
capital components are equity, preference, and debt. Capital, like any other factor of production,
has a cost. A company’s cost of capital is the average cost of the various capital components (or
securities) employed by it. Put differently, it is the average rate of return required by the
investors who provide capital to the company.
The cost of capital is a central concept in financial management. It is used for evaluating
investment projects, for determining the capital structure, for assessing leasing proposals, for
setting the rates that regulated organisations like electric utilities can charge to their customers,
so on and so forth.
Now in this unit we will discuss how a company’s cost of capital is calculated.

Concept of Average Cost of Capital

A company’s cost of capital is the weighted average cost of various sources of finance used by it,
viz. equity, preference, and debt.
Suppose that a company uses equity, preference, and debt in the following proportions: 50, 10,
and 40. If the component costs of equity, preference, and debt are 16 per cent, 12 per cent, and 8
per cent respectively, the Weighted Average Cost of Capital (WACC) will be:
WACC = (Proportion of equity) (Cost of equity) + (Proportion of preference) (Cost
of preference) + (Proportion of debt) × (Cost of debt)
= (0.5)(16) + (0.10)(12) + (0.4)(8) = 12.4 per cent
For the sake of simplicity, we have considered only three types of capital (equity; non-convertible,
non-callable preference; and non-convertible, non-callable debt). We have ignored other forms
of capital like convertible or callable preference, convertible or callable debt, bonds with payments
linked to stock market index, bonds that are puttable or extendable, warrants, so on and so forth.
Calculating the cost of these forms of capital is somewhat complicated. Fortunately, more often
than not, they are a minor source of capital. Hence, excluding them may not make a material
difference.
Debt includes long term debt as well as short term debt (such as working capital loans and
commercial paper). Some companies leave out the cost of short term debt while calculating the
weighted average cost of capital. In principle, this is not correct. Investors who provide short
term debt also have a claim on the earnings of the firm. If a company ignores this claim, it will
misstate the rate of return required on its investments.

Non interest bearing liabilities, such as trade creditors, are not included in the calculation of the
weighted average cost of capital. This is done to ensure consistency and simplify valuation.
True, non interest bearing liabilities have a cost. However, this cost is implicitly reflected in the
price paid by the firm to acquire goods and services. Hence, it is already taken care of before the
free cash flow is determined. While it is possible to separate the implicit financing costs of non
interest bearing liabilities from the cash flow, it will make the analysis needlessly more complex,
without contributing to the quality thereof.

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