Page 73 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Fundamentals of Project Management

Notes 2. Market Risk Premium: The market risk premium reflects the perceived risk of equity
stocks and investor aversion to risk. A factor beyond the control of individual firms,
market risk premium affects the cost of equity directly and the cost of debt indirectly
(through a substitution effect).
3. Tax Rates: The tax policy of the government has a bearing on cost of capital. Corporate tax
rate has a direct impact on the cost of debt as used in the weighted average cost of capital.
The capital gains tax rate relative to the rate on ordinary income has indirect effect on the
cost of equity relative to the cost of debt.

Factors within a Firm’s Control

The cost of capital of a firm is affected by its investment policy, capital structure policy and
dividend policy.

1. Investment Policy: To estimate the cost of capital, we start with the rates of required on the
outstanding equity and debt of the firm. These rates reflect how risky firm’s existing assets
are. If a firm plans to invest in assets similar to those currently then its marginal cost of
capital would be more or less the same as its current cash, capital. On the other hand, if the
riskiness of its proposed investments is likely to be different from the riskiness of its
existing investments, its marginal cost of capital should reflect the riskiness of the proposed
investments.

2. Capital Structure Policy: To calculate the WACC we assumed a given target capital,
structure. Of course, a firm can change its capital structure and such a change is to affect the
cost of capital because the post tax cost of debt is lower than the cost equity and equity
beta, an input for calculating the cost of equity, is a function of financial leverage.

3. Dividend Policy: The dividend policy of a firm may affect its cost of equity.
Misconception Surrounding Cost of Capital

The cost of capital is a central concept in financial management linking the investment and
financing decisions. Hence, it should be calculated correctly and used properly in investment
evaluation. Despite this injunction, we find that several errors characterize the application of
this concept. The more common misconceptions, along with suggestions to overcome them, are
discussed here.
1. The concept of cost of capital is too academic or impractical: Some companies do not
calculate the cost of capital because they regard it as ‘academic’, ‘impractical’, ‘irrelevant’,
or ‘imprecise.’ These misgivings about cost of capital appear to be unjustified. Such
reservation can be dispelled by emphasising the following points:
(a) The cost of capital is an essential ingredient of discounted cash flow analysis. Since
discounted cash flow analysis is now widely used, cost of capital can scarcely be
considered ‘academic’ or ‘impractical’.
(b) Out of the various inputs required for discounted cash flow analysis, viz. project life,
project cash flows (consisting of initial investment, operating cash flows, and terminal
cash flow) and cost of capital, the last one, viz. the cost of capital can perhaps be
calculated most reliably and accurately. So a concern about its imprecision seems to
be misplaced.
2. Current liabilities (accounts payable and provisions) are considered as capital components:
Sometimes it is argued that accounts payable and accruals are sources of funding to be
considered in the calculation of the WACC. This view is not correct because what is not
provided by investors is not capital.

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