Module 1

Cost of capital

Meaning

Cost of capital is a very important concept in decision making process of

financial management. It ia denoted by letter ‘K’. Cost of capital can be defined as “
The minimum rate of return that a firm must earn on its investment for the market value
of the firm to remain unchanged”. In other words, a company’s cost of capital refers to
the cost that it must pay in order to raise new capital funds. Cost of capital is a
calculation of the minimum return a company would need to justify a capital budgeting
project. It also called hurdle rate, required rate, cut off rate etc. It is called dividend in
case of share capital and interest in case of debentures.

On raising funds from the market, various sources, the firm has to pay some
additional amount, apart from the principal itself. The additional amount is nothing but
the cost of capital, i.e., cost of capital which is either paid in lumpsum or periodic
intervals

Cost of capital used for two purposes, simultaneously, firstly, a comparison of

alternative source of funds may be made to select one which has least cost and
maximum contribution to wealth maximization, secondly, to evaluate investment
proposals, as it provides a benchmark to yield a minimum return.

Definition

According to I. M. Pandey, “The project’s cost of capital is the minimum required rate
of return on funds committed to the project, which depends on the riskiness of its cash
flows”.

According to Hampton, John J., “cost of capital is the rate of return the firm requires
from investment in order to increase the value of the firm in the market place”.
Significance of Cost of Capital

1. Capital allocation and project evaluation

The cost of capital is paramount in capital allocation decisions. Companies must decide
where to invest their limited resources, and the cost of capital serves as a benchmark
for evaluating potential projects. By comparing the expected returns of a project with
the cost of capital, firms can make informed investment decisions that align with
shareholder value maximization.

2. Financial performance measurement

It serves as a yardstick for assessing financial performance. A company’s ability to

generate returns above its cost of capital indicates operational efficiency and effective
resource utilisation. Shareholders and investors often scrutinize this metric as it reflects
the company’s capacity to create value and generate sustainable profits.

3. Cost of debt and equity balancing

The cost of capital guides the balance between debt and equity in a firm’s capital
structure. As companies strives to minimise their overall cost of capital, they navigate
the trade -off between the lower cost of debt and the potential risks associated with
increased leverage. Striking the right balance ensures an optimal capital structure that
minimises cost while maintaining financial flexibility.

4. Investor expectations and market perception

It influences investor expectations and market perception. A company’s cost of capital

is indicative of the returns investors requires for providing funds. If a company
consistently exceeds or falls short of this benchmark, it can impact investor confidence
and influence stock prices. Managing and meeting theses expectations are crucial for
maintaining a positive market perception.

5. Risk management

The cost of capital integrates risks considerations. The cost of equity, for instance,
incorporates the risk premium investors demand for investing in a particular stock.
Understanding these risk components aids in strategic decision – making and risk
management. Companies can adjust their capital structure and investment strategies to
mitigate risk and align with their cost of capital.

6. Capital structure optimization

It facilitates capital structures optimization. Achieving the right mix of debt and equity
is essential for minimizing the cost of capital. Firms aim to find the optimal capital
structure that maximises shareholder value. This involves assessing the impact of
various financing options on the overall cost of capital and choosing the combination
that minimizes this metric.

7. Market competitiveness

The cost of capital impacts a company’s competitiveness. In industries where access

to capital is a critical factor, having a lower cost of capital can provide a competitive
advantage. The advantage enables companies to undertakes projects and investments
that might be financially unfeasible for competitor with higher capital costs.

8. Dividend policy and shareholder returns

It guides dividend policy. Companies consider the cost of capital when determining
whether to distribute profits as dividends or reinvest in the business. The decisions
affect shareholders returns and influencing the overall attractiveness of the company’s
stock to investors.

9. Economic Value Added and shareholder wealth

The cost of capital is integral to economic value added, a measure of a company’s

ability to generates wealth for shareholders. By deducting the cost of capital from the
Net Operating Profit After Taxes, EVA provides a clear picture of whether a company
is creating or eroding shareholder value.

10. Strategic planning and long-term viability

it informs strategic planning and ensures long term viability. By aligning investment
decisions with the cost of capital, companies can focus on projects that contribute most
significantly to shareholder value over long term. This strategic alignment is crucial
for sustainable growth and maintaining a competitive edge in the dynamic business
environment.

Importance of cost of capital

1. It helps in evaluating the investment options, by converting the future cash

flows of the investments avenues into present value by discounting it.
2. It is helpful in capital budgeting decisions regarding the source of finance
used by the company.
3. It is vital in designing the optimum capital structure of the firm, where in the
firm’s value is maximum, and the cost of capital is minimum.
4. It can also be used to appraise the performance of specific projects by
comparing the performance against the cost of capital.
5. It is useful in framing optimum credit policy, i.e., at the time of deciding
credit period to be allowed to the customers or debtors, it should be compared
with the cost of allowing credit period.

Classification / Types of cost of capital

1. Explicit cost and implicit cost

2. Historical cost and future cost
3. Average cost and marginal cost
4. Specific cost and composite cost
5. Spot and normalised cost

1. Explicit cost and implicit cost

• Explicit cost

The discount rate at which equates the present value of cash inflows to the present
value of cash outflows is the explicit cost. This cost of any source of capital is the
discount rate that equates the present value of the cash inflows that are incremental to
the taking of financial opportunity with the present value of its incremental cash
outflows.

• Implicit cost

The rate of return which can be earned by investing the capital in alternative
investment by the company or the shareholders is known as implicit cost. It is the rate
of return associated with the best investment opportunity for the firm and its
shareholders that would be forgone, if project presently under consideration by the firm
were accepted.

2. Historical cost and future cost

• Historical cost

Historical cost refers to the cost which has already been incurred for financing a project.
Historical cost is book costs which are related to the past, and so they are calculated on
the basis of past data.

• Future cost

Future cost refers to the estimated cost of funds to be raised for financing a project. For
financial decisions, future costs are more relevant than historical costs.

3. Average cost and marginal cost

• Average cost

Average cost of capital is the weighted average of the specific costs of various sources
of capital. It is calculated on the basis of each source of capital and the weighted
assigned to them in the proportion of each source of capital in the total capital structure.

• Marginal cost

Marginal cost of capital is the weighted average cost of new or incremental funds raised
by a concern. In other words, it is the average cost of capital which has to be incurred
to obtain additional funds required by concern. In short, it is the cost of additional
amount of capital raised by firm.
 4. Specific cost and composite cost
• Specific cost

The cost of each specific component or source of capital is called cost of capital. The
cost of specific source of capital or a particular component of capital is known as
specific cost or component cost.

• Composite cost

It is the combined costs of various source of capital. It is the average of all the specific
costs of funds inducted into the capital structure of a company. It also called as
weighted average cost of capital.

5. Spot cost and normalised cost

• Spot cost

It is the cost prevailing in the market at a certain point of time. It is considered in

financing decision involving alternative appraisals.

• Normalised cost

Normalised cost is the long- term cost estimated by some averaging process from
which the cyclical elements is removed. It is used in taking overall investment
decisions.

Factors affecting the cost of capital

• Internal factors
1. Capital structure policy: The firm has control over its capital structure,
targeting an optimal capital structure. As more debt is issued, the cost of debt
increases and as more equity is issued the cost of equity increases.
2. Dividend policy: It is the policy of the management of a company concerning
the portion of earnings or profits to be distributed to the shareholders as
dividend and the portion of profits to retained on the company as retained
earnings.
 3. Investment policy: When making investment decisions, the company is
making investment with similar degrees of risk. If a company changes its
investment policy relative to it’s both cost of debt and cost of equity change.
4. Financial risk: It is another type of risk which can affect the cost of capital of
a firm the particular composition and mixing of different sources of finance,
known as the financial plan can affect the return available to the investor.

• External factors:
1. Level of interest rate: The level of interest rate will affect the cost of debt and
potentially, the cost of equity. For example: when interest rates increase the
cost of debt increases, which increases the cost of capital.
2. Tax rates : Tax rates affects the after- tax cost of debt. As tax rates increase,
the cost of debt decreases, decreasing the cost of capital.
3. Market condition: the market condition of product produced by the project
for which a fund is required is an important factor for determining the cost of
capital.

Components of cost of capital

1. Cost of debentures
2. Cost of equity
3. Cost of preference share
4. Cost of retained earnings
5. Weighted average cost of capital

1. Cost of Debentures

The debt capital is generally, raised through issue of debentures and bonds and long-
term loans from financial institutions. The contractual rate of interest which is
before tax rate of interest has to be considered. So, the cost of debt finance is the
contractual interest rate adjusted further for the tax saving on interest. In short, the
cost of debt capital refers to the rate of return that must be earned on the borrowed
capital, to keep the earnings of the common stock holders unchanged.

2. Cost of Preference Share

Here, is an important difference between the cost of preference share and cost of
debentures. This is because, dividends paid on preference share capital is not
adjusted for tax purpose. The cost of preference share capital is the rate of return on
preferred stock that must be earned to keep the earnings available to the common
stock holders unchanged. In other words, preference share carries a fixed rate of
dividend and the rate of dividend is fixed well in advance at the time of their issue,
so the cost of preference share capital is computed with reference to the expected
by the shareholders. i.e., the stipulated rate of dividend on preference share.

3. Cost of Equity

The cost of equity capital is an imputed cost which is measured by current earnings
per share relative to the current market price per share. This is earning price ratio.
Cost of equity share capital is the minimum rate of return that a company must earn
on equity financed portion of its investment in order to leave unchanged the market
price of its stock. It is clear that the minimum rate of return on equity investment is
called the cost of equity.

4. Cost of Retained Earnings

Retained earnings are the profits which have not been distributed by a company to
its shareholders as dividend but have been retained in the company to be used for
future expansion. The cost of retained earnings is calculated on the assumption that
the retained earnings is also distributed as dividend to equity shareholders and they
invest the amount on certain securities to get returns. The expected return on
reinvestment is considered as cost of retained earnings.
5. Weighted Average Cost of Capital

It is the average of the costs of specific sources of capital employed by a company,

properly weighted by the proportion the various source of capital on the company’s
capital structure. In short, weighted average cost of capital is the average cost of the
specific costs of various source of financing.
Capital structure

Capital structure means the arrangement of capital from different sources so

that the long-term funds needed for business are raised.

Capital structure refers to the proportion or combination of equity share capital,

preference share, debentures, long term loans, retained earnings, other long-term
source of funds in the total amount of capital which a firm should raised to turn its
business.

Capital structure forms parts of the study of financing decisions. Financing

decisions is concerned with the procurement of the required long – term funds at the
proper time. It deals with the identification of the sources from which funds can be
raised and the determination of the amount of funds that can be raised from each source.
These aspects of financing decision make up the capital structure of an enterprises.

Definition of capital structure

According to I. M. Panday “Capital structure refers to mix of long-term source of funds,

such as, debentures, long term debt, preference share capital, equity share capital
including reserves and surplus”.

According to Jhon J. Hampton, “Capital structure is the combination of debt and equity
securities that comprises a firm’s financing of its assets”.

Factors influencing or determining the capital structure

There are a number of factors influencing or determining the capital structure of a

company. So, while determining the capital structure of a company, the management
must keep in mind the various factors that influences the capital structure.

1. Desire to retain control

The capital structure of a company is also influenced by desire of the promotors and
the existing management of the company to retain control over the affairs of the
company. As the preference shareholders and debentures holders do not have much say
in the management of the company, if the promoters and management want to raise
funds without diluting their control over the affairs of the company, they have to issue
preference shares and debentures and not equity shares. Thus, the desire of the
management to retain control over the affairs of the company influences the capital
structure of the company.

2. Nature of the enterprises

The nature of the enterprises also influences the capital structure of the company.
For instance, companies like public utilities which enjoy monopoly in the market and
have stability in their earnings can easily raise capital by issue of preference shares and
debentures. On the other hand, companies, such as manufacturing companies, which
are subject to trade cycles and competition and which do not have stable earnings, have
necessarily to depend on equity shares for raising funds. Similarly, trading companies
which do not have much fixed assets to be charged in favour of debentures holders
cannot raise much funds by the issue of debentures. They have to meet their capital
requirements by the issue of equity shares and preference shares.

3. Size of company

The size of a company influences its capital structure. Generally, small companies,
which do not have better bargaining power, will find it difficult to raise funds by the
issue of debentures, so, they have to raise funds mainly by the issue of equity shares.
On the other hand, large companies, which have stronger financial position and better
bargaining power, can raise funds from any source they want.

4. Purpose of finance

The capital structure of a company is influenced by the purpose of finance . if funds

are required by a company for directing productive purposes, such as the establishment
of new project, construction of new factory, purchases of additional machinery etc. the
company can afford to raise the funds by the issue of debentures as the interest on
debentures can be paid easily out of the earnings from the productive assets. On the
other hand, if funds are required by the company for non – productive purposes, such
as the provision of welfare facilities to the employees, it would be advisable for the
company to raise the funds by the issue of equity shares.

5. Period of finance

The period of finance also influences the capital structure of a company. For instance,
if funds are required more or less permanently, it would be advisable for the company
to raise the funds by the issue of equity shares, which provides more permanent capital.
On the other hand, if funds are required for a period of 8 to 10years, then it would be
better for the company to raise the funds by the issue of dentures or redeemable
preference shares or through term loans from financial institutions.

6. Desire to have flexibility

The desire of a company to have a flexible financial plan, which will enable the
company to raise funds easily in the case of emergencies, also influences the capital
structure of a company. Generally, a company which desires to have flexibility in its
financial plan raises its initial capital through the issue of equity shares and preference
shares. It resorts to the issue of debentures only at a later stage to raise funds for
financing the expansion.

7. Need to make provision for the future

The need to make provision for future also influences the capital structure of a
company. While planning the capital structure, the management of the company must
make adequate provision for the future. To ensure adequate provision for the future, it
would be always advisable for a company not to issue all types of securities at on time.
It would be always safe to keep the best security at one time. It would be always safe
to keep the best security or some of the best security or some of the best securities till
the last.
 8. Legal requirement

Legal requirements also affect the capital structure of a company. For instance, under
the banking regulation act of 1949, a banking company cannot issue any security other
than equity shares.

9. Government policies

The government policies also influence the capital structure of a company. For
instance, the provision of the capital issues control act of 1947, which are dependent
upon the polices of the government, influences the capital structure of a company
considerably. Similarly, the lending policies of the financial institutions, which are
dependent upon the policies of the government, also influences the capital structure of
a company. So also, the monetary and fiscal policies of the government influence the
capital structure of a company.

10. Trading on equity

The term ‘equity’ means equity share capital, and the term ‘trading’ means taking
advantages of. So, trading on equity means taking advantages of equity share capital
as a base to raise funds through the issue of preference share capital and debentures on
reasonable terms to ensure higher return on equity share capital. In short, it is the act
of ensuring higher return to equity shareholders at the expense of preference
shareholders and debentures holders.

Optimum capital structure / efficient capital structure appropriate capital

structure/balanced capital structure / sound capital structure

Optimum capital structure refers to that capital structure at which there is an ideal
relationship between debt and equity securities, resulting in maximising the value of
company’ equity shares in the stock exchange and minimizing the average cost of
capital.
In short, optimum capital structure is that capital structure at which the value of the
equity shares of the company in the stock exchange is the maximum, while the average
cost of capital is the minimum.

1. Maximization of return or profit

One of the important objectives of balanced capital structure is the maximization of

return or profit. This objective can be achieved by maximizing the return and
minimizing the cost of issue and the cost of financing.

2. Minimization of cost

Another important objective of balanced financial structure is minimising the cost or

raising funds i.e., raising of funds at the lowest possible cost in the given situation

3. Minimisation of risks

Minimization of various kinds of risks like market risk, management risk etc. is one of
the objectives of balanced capital structure.

4. Preservation of control

Preservation of control, i.e., preservation of the rights of the equity shareholders to

control the affairs of the company, is another important objective of balanced financial
structure.

5. Maintaining of proper liquidity

Another important objective of balanced capital structure is to maintain proper

liquidity. This objective can be achieved by maintaining proper balance between fixed
assets and liquid assets.

6. Full utilisation of resources

Yet another objective of balanced capital structure is to ensure that the resources
available with the company are utilised fully and efficiency.
 7. Flexibility

Flexibility is yet another objective of balanced capital structure. That is, yet another
objective of balanced capital structure is to see that the capital structure is flexible
enough to incorporate the necessary changes whenever required.

Features of optimum capital structure / efficient capital structure

appropriate capital structure/balanced capital structure / sound capital
structure

1. Clear – cut objectives

A sound capital structure should be guided by clear – cut objectives. That is, a sound
capital structure should be guided by the twin objectives of maximisation of wealth of
the company and minimisation of cost of capital.

2. Profitability

A sound capital structure must be profitable. That is, it must be such as to minimise the
cost of capital and to maximise the earnings per equity share. It may be noted that this
objective could be achieved only through the adoption on equity.

3. Solvency

A sound capital structure should ensure the solvency of the company. That is, it must
ensure that the debt content in the capital structure is not so excessive as to threaten the
solvency of the company. That means, excess borrowings should be avoided.

4. Flexibility

A sound capital structure should be as flexible as possible. That is, the capital structure
should be such that it can be easily adjusted or changed to meet the requirement of
changing conditions. In short, it should be such as to facilitate easy expansion or
contraction of capital structure.
 5. Conservatism

A sound capital structure should take into account the policy of conservatism. That is,
it should ensure that the debt content in the capital structure should not exceed the limit
which the company can bear. This policy requires the creation of reserves and surplus
at a fairy high figure.

6. Preservation of control

A sound or balanced capital structure should be such as to ensure that the present
management does not lose the control of the company. That is, it should provide
maximum controlling power to existing equity shareholders over the affairs of the
company.

7. Simplicity

A sound or efficient capital structure should be as simple as possible. That is, it should
be easy to understand and simple to operate.

Capital structure theories

Capital structure theories or approach refers to theories which explain the inter-
relationship between capital structure, overall cost of capital and total value of the firm.

Important capital structure theories:

1. Net Income (NI) approach

2. Net Operating Income (NOI) approach
3. Traditional approach
4. Modigliani – miller approach
Assumptions underlying capital structure theories

Capital structure theories are based on certain assumptions.

Those assumptions are:

1. There are only two sources of capital or funds used by a firm, viz., long term
debt and equity shares
2. There is no corporate tax
3. The firm distributes 100% of its earnings as dividend. So, there are no retained
earnings.
4. The operating profits of a firm are not expected to grow.
5. The firm’s total assets remain constant and do not change.
6. The firm’s total capitalisation remains constant.
7. The business risk or operating risk remains constant.

1. Net income approach or theory

• This theory was developed by David Durand.
• According to this approach the value of the firm is increase and decrease
overall cost of capital by increasing the proportion of debt financing in capital
structure. It is due to the fact that debt is generally a cheaper source of finance
because of interest rate and benefit of tax.

Assumptions of NI approach

1. There is no corporate tax

2. The cost of debt is less than the cost of equity.
3. The use of debt does not change the risk perception of investors.
4. Earnings are constant.
 2. Net Operating income approach
• This theory was developed by David Durand.
• According to NOI approach, the market value of a firm is not affected by
changes in the capital structure of the firm, in other words, any changes in
leverage will not lead to any change in the total value of the firm and the
market price of the shares, as the overall cost of capital is independent of the
degree of leverage. Since the overall cost of capital remains constant for all
degree of leverages there ios nothing as optimal capital structure.

Assumptions of NOI approach

1. The overall cost of capital remains constant regardless of any changes in the
degree of financial leverage.
2. The cost of debt would remain constant.
3. The company does not pay corporate tax
4. The business risk remains constant at every level of debt- equity.
5. The overall capitalisation rate or overall cost of capital is used to calculate the
value of the firm.

3. Traditional approach
• This theory propounded by Ezra Solomon.
• As per traditional approach, as firm should make judicious use of both the
debt and equity to achieve a capital structure which may be called the
optimum capital structure.
• At this capital structure, the overall cost of capital, WAAC of the firm will
be minimum and the value of firm maximum.
• The traditional view point states that the value of the firm increases with
increase in the financial leverage but up to a certain limit only. Beyond this
limit, the increase in financial leverage will increase its WAAC and the value
of the firm will decline.
4. Modigliani -Miller approach

Modigliani -Miller approach, the cost of capital as well as the value of firm remains
unaffected by changes in the capital structure in the absence of taxes. That is,
according to this approach, the WACC not change with a change in the proposition
of debt to equity in the capital structure of the firm.

Assumptions of MM approach

1. Capital market are perfect

2. Transaction in securities is cost less.
3. Information is freely available, and investors are well informed.
4. Investors are rational and behave rationally.
5. There is no corporate tax
6. Firms distributes all their net earnings to the shareholders.
7. Firms can be grouped into homogeneous risk classes on the basis of their
business risk.

Criticisms or limitations of MM theory

1. The assumptions that firms and individuals can borrow and lend at the same rates
of interest does not hold in actual practice.
2. The assumption that personals leverage is a perfect substitute for corporate
leverage is incorrect and does not hold good in practice.
3. The assumption that there are no transaction costs in arbitrage process is not
correct, because in actual practice, the security dealers have to incur brokerage,
underwriting commission and other similar costs.
4. The M-M theory has ignored the institutional restrictions which impede the
working of arbitrage process.
 ❖ Arbitrage process

The term arbitrage refers to an act of buying a security in one market at a lower price
and selling it in another market at a higher price to take advantage of the price
differentials in the market.

Arbitrage process means shifting of investment in shares from levered firm to

unlevered firm in order to get more revenue, M-M sates that to get this benefits investor
is required barrow from bank. That is personally levered.

❖ Trade off theory

The trade- off theory of capital structure is the idea that a company choose how much
debt finance and how much equity finance to use by balancing the costs and benefits.

Optimal level of leverage is achieved by balancing the benefits from tax benefits of
debt and the expected costs of bankruptcy.