Cost of Capital

Cost of Capital

There are two important reasons for a business manager to be concerned with the determination of his firms cost of capital. First he may want to know how different capital structures affect the cost of obtaining capital in the firms present capital of reducing the cost of the firm of obtaining new capital, Secondly, he may want to use the cost of capital at the discount rate (the cut-off rate) in evaluating investment decision is directly related to financing decision because use the acceptance of investment proposals depends upon how those proposals will be financed. In the previous lesson, We have already seen that the discount rate is the vehicle by which we judge the attractiveness of an investment opportunity. This rate usually is the firm’s cost of capital.

Concepts and Definition :

Financial management, facing its largest and most difficult job. i.e., capital budgeting has to know the cost of the funds used for a project to compare with the expected rate of returns from that project. The cost of capital represents a cut-off rate for the allocation of capital to investment project. Thus, the rate of financial cost is needed as a ‘hurdle’ or “cut-off” signal. In other words, the cost of capital is the minimum require rate that the project must yield if it is to be adopted.

Recalling that project should be accepted if they will increase share (i.e., maximise shareholders wealth), we can say that the cost of capital is the additional earning on the new investment required to keep share price form failing. According to James C.Van Horne, the cost of capital may be defined as “the rate of return on a project that leave unchanged the market price of the stock” In this sense, it is the required rate of return needed to justify the use of capital.

A company has made available a wide assortment of financing methods, each with an explicit, cost, So we must determine the cost of funds raised by (i) relating profits (ii) issuing share and (iii) by borrowing. One needs to know the relative cost of alternative sources of funds in order to minimise these costs in order, that is to choose the optimum capital structure is an abstraction that express the rate of sacrifice being paid by a business to those who supply funds for the operation of the firm (Joseph F. Bradley)

However, the cost of capital in general is best thought of as a measure that is developed to determine the cut-off point in capital is the minimum required rate of return that the investment project must if is to be profitable and hence adopted. Since profitability is defined in terms of its effect on the shareholders, this required rate is one that will not affect the price of the shares of shareholders wealth adversely. That is, if an investment project is to be adopted, it must not depress the net expected returns per share, or, if the multiplier is adversely affected by the financing, the increased returns per share must be more than off-setting. In short, the cost concept that sets the minimum rate that the investment must promise to return; at rates of return higher than the cost of capital, the price of the shares of shareholder’s wealth can be expected to rise.