Computation of Cost of Capital
There are really two basic approaches to computing the cost of capital. The piecemeal approach considers cash, financing as a separate problems, The other approach develops an average of overall cost of capital. Distinction is, therefore, made between (i) the cost of a specific source of funds i.e., debt. preference shares, equity shares, and retained earnings, and (ii) the inclusive or composite cost of capital which at any time reflects the amount of funds available to a firm at a particular time from various sources at different prices. This cost is also referred to as average cost of funds. The concept of average or specific cost of capital is relevant for investment decisions and most financing decisions. It is only in financing decisions and most financing decisions. It is only in financing decisions (a) involving alternatives which may not affect the firms basic capital structure (as debentures) or (b) where marginal cost is more relevant for financing additional projects, that it is appropriate to use specific cost as criterion for decision-making.
The measurement of company’s cost of capital is not an exact procedure. It is based largely on forecasts that, of course, are subject to various margins of error. The compute value for cost of capital can, therefore, be regarded as a fair approximation of the cost of capital inputs consistent with (i) company needs, (ii) the conditions under which it is raising its capital. (iii) the level of expectation and (iv) corporate police constraints (Kuchhal).
In order is measure the overall, composite cost of capital to the company, it is necessary first to consider the cost of specific method of financing. Here we shall be primarily concerned with the explicit cost. The explicit cost of a source of financing may be defined. In the words of Van Horne, as “the discount rate that equates the present value of the funds received by the firm. Net of underwriting and other costs with the present value of expected outflows”, These outflows may be interest payments, repayment or principal, or dividend. Thus, as Van Horne puts it, the explicit cost of a specific method of financing can be determined by solving the following equations for k (discount rate) :
K0 = C1/(1+k)+ C2/ (1+k)2+…………..+ C2/ (1+k)n ……(1)
Where l0 is the amount of funds received by the firm O, and Cn is the outflow in period n. (Note that k here is nothing but the minimum desired rate of return of the DCF rate used in capital budgeting decisions).