Cost of Capital – Concept

Principle & Practice of Management

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Cost of Capital- Concept

The capital cost is a concept having many different meanings. The three viewpoints, regarding the capital cost, is given below:
1. From Investors’ View Point: Investor may define it as “the measurement of the sacrifice made by him in capital formation.” For example, Mr A an investor invested in a company’s equity shares, amount Rs. 1,00,000, instead of investing in a bank at the rate of 7 per cent interest. Here he had sacrificed 7 per cent interest for not having invested in the bank.
2. Firms Point: It is the minimum required rate of return needed to justify the use of capital. For example, a firm raised Rs. 50 lakhs through the issues of 10 per cent debentures, for justifying this issue, a minimum rate of return it has to earn is 10 per cent.
3. Capital Expenditure Point: The capital cost is the minimum required rate of return, the hurdle or target rate or the cutoff rate or any discounting rate used to value cash flows.
Capital Cost
For example, Firm ‘A’ is planning to invest in a project, that requires Rs. 20 lakh as the initial investment and provides cash flows for a period of 5 years. So for the conversion of future 5 years cash flows into present value, the cost of capital is needed. The capital cost represents the rate of return that the firm must pay to the fund suppliers, who have provided the capital. In other words, the capital cost is the weighted average cost of various sources of finance used by the firm. The sources are equity, preference, long-term debt and short-term debt.
“The rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due.” – Hunt, William and Donaldson
“Capital Cost is the minimum required rate of earnings or the cut-off rate of capital expenditures.”- Solomon Ezra
“A cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.”
– James C. Van Horne
“The rate of return the firm requires, from investment in order to increase the value of the firm in the marketplace.” – Hampton, John J
Thus, as defined above, we can say, that cost of capital is that minimum rate of return, which a firm must and is expected to earn on its investments so as to maintain the market value of its shares. It is also known as Weighted Average Cost of Capital (WACC), the composite cost of capital or combined cost of capital. It is expressed in terms of percentage.