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Cost of Capital: Introduction and Concept

Prerequisites

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1. What is Cost of Capital?

Definition: Cost of Capital is the minimum rate of return that a firm must earn on its investments to satisfy the expectations of investors who provide funds to the firm.

Simple Meaning: It is the "price" the company pays for using money from different sources.

2. Two Perspectives

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Key Insight: The company's cost = Investor's required return

3. Importance / Significance of Cost of Capital

3.1 In Investment Decisions (Capital Budgeting)

  • Used as discount rate in NPV calculation
  • Hurdle rate for IRR comparison
  • Project accepted only if Return > Cost of Capital

Example:

Project returns 15% per annum
Cost of Capital = 12%
Decision: Accept (15% > 12%)

3.2 In Financing Decisions (Capital Structure)

  • Determines optimal mix of debt and equity
  • Aim: Minimize Weighted Average Cost of Capital (WACC)
  • Lower WACC = Higher firm value

3.3 In Performance Evaluation

  • Measure managerial efficiency
  • Economic Value Added (EVA) = Return - Cost of Capital

3.4 In Valuation

  • Used to discount future cash flows in company valuation
  • Determines intrinsic value of firm

4. Classification of Cost of Capital

4.1 Specific Cost

Cost of individual source of finance.

Examples:

  • Cost of Equity
  • Cost of Debt
  • Cost of Preference Shares
  • Cost of Retained Earnings

4.2 Weighted Average Cost of Capital (WACC)

Overall cost considering all sources and their proportions.

Formula:

WACC Formula

WACC = (We × Ke) + (Wd × Kd) + (Wp × Kp)

Where:

  • We, Wd, Wp = Weight (proportion) of Equity, Debt, Preference
  • Ke, Kd, Kp = Cost of Equity, Debt, Preference
  • Weights add up to 1 (or 100%)

5. Assumptions in Cost of Capital Calculation

  1. Business Risk Constant: Firm's operating risk doesn't change with financing
  2. Financial Risk Changes: Only financial leverage varies
  3. Dividend Policy Constant: Payout ratio remains unchanged
  4. No Taxes (in theoretical models): Simplifying assumption, later relaxed

6. Factors Affecting Cost of Capital

1. Risk of the Firm:

  • Higher business risk → Higher cost
  • Investors demand premium for risk

2. Capital Structure:

  • Higher debt → Higher financial risk → Higher cost of equity
  • But debt is cheaper due to tax shield

3. Inflation:

  • Higher inflation → Higher required return

4. Market Conditions:

  • Bull market → Lower cost (easy to raise funds)
  • Bear market → Higher cost

5. Tax Rates:

  • Higher tax → Lower after-tax cost of debt (interest is deductible)

Exam Pattern Questions and Answers

Question 1: "Define Cost of Capital and explain its significance." (6 Marks)

Answer:

Definition (2 marks): Cost of Capital is the minimum rate of return that a firm must earn on its investments to maintain the market value of its equity shares and satisfy the expectations of various investors who provide long-term funds. It represents the firm's cost of financing and acts as a benchmark for investment decisions.

Significance (4 marks):

  1. Capital Budgeting Decisions: Cost of capital serves as the discount rate in NPV calculations and the hurdle rate for accepting projects. Only projects earning returns greater than the cost of capital create value.
  2. Capital Structure Decisions: Helps determine the optimal mix of debt and equity by comparing the costs of different sources. The aim is to minimize the Weighted Average Cost of Capital.
  3. Performance Evaluation: Acts as a benchmark to evaluate whether management is generating adequate returns on invested capital.
  4. Firm Valuation: Used as the discount rate in DCF valuation models to determine the intrinsic value of the company.

Question 2: "Distinguish between Specific Cost and Weighted Average Cost of Capital." (4 Marks)

Answer:

Specific Cost (2 marks): This refers to the cost of an individual source of finance in isolation. For example, cost of equity shares, cost of debentures, cost of preference shares. Each source has been its specific cost calculated based on its own characteristics and risk.

Weighted Average Cost of Capital (WACC) (2 marks): This is the overall cost of capital for the firm, calculated by taking the weighted average of all specific costs. The weights are the proportions of each source in the total capital structure. WACC = (Weight of Equity × Cost of Equity) + (Weight of Debt × Cost of Debt) + ... It represents the average rate the company pays for all its financing.

Summary

Cost of Capital:

  • Minimum required return on investments
  • Company's cost = Investor's return

Importance:

  1. Investment decisions (NPV discount rate)
  2. Capital structure (optimize mix)
  3. Performance evaluation
  4. Valuation

Types:

  • Specific: Individual source cost
  • WACC: Weighted average of all

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Quiz Time! 🎯

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