What is Cost of Capital?
According to capital budgeting point of view " cost of capital is the discount rate that should be used to determine the present value of estimated future cash proceeds for eventually determining whether the project is worth undertaking or not".
According to khan and jain " cost of capital is the minimum rate of return that must be earned by a firm on its on investment for the market value of the firm to remain unchanged".
Cost of Capital Importance
(a) Capital Budgeting Decision:
Cost of capital is important factor in taking budgeting decisions for a firm. Generally, cost of capital is the discount rate used in evaluating the ability of projects to find out the PV and NPV.
(b) Capital Structure Decision:
Cost of capital is an important factor in determining the company's optimum capital structure. At the time of raising capital from different source such as debt and equity. The objective of the firm at minimizing the cost of capital and maximizing the market value after considering the risk factor.
(c) Maximization of the value of firm:
For the purpose of the firm, a firm must always aim at minimizing the average cost of capital. Therefore, a firm formulate an optimum mix of debt and equity capital.
(d) Dividend Decision:
Cost of capital helps to take dividends decision. Dividends denote the part of the profits of a form.
(e) Evaluation of Financial Performance:
By making comparison between actual profitability of the project that is undertaken with overall cost of capital.
Computation of Cost of Capital
It includes two important parts.
(i) Measurement of specific costs
(ii) Measurement of Weighted Average Cost Of Capital(WACC)
(i) Measurement of specific cost of capital:
The measurement of specific cost of capital of different sources of capital. Such as,
(a) Cost of debt/debenture capital
(b) Cost of preference share capital
(c) Cost of equity share capital
(d) Cost of retained earnings
(ii) Measurement of WACC:
Weighted average cost of capital is mixed between equity share capital and debt capital.
Cost of debenture: The cost of debt refers to the rate of interest payments of obligations used to raise capital for a company. Debentures issues by a company may be redeemable or irredeemable and may be estimated before or after tax has been deducted. They issues at par, at premium or at discount.
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