The term cost of capital refers to the maximum rate of return a firm must earn on its investment so that the market value of company’s equity shares does not fall. This is a consonance with the overall firm’s objective of wealth maximization. This is possible only when the firm earns a return on the projects financed by equity shareholders funds at a rate which is at least equal to the rate of return expected by them. If a firm fails to earn return at the expected rate, the market value of the shares would fall and thus result in reduction of overall wealth of the shareholders. Thus, a firm’s cost of capital may be defined as “the rate of return the firm requires from investment in order to increase the value of the firm in the market place”.
The three components of cost of capital are:
1. Cost of Debt
Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained later.
(a) Debt issued at par: The computation of cost of debt issued at par is comparatively an easy task. It is the explicit interest rate adjusted further for the tax liability of the company. It may be computed according to the following formula:
Kd = (l-T)R
- Kd = Cost of debt;
- T = Marginal tax rate;
- R = Debenture interest rate.
The tax is deducted out of the interest payable, because interest is treated as an expense while computing the firm’s income for tax purposes. However, the tax adjusted rate of interest should be used only in those cases where the “earning of the firm before interest and tax” (EBIT) is equal to or exceed the interest. In case, EBIT is in negative, the cost of debt should be calculated before adjusting the interest rate for tax.
(b) Debt issued at premium or discount: In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realized on account of issue of such debentures or bonds. Such cost may further be adjusted keeping in view the tax applicable to the company. Cost of debt can be calculated according to the following formula:
- Kd = Cost of debt after tax.
- I = Annual interest payment.
- NP = Net proceeds of loans or debentures.
- T = Tax rate.
The computation of the cost of preference capital however poses some conceptual problems. In case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while in case of preference shares, there is no such legal obligation. Hence, some people argue that dividends payable on preference share capital do not constitute cost. However, this is not true. This is because, though it is not legally binding on the company to pay dividends on preference shares, it is generally paid whenever the company makes sufficient profits. The failure to pay dividend may be better of serious concern from the point of view of equity shareholders. They may even lose control of the company because of the preference shareholders getting the legal right to participate in the general meetings of the company with equity shareholders under certain conditions in the event of failure of the company to pay them their dividends. Moreover, the accumulation of arrears of preference dividends may adversely affect the right of equity shareholders to receive dividends. This is because no dividend can be paid to them unless the arrears of preference dividend are cleared. On account of these reasons the cost of preference capital is also computed on the same basis as that of debentures. The method of its computation can be put in the form of the following equation:
- Kp = Cost of preference share capital
- Dp = Fixed preference dividend
- Np = Net proceeds of preference shares.
In case of redeemable preference shares, the cost of capital is the discount rate that equals the net proceeds of sale of preference shares with the present value of future dividends and principal repayments.