Investment in capital projects needs funds. These funds are provided by the investors like equity shareholders, preference shareholders, debenture holders, etc in expectation of a minimum return from the firm. The minimum return expected by the investors depends upon the risk perception of the investor as well as on the risk-return characteristics of the firm. This minimum return expected by the investors, which in turn, is the cost of procuring funds for the firm, is termed as the cost of capital of the firm. Thus, the cost of capital of a firm is the minimum rate of return that it must earn on its investments in order to satisfy the expectation of the various categories of investors who have invested in the firm.
A firm procures funds from various sources by issuing different securities to finance its projects. Each of these sources of finance entails cost to the firm. Since the minimum rate of return expected by various investors – equity investor and debt investor – will be different depending upon their risk perception of the firm, the cost of each source of finance will be different. Thus the overall cost of capital of a firm will be the weighted average of the cost of different sources of finance, with the proportion of each source of finance as the weight. Unless the firm earns this minimum rate of return, the investors will be tempted to pull out of the company, let alone, to participate in any further capital issue.
We have seen that the cost of capital of a firm is the minimum required rates of return of various investors – shareholders and debt investors- who supply funds to the firm. How does a firm determine the required rates of return of each investor? The required rates of return are market determined and is reflected in the market price of each security. An investor, before investing in a security, evaluates the risk-return profile of an investment and assigns a risk premium to the security. This risk premium and expected return of an investor is incorporated in the market price of the security. Thus the market price of a security is a function of the return expected by the investors.
Significance of Cost of Capital
The basic objective of financial management is to maximize the wealth of the shareholders or the value of the firm. The value of a firm is inversely related to the cost of capital of the firm. So in order to maximize the value of a firm, the overall cost of capital of the firm should be minimized.
- In capital structure planning a company strives to achieve the optimal capital structure in order to maximize the value of the firm. The optimal capital structure occurs at a point where the overall cost of capital is minimum.
- Since overall cost of capital is the minimum rate of return required by the investors, this rate is used as the discount rate or the cut-off rate for evaluating the capital budgeting proposals.
There are various sources of finance that are used by the firm for financing its investment activities. The major sources are equity capital and debt. Equity capital represents ownership capital. Equity shares are financial instruments to raise equity capital. A debt may be in the form of secured/unsecured loans, debentures, bonds, etc. The debt carries a fixed rate of interest and the payment of interest is mandatory irrespective of the profit earned or loss incurred by the firm. Since interest payable on debt is tax deductible, the usage of debt provides a tax shield to the company.
- Cost of Equity Share Capital: Theoretically, the cost of equity share capital is the minimum return expected by the equity investors. The minimum return expected by the equity investors depends upon the risk perception of the investor as well as on the risk-return complexion of the firm.
- Cost of Preference Share Capital: The cost of preference share capital is the discount rate which equates the net proceeds from issue of preference shares to the present value of the expected cash outflows in the form of dividend and principal repayment on redemption.
- Cost of Debentures or Bonds: The cost of debentures or bonds is defined as the discount rate which equates the net proceeds from issue of debentures to the present value of the expected cash outflows in the form of interest and principal repayment.