The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity, debt, and retained earnings. If a firm fails to earn a return at the expected rate, the market value of the shares will fall and it will result in the reduction of the overall wealth of the shareholders.
Assumption of Cost of Capital
The cost of capital is based on certain assumptions that are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts:
A. It is not a cost as such. It is merely a hurdle rate.
B. It is the minimum rate of return.
C. It consists of three important risks such as zero risk level, business risk, and financial risk. The cost of capital can be measured with the help of the following equation.
K = rj + b + f.
K = Cost of capital.
rj = The riskless cost of the particular type of finance, b = The business risk premium.
f = The financial risk premium.
Importance of Cost of Capital
Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.
1. Importance to Capital Budgeting Decision: Capital budgeting decision largely depends on the cost of capital of each source. According to the net present value method, the present value of cash inflow must be more than the present value of cash outflow. Hence, the cost of capital is used to make capital budgeting decisions.
2. Importance to Capital Structure Decision: Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses a particular type of source if the cost of capital is suitable. Hence, the cost of capital helps to take decisions regarding structure.
3. Importance to Evolution of Financial Performance: Cost of capital is one of the important factors in determining claim which affects the capital budgeting, capital structure, and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
4. Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in some other areas such as the market value of a share, earning capacity of securities, etc. hence; it plays a major part in financial management.