What is Cost of Capital?
No discussion on capital budgeting is complete without a thorough discussion on the cost of capital. In simplest terms, the cost of capital is defined as the cut-off rate or the minimum rate of return that is required from an investment. According to the Solomon Ezra, Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure.
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Importance of Cost of Capital
The concept of cost of capital is extremely useful for multiple areas of financial management including capital budgeting such as fixing discount rates, designing capital structure and evaluating financial performance. The cost of capital forms the basis of fixing discount rate which is the rate at which future cash flows are discounted to determine the present values of future cash flows for comparing initial investment and arriving at the Net Present Value of any project.
When the project managers are using the IRR or NPV techniques of capital budgeting, the projects are considered profitable if the NPV is positive when cashflows are discounted at cost of capital or the IRR of the project is greater than the cost of capital. Further, the concept of cost of capital is used for designing the capital structure of a company.
It means that the combination of debt and equity that costs minimum to the company can also be decided with the help of cost of capital. One of the most significant uses of cost of capital is that it helps investors make their investment decisions. For instance, an investor can choose to invest in different companies that offer different rates of return and having different risk levels.
Factors Affecting Capital Costs
The cost of capital is cost to a company but profit to a shareholder. The cost of capital is influenced by a number of factors such as economic factors, market conditions, economic opportunities, capital provider preferences, risk, inflation, fiscal policy, reserve surpluses and shortfalls, trade activity, trade surpluses and deficits, country risk and exchange rate risk.
Some of the important factors that affect cost of capital are shown in Figure:
Let us now discuss the factors affecting the cost of capital.
The law of demand and supply also applies to the cost of capital. When the demand for capital grows, the cost of capital also increases and vice versa. The economic opportunities that prevail in the market have a significant impact on demand for capital. If the market is booming, more people start engaging in businesses. Entrepreneurs require funds to put their business plans into action. As a result, the cost of capital increases in direct proportion to the market conditions.
Preferences of Capital Providers
When individuals or entities have excess to money, they may either save it or spend it. It is their personal choice but it is also influenced, to a large amount, by society. For example, Japanese individuals are more inclined to save as compared to Americans. The interest rate or returns available for investments also impact the usability of capital. When supply of funds is high then capital may be raised at low cost and vice versa.
In business, it is frequently quoted that high-risk may lead to high-rewards. If a project carries a high level of risk, the investor’s expected returns are also equally high so as to compensate for the risk. An entrepreneur starting a new business might not want to choose a higher operating cost because it could potentially jeopardise the visibility of the whole project. As a result, risks associated with a project play an important role in determining capital activities in the market.
All capital providers want to invest in such a way that their profits are maximised. The difference between the actual return and inflation is known as real income. Inflation has traditionally been the lowest standard for investing. For making profits, an investment should outperform inflation and generate real income.