Concept of cost of capital

In this topic Concept of cost of capital, we discussed the definitions, assumptions, and applications of cost of capital in brief.

Cost of capital is the rate the firm has to pay for the use of debt, preferred stock, common stock, and/ or retained earnings. In other words, it is the rate that must be earned on the firm's investment in order to satisfy all the investor's required rates of return.

The overall cost of capital reflects the combined costs of all long-term sources of financing i.e debt, preferred stock, common stock, used by the firm. This overall cost of capital is called weighted average cost of capital (WACC).

It is also called the minimum required rate of return on investment at which the price of a firm's common stock remains unchanged.

Basic assumptions of cost of capital are as follows:

1. Constant Business Risk
2. Constant Financial Risk
3. Constant Dividend Policy
4. Constant Tax Rate

Constant Business Risk:

Business risk is defined as the potential variability of returns on investment. It is the risk to the firm of being unable to cover the operating costs.

Constant Financial Risk:

Financial risk is the variability in returns of common stock, resulting from a change in the proportion of debt and preferred stock financing. The firm has to cover the financial obligations such as interest, preferred stock, dividend, etc.

Constant Dividend Policy:

The growth rate fluctuates if the company does not keep a constant dividend payout ratio. It is made constant to simplify the computation of the cost of capital.

Constant Tax Rate:

The cost of capital is calculated after-tax, to calculate the overall cost of capital. So, we assume the tax constant as a change in tax rate affects the cost of capital and calculation also becomes complex.

Applications of cost of capital are as follows:

1. It is an important concept in financing decision-making (Financing Decision).
2. It is used as a standard for evaluating investment projects (Investment Decision).
3. Designing capital structures (Capital Structure Decision)
4. Determining appropriate dividend payout ratios (Dividend Policy Decision).

Investment Decision:

The cash flows of long-term investment projects are discounted, which is called Net present value (NPV). The project with a positive NPV of the project is accepted, otherwise rejected. IRR is the discounting rate at which the NPV of the project equals zero. So, the project with a higher IRR is accepted than the project with a lower IRR.

Capital Structure decision:

An optimal capital structure minimizes the overall cost of capital and maximizes the value of the firm. So, the firm is structured so as to have a minimized overall cost of capital.

Dividend Policy Decision:

The cost of equity capital and reinvestment rate of return is compared and the appropriate dividend payout ratio is determined, If the reinvestment rate of return is higher than the cost of equity, the company should not pay a higher dividend. Similarly, the company should not retain profit if the reinvestment rate of return is less than the cost of euiqty.