What is Cost Of Capital? Calculation Examples and Formula

cost-of-capital

 

Every business organization has its own cost of capital. Capital expenditure refers to the expenditure of funds raised from various sources.

Generally, the expected income of fund providers is considered as capital expenditure for the institution. Business organizations raise required funds from various sources.

The cost of capital for different sources of funds is not equal. As a result, each source needs to be assessed separately for the cost of capital.

In this article, we will learn more about the cost of capital, the importance of cost of capital, the cost of capital of various sources of funds, and other topics.

 

Introduction Of  Cost Of Capital

 
 

There are various sources of financing. For example owner’s own capital, loans from friends, bank loans and loans from other financial institutions, etc.

 

From each such source, the money providers have an expected return. Here the expected income for the fund provider is considered as the cost of capital for the fundraising institution.

 

For example: If Rahim takes a loan from a bank at 15% interest to buy a fridge, his cost of capital will be 15%. Similarly, if Karim raised the money to buy the sewing machine on his own, the opportunity cost of the money would be his capital cost. That is, if it appears that he could have earned 15% of his income by investing the money elsewhere, then his cost of capital will be 15%.

 

Large corporations obtain the funds required for their investments from one or more sources. In this case, the average rate of cost of capital from all sources will be considered as the applicable cost of capital for the business.

 

 

Suppose a company needs 10 lakh rupees for investment. Out of these 10 lakh rupees, the company decided to sell 5 lakh rupees of shares and borrow 5 lakh rupees from the bank. The shareholders expect an 18% return on their investment and agree to lend the bank an interest rate of 12%.

 

As a result, the cost of capital from the share sale source will be 18% and the cost of capital from the bank loan source will be 12% for the company. Averaging the cost of capital of the two sources gives the rate i.e. (18%×.50+12%×.50)=15% as the average cost of capital for the firm.

 

Note here that since the cost of capital of the company is 15% the company must earn a minimum return of 15% on its investment before accounting for the cost of funds, otherwise the company will not be able to meet the expected return of the shareholders and the expected return of the bank.

 

Therefore, it can be said that the minimum rate of return required by the organization on its investment to meet the expected income of the owners of funds collected from various sources is called the cost of funds.

 

Significance of capital costing

 
 

Cost of capital plays an important role in taking various financial management decisions of the organization.

 

Cost of capital is applied to everything from choosing the right source of financing to the evaluation of investment opportunities or projects for the organization’s needs. The significance of capital expenditure is highlighted below.

 

First: Investment decision-related. Let’s say a company takes a loan of 50 lakh rupees from Sonali Bank at an 18% interest rate for a factory. After commissioning the factory, it was found that the business was earning 10%, which was lower than the 18% interest rate charged to Sonali Bank.

 

As a result, the company will not be able to pay the money to Sonali Bank. In this case, the transaction will fail.

Therefore, it is necessary to make investment decisions knowing the cost of funds and earning more than that.

Therefore it can be said that accurate cost of funds estimation is considered a prerequisite for making sound investment decisions.

 

 

Second: Capital structure-related.Every organization has a desirable credit policy. Required debt ratio refers to how much of the total capital of the organization is raised from borrowings.

 

Owners’ equity in a business is called total capital. A company can raise 50% of its total capital in equity and 50% debt or 60% equity and 40% debt or 40% equity and 60% debt, in any such ratio. The firm has to determine the cost of capital structure for each such ratio and decide to adopt the alternative ratio that has the lowest cost of capital. Hence the cost of capital also carries significance in choosing the right capital structure for the business.

 

Determination of Capital Expenditure

 
 

Businesses usually raise the money needed to implement their long-term investment decisions from long-term sources of funds. Among these long-term funds are long-term debt capital, preference share capital, ordinary share capital, and retained earnings.

 

A public limited company generally raises funds from these four sources for long-term investment opportunities or projects. Each such source has different expected returns and risks to investors or investors.

 

For example, the expected income of debt capital providers and the expected income of common stockholders are not equal.

 

Since the expected return of investors or finance providers is considered the cost of capital of the business enterprise, the cost of capital varies among different sources of financing of the business enterprise.

 

 

This variation in the cost of capital refers to variation in the expected rate of return of investors or suppliers and variation in the type of risk involved. Generally, the more risky the money providers perceive their investment to be, the higher their expected rate of return. Now a brief idea about capital expenditure from various sources will be given.

 

a) Cost of debt capital

Every organization usually collects business loans from one or more sources.

 

For example, small business establishments such as grocery stores, hair-cutting salons, drug stores, etc., are the main source of debt capital for business establishments from banks or financial institutions.

 

Again, big business organizations or companies raise money by selling bonds or debentures along with loans from banks or financial institutions. Determining the cost of debt capital is very easy if you raise capital by taking a loan from a bank or financial institution. In this case, the interest rate charged by the bank is considered a capital expenditure for the business organization.

 

 

Suppose Sonali Bank agrees to lend Rs 10 lakh to a grocer at 15% interest.

 

In this case, the grocer’s cost of debt capital will be 15 percent. However, this rate is treated as a pre-tax cost of capital for the organization. Note that the amount of interest that a business usually pays on debt capital is the taxable profit of the organization is determined by deducting it from the previous profit. As a result, the company has to pay less tax. So the loan taken from the bank or financial institution brings benefits to the business organization. The pre-tax cost of debt capital needs to be adjusted considering this benefit.

 

The pre-tax cost of debt is adjusted using the formula described below.

Tax-adjusted cost of debt capital = pre-tax cost of debt capital × (1- tax rate)

Adjusting the grocer’s pre-tax cost of debt capital of 15% to a 30% tax rate gives the tax-adjusted cost of debt capital as follows

Tax-adjusted cost of debt capital = 15% (1-.30)

= 15% X .70

= 10.50%

 

b) Cost of preference shares

 
 

Determining the cost of preference shares is different from determining the cost of debt capital. Because there are several differences between debt capital and preference shares. Providers of loan capital to organizations usually receive interest for a fixed period. Preference shareholders on the other hand get dividends at a fixed rate for an indefinite period. 

 

However, companies are not always obliged to pay dividends to preference shareholders. However, even if the company is not obliged to pay dividends, if it earns enough profit, it pays dividends to the preferred shareholders. Therefore it can be said that the cost of preference shares depends on the expected dividend of the shareholders.

 

The cost of preference shares is obtained by calculating the ratio of a dividend of preference shares and proceeds from the sale of shares. It can be determined with the help of a formula as follows:

 

Cost of Preference Shares 

= ( Expected dividends to shareholders / Proceeds from the sale of shares)× 100

 

c) common share capital expenditure

 

 

You know that companies raise their capital by selling common shares in the market. Again the company can raise funds from the accumulated profits of the business.

 

Note that retained earnings, retained earnings, and retained earnings are used interchangeably. Common share capital differs from other sources of finance.

 

First, unlike other sources of equity capital, companies are not always obligated to pay dividends. Second, even if dividends are paid, the amount or rate of dividend paid is not always the same.

 

For these reasons, the determination of the cost of common share capital is different from the determination of the cost of other sources.

 

Shareholders of companies usually buy shares in hopes of receiving dividends and profits from share price appreciation.

 

 

Hence, the cost of share capital refers to the expected rate of return to investors or share owners from dividends and share appreciation gains.

 

Some problems arise in determining the general cost of capital. First, determining future expected dividends is a complex task as the dividend rate is not as fixed as on preference shares. Secondly, estimating the company’s future earnings and dividend growth rate is another complex task.

 

Because of these complexities, there is no single method of determining the cost of common share capital. Different methods of capital costing are developed based on different assumptions. Two simple methods of calculating the cost of common share capital are discussed below.

 

Zero dividend growth method

 
 

This is a simple method of determining capital expenditure. In this method, it is assumed that the dividend paid by the company in the current year, will declare the same amount of dividend in the future years as well. That is, there will be any change in the expected dividend of the shareholders.

 

For example, if a company pays a dividend of 10 rupees per share this year, it is assumed that the company will pay a dividend of 10 rupees per share in the coming years. In this method, dividing the dividend paid per share by the current market price of the share gives the common cost of share capital. The following is shown with the help of formulas:

 

Common share capital expenditure= ( dividend / share price )

 

Here,

dividend  = Expected dividend at the end of the year.

Share price = current market value of the share

 
Example:
 
 
The current market price of a company’s share is Rs. 110. The company declared a dividend of Rs 10 per share this year. The cost of the common share capital of the company can be determined as follows:
 
Cost of common share capital = 10 / 110
                                                 = 0.0909 = 9.09%
 
 

The fixed dividend growth method

Companies with no change in dividends in future years are actually rare. Generally, companies pay dividends at different rates every year.
 
One such method is the fixed rate dividend growth method. Assuming that the company does not pay the same amount of dividend every year. However, this method has some presuppositions.
 
 
The terms assume that the company’s dividend will increase every year and that the rate of increase will be the same amount every year. For example, if a company declares a dividend of Rs 10 in the current year and the expected dividend growth rate of the company is 10%, then
 
The expected dividend after 1 year is 10 (1+0.10)=11 Rs
 
The expected dividend after 2 years will be 11 (1+0.10)=12.1 Rs
 
Expected dividend after 3 years will be 12.1 (1+0.10)  = 13.31 Rs
 
Thus the expected dividend increases at the rate of 10% every year.
 
The cost of common share capital under the constant rate dividend growth method can be calculated as follows:
 
 
Cost of common share capital = (dividend/share price) + Growth rate
 
 

d) Expenditure on retained earnings

 
 

One of the sources of company financing is retained earnings. The amount of money that the company earns as profit every year, not all of it is distributed to the shareholders as a dividend but some part is kept in the company.

 

For example: If a company earns a profit of Rs.50 lakhs in a year and keeps Rs.25 lakhs out of that profit in the business, Rs.25 lakhs will be treated as retained income of the business. In this way, from the saved income, various investment opportunities or projects are later financed.

 

Funded from saved income, it may seem to many that there is no cost to saved income. But this idea is wrong. Because this saved income has an opportunity cost even though it has no apparent external cost.

 

 

Before understanding the opportunity cost of retained earnings, it is necessary to understand the general concept of opportunity cost. Think, your father has a deposit of 10 lakh rupees in one of the banks. Your brother said to your father one day, father, give me the 10 lakh rupees in your account, I will do business.

 

Your brother is not right. Because the money is not actually lying idle, the bank will pay interest on this Rs 10 lakh at a fixed rate. As a result, if your father gives the money to your brother, then you will not get the income that would have been due to interest. Consequently, not earning interest income is an opportunity cost of giving your brother money for the business.

 

Similarly, leaving company earnings undistributed to shareholders has an opportunity cost from the shareholders’ perspective. If the profits earned by the company were distributed among the shareholders instead of being retained as retained earnings in the company, the shareholders could invest the money elsewhere and earn additional income. As a result, if the company does not distribute the profit or income earned, the shareholders are deprived of the income received by investing the money elsewhere.

 

 

Here the foregone income from investing money elsewhere is termed the opportunity cost of retained earnings. For example, if a company distributes all of its profits to its shareholders and the shareholders invest the money elsewhere to earn 15 percent, the company’s retained earnings have an opportunity cost of 15 percent.

 

Average capital expenditure

Through the above methods, we know that the cost of different sources of capital is different. For example, the cost of debt capital is one, while the cost of equity capital is another.

 

So the natural question is that when a business uses some debt capital and at the same time uses some equity capital, what is the cost of capital of the business?

 

 

The answer is the average of all.

 

Conclusion:

The cost of capital refers to the amount an investor charges for lending out his or her money. It is this cost that companies pay when they borrow funds from investors such as banks etc. While the cost of borrowing is a fixed cost, the amount can vary based on market conditions and risk assessment.

 

Now that you know everything about the Cost of Capital, we hope it motivates you to raise your game and start making smarter decisions regarding securing funds in order to grow your business faster!

 

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