Cost of Capital | Financial Management- Meaning, Importance and Types

Cost of Capital in Financial Management

Let’s start this with an example. Like You have 10 Lacs in your Bank Account. Now You want to invest that money. So, For Which decision You should give more priority in managing your Finance?? Where to Invest, Why to Invest, How Much to Invest?? This can be. But Your Priority should be the expected Rate of Return which you will get in return which is also known as the Cost of Capital in Financial Management.

The Expected/Average Rate of Return is the rate which the Investors would expect from their Investing amount. It plays a major role in Financial Management. To get Complete Financial Management Notes, Click here.

In retained earnings, the Cost of Capital is known as an Opportunity Cost. In simple, Cost of Capital is simply the cost paid for using the capital.


Definition of Cost of Capital


Definition of Cost of Capital

What is Cost of Capital in Financial Management according to the authors?? So, Let’s know about that.

Acc. to John Hampton Jr., “The Rate of Return the firms required from the investment in order to increase the Value of Firm in the Marketplace.”
Now, Come to the Formula of Cost of Capital. Cost of Capital is denoted by Ko.

Ko= Rf +Br + Fr

Rf= Risk Free Rate of Return

Br= Business Risk

Fr= Financial Risk


Importance of Cost of Capital in Financial Management


  • It uses as an Acceptance Criteria in Capital Budgeting because if NPV is greater than the Cost of Capital, then the results are satisfactory otherwise not.
  • Cost of Capital is a base for taking the other Financial Decisions like Dividend Decision, Financial Policy.
  • It helps to take as a standard rate in Financial Management that this much rate should be achieved.
  • Cost of Capital refers to be a part of Capital Mix in Capital Structure because Companies look for the optimum mix of financing of both Debt and Equity.
  • It also helps to know the Finance of the Business.

Types of Cost of Capital in Financial Management


There are basically three types of Cost of Capital in Financial Management that are-

Cost of Debt Capital


Cost of Debt

Cost of Debt Capital in Financial Management is to use the Capital of Financial Institutions or Banks. In this, Companies give them Fixed amount of Interest. Cost of Capital is denoted by Kd. Now, come to the Formulas of Cost of Debt Capital-

It is divided into three cases-


Cost of Debt Capital without Tax

Kd = I/P

Here, I stands for Interest and P stands for Principal Amount.


Cost of Debt Capital with tax

Kd =I/NP (1-t)

NP is Net Proceeds.


Redeemable Debentures

This is also in two cases-


Without Tax-

Kd= I+ 1/n  (RV-NP) / ½(RV+NP)

Here, RV is Redeemable Value and NP is Net Proceeds.


With Tax

Kd= I(1-t) +(RV-NP)/ ½ (RV+NP)


Cost of Equity Capital


Cost of Equity

Cost of Equity Capital in Financial Management means to use the capital of Equity Shareholders. The Shareholders buy the shares of the Firm and get dividends when Firm earns the profit. Equity Shareholders also have voting rights. The Symbol of Cost of Equity Capital is Ke.

Cost of Equity Capital can be calculated in three ways-


Dividend Yield Model

In this model, Equity Shareholders get the dividend on a regular basis. The Formula of Dividend Yield Model is as follows-

                                 Ke=D/NP

Here, D is Dividend and NP is Net Proceeds.


Dividend Yield plus Growth Model

In this, they get dividends on a regular basis but with the Company Growth rate either it is Increasing or decreasing.

                    Ke=D/NP + G(Growth)


Earning Yield Model

In Earning Yield Model, Shareholders get the dividend according to the earnings per Share. Here is the Formula below-

                             Ke= EPS/ No. Of Shares

EPS is Earning Per Share.


Weighted Average Cost of Capital


The weighted average cost of capital in financial management

In this, it includes the Average Cost by assigning their weights. It is denoted by by Kw.

There are two Formulas of Weighted Average Cost of Capital in Financial Management that are as follows-


Traditional Formula

Kw= ΣXW/ΣW


Modern Formula( Priority Basis)

Kw= Ke(E/D+E) + Kd(1-t)(D/D+E)


Factors Affecting the Cost of Capital in Financial Management


factors affecting the cost of capital in financial management

There can be plenty of factors which affect the Cost of Capital in Financial Management. Some are as follows-

Risk Rate

Risk Rate is one of the most Important factors that affect the Cost of Capital in Financial Management. If there is a higher risk , then the Expected Rate of Return will also be High and vice-versa.

Market Opportunity

The Market Opportunity also plays a prominent role in the Cost of Capital. If there are not any profitable business in the market, then the Cost of Capital will also be less.

Inflation

If there is Inflation is the market which results in decreasing the Money Supply. In this case, Investors will look for the Investment which has high expected rate of return.

Amount of Investment

Amount of the Investment also affect the Cost of Capital in Financial Management. If You invest less amount of Investment, then obvious rate of return will also be less and vice-versa.

Preference of Capital Providers

Preference of Investors is also an important factor that affects the Cost of Capital. If the Capital Providers prefer consumption, then the supply of money will decrease which results in increase of Cost of Capital.

In the same way, if Capital Providers prefers savings, then it will decrease the Cost of Capital.

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