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Cost Of Capital

Cost of Capital Assignment / Homework Help

The cost of capital in operational terms refers to the discount rate that would be used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. It is defined as "the minimum rate of return" that a firm must earn on its investment for the market value of the firm to remain unchanged.

In economic terms, there are two approaches to define cost of capital. According to the first approach, it is the cost of acquiring the funds required to finance the proposed project. That is the cost of capital is a borrowing rate of the firm. Alternatively, cost of capital in terms of lending rates, may refer to the opportunity cost of the funds to the firm i.e., what the firm could have earned by investing the funds elsewhere. We use the term in the sense of borrowing rate. This is mainly because firms which have to take capital budgeting decisions would rarely, if ever invest funds outside. The approach is based on the borrowing rate is therefore practical and more realistic.

According to the second approach, cost of capital is defined as the weighted average of the cost of each type of capital. Each security capital is given a weight according to either the book value or the market value, most practically the market value, compared to the total security value of the firm. The term "security" includes equity shares, preference shares, retained earnings, debentures and other interest bearing securities. cost of capital is a borrowing rate of the firm.


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Basic Aspects of concept of Cost of capital

There are three basic aspects of concept of cost. They are:
  • It is not a cost as such.
  • It is the minimum rate of return.
  • It comprises the following 3 components:

    • Return at Zero risk level – This refers to the expected rate of return when a project involves no risk whether business or financial.
    • Premium for business risk – The term business risk refers to the variability in operating profit due to change in sales. The concept is higher the risk, higher is the expected return.
    • Premium for financial risk – The term financial risk refers to the risk on account of pattern of capital structure. In general, it can be said that a firm having higher debt content in its capital structure is more risky as compared to a firm which has comparatively low debt content.

    The above three components of the cost of capital may be put in the form of following equation:

    K = r0 + b + f

    Where:

    K    = Cost of capital
    B    = Premium for business risk
    f     = Premium for financial risk
Importance of Cost of capital:
  • It is relevant in the field of managerial decision as this dynamic concept is affected by a company’s capital structure, its’ financing plans for the future and any changes in the rate of earnings.
  • When taking decisions based on Net Present Value method, the cost of capital is usually the discount rate that discounts the cash inflows.
  • It is important in designing the capital structure of a firm.
  • It is helpful in evaluation of expansion projects, evaluation of the financial performance of the top management through the comparison of the projected overall cost of capital and the actual cost incurred in raising the required funds.
  • It is a vital factor in management decision about the method of financing at a given time. Costs of various sources of capital at a given time influence the management’s decision in favor of a certain capital.

Importance of Cost of capital:

Cost of capital can be classified as follows:
  • Explicit cost of capital – It may be defined as the discount rate that equates the present value of funds received by the firm net of underwriting costs, with the present value of expected cash outflows. It is the rate of return of the cash flows of financing opportunity. It is, in other words, the internal rate of return the firm pays for financing.
  • Implicit cost of capital - The implicit cost may be defined as the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm were accepted.
  • Future cost of capital – It is the projected cost of capital used in designing the capital structure to minimize the future cost of capital and to control it.
  • Historical cost of capital – It is the cost which has already been incurred for financing a particular project. These costs are useful in projecting future costs.
  • Specific cost of capital – It is the cost associated with particular component of capital structure.
  • Average cost of capital – It is the average of various cost of the weighted average of the costs of each component of funds employed by the concern, the weights being the proportion of each component in the capital structure.
  • Combined cost of capital – It includes the cost of capital from all sources namely, debt, equity, preference capital and retained earnings. It is also called as the weighted cost of capital.
  • Marginal cost of capital – Marginal cost of capital is the weighted average cost of new funds raised by the firm. For capital budgeting and financing decisions, the marginal cost of capital is the most important factor to be considered.