The ‘Cost of Capital is the minimum rate of return, which enables a company to make such an amount of profit on its investment so as to ensure that the market value of the company’s equity shares either increases or remains at the same level. This is in conformity with any company’s goal of ‘Wealth Maximisation’ for its shareholders.
`Wealth Maximisation’ for the shareholders of a company is feasible only when the projects financed by the company (shareholders money) generate revenues at a rate equal or more than the rate expected by the shareholders. In case, the company is unable to earn the expected rate of return, the possibility of a decrease in the market value of the company’s shares cannot be ruled out, which ultimately may result in erosion of the shareholder’s wealth. Some of the prominent authorities on the subject have defined ‘Cost of Capital’ as follows:
Definition of Cost of Capital
According to James C Van Horne, “A cut-off rate for the allocation of capital to investments of project. It is the rate of return on a project that will leave unchanged the market price of the stock”.
In simple words, the minimum rate of return expected by the investors of the business on the projects is called the cost of capital.
The opportunity cost of capital is the lost value of an investment due to the investment made in some other projects. For an investor, it is the choice offered to him to invest in one project over another.
For example, the use of fixed assets like vacant land can be used as an opportunity cost for the investor if he had used it for some other purpose.
In financial markets, securities such as equity shares, debentures, and government gilt-edged securities are available for investment. The rate of return earned from these investments (securities) is known as the opportunity cost of an investment in capital projects, and if the company had invested this money elsewhere it could get a better return which is not possible in this capital project. Therefore, it is advisable for the company to take consideration of all the factors during investment in the projects.
The term “Opportunity Cost” of the investment is also known as the ‘Minimum Required Rate of Return’, ‘Cost of Capital’, and ‘Discount Rate or Interest Rate’.
Factors Affecting Cost of Capital
Cost of capital for a company is influenced by a number of factors (both external as well as internal for the company), some of which are as follows:
1) General Economic Conditions:
This is a factor external to a company’s operational boundaries and beyond its control. General conditions prevailing in the economy of a country are largely responsible for the demand for and supply of capital and inflationary expectations.
- In case of an increase in the demand for capital without a corresponding increase in the supply thereof, the cost of capital (interest rate) would be high. In a reverse scenario, where the demand is weak and supply is sufficient, the cost of capital is likely to below.
- A high inflation rate affects the purchasing power of money and results in its reduced value. In such a condition, investors or shareholders expect a high rate of return as a part of compensation. The cost of capital, in such conditions, tends to be high.
2) Market Conditions:
Market conditions prevailing at a particular point of time are responsible for the level of risks associated with a financial instrument. The risk inbuilt in a financial instrument is directly proportional to the interest offered by such an instrument. Investors prefer to invest in a high-risk bearing instrument only when the rate of interest offered by it is relatively high and attractive enough to enter into such a risky zone. With an increase in the risk associated with an instrument, an increased rate of interest is expected by the investors.
Such an increase is termed as a risk premium. This causes the cost of funds to inflate. Further, the marketability of an instrument and its price stability is equally significant; the easy marketability of a financial product at the relatively stable price may bring the investors expectation of the rate of return at a lower level, resulting in a lower cost of capital. In the opposite situation, which is poor marketability and the unstable market price of an instrument, the investors’ expectations regarding the rate of interest would be higher and as a result, the cost of funds is likely to be high.
3) Company’s Operations and Financing Decisions:
Certain controversial decisions taken by a company may also result in risks or fluctuations in the return. Risks arising out of such decisions may be categorized into two groups, which are as follows: i) Business Risk, and ii) Financial Risks.
- Business risks are the outcome of the company’s investment decisions and are characterized by variable returns on assets.
- Financial risks are an increase in fluctuation in return to the equity shareholders, which is the result of the utilisation of debt and preference share. With an increase in business and financial risks, investors expectation with regard to the rate of return also increases, ultimately increasing the cost of capital. Vice versa of the above phenomenon is also true, i.e., decreased business and financial risks are followed by the decrease in the cost of capital.
4) Amount of Financing:
The cost of funds is directly proportional to the required amount of funds. With the increased requirement of funds for a company, there is an increase in the weighted cost of capital due to various reasons, some of which are mentioned below:
- With the issue of more securities or instruments, the cost of selling securities (floatation cost) also tends to be more, which affects the cost of funds to the company.
- If a company approaches the market for an amount of capital not in proportion with the strength of its capital or the size of the company, investors expectation of rate of return increases, which in turn increases the cost of capital.
- Institutional lenders express some objection to giving approval of huge amount of funds in the absence of relevant documents with regard to the company’s potential to ensure appropriate application of borrowed funds into the business.
- With the increasing size of the issue, the need to reduce the price of the security or instrument also increases, which in turn results in the increased cost of capital.