What are the components of cost of capital? Classification and Importance of the cost of capital.

Components of cost of capital

In the firm, (components of cost of capital) can be divided in three types.

Return at zero risk level: This is the rate of return expected when the firm conducts projects with zero risk.

Premium for business risk: Business risk refers to the unpredictability of running gains due to changes in sales. The higher the business risk, the higher the premium expected by the buyers.

Premium for financial risk: Risk coming out of the problem of fixed income Securities like debt and preference capital are called financial risks.” The higher the financial danger, the higher the expected rate of return by the producers of funds.

To sum up it may be said that cost of capital (K) consists of the following 3 components:

  • Riskless cost of particular source (a)
  • Business risk premium (b)
  • Financial risk premium (c)

K= a+b+c (15=10+2+3) %

Here is a table outlining the components of cost of capital:

Cost of DebtThe cost of debt represents the interest expense a company incurs on its outstanding debt. It includes the interest rate on debt instruments such as bonds and loans, as well as any other related borrowing costs.
Cost of EquityThe cost of equity is the return expected by shareholders or investors for holding the company’s stock. It is the cost of using equity capital to finance the business, and it is often calculated using the Capital Asset Pricing Model (CAPM) or other equity pricing models.
Cost of Preferred StockFor companies that have preferred stock, the cost of preferred stock refers to the dividend rate or yield that the company must pay to holders of preferred shares. It represents the cost of using this type of financing to raise capital.
Weighted Average Cost of Capital (WACC)WACC is the overall cost of capital for a company, taking into account the proportion of each type of capital (debt, equity, and preferred stock) in the company’s capital structure. It is calculated by weighting the cost of each component by its respective proportion in the capital mix.
Marginal Cost of CapitalThe marginal cost of capital represents the cost of raising additional capital for the company. It is crucial for determining the optimal capital structure and making decisions regarding new investment projects.

Note: The table above includes the primary components of cost of capital. Depending on the specific circumstances and complexity of the company’s capital structure, there may be additional factors to consider.

Classification of cost of capital

The classification of cost of capital is important because it helps companies and investors understand the different components of the cost of capital and their implications.

1. Explicit and Implicit Costs of Capital:

The cost of capital can be either clear or implied. The explicit cost of capital of any source is the discount rate that matches the present value of the cash streams that are incremental to the taking of the financial chance with the present value of its additional cash losses. It is the internal rate of return for cash sources and outflows.

The general formula for the explicit cost of capital of any source of finance would be as below.

components-of-cost-of-capital

The discount rate, which solves the above equation, is 10%. So K=10%.

The hidden cost of capital is also known as the potential cost of capital. It is the rate of return linked to the best investment chance for the company and its shareholders that will be foregone if the idea presently under review by The company is selected. In simple words, the potential cost of cash may be defined as the rate of return that a company or a person can make on the next best possible use of cash. For example, Mr. X has the choice of spending his Rs. 1,000 either in shares or 12% bank savings. If he spends Rs. 1,000 on shares, the potential cost of capital is 12%.


2. Historical and Future Cost of Capital:The historical cost of capital is the cost of capital for the sources of credit already raised by a company. Whereas the future cost of capital is the cost of capital of sources of cash that will be raised in the future. The future cost of cash is more useful for decision-making.

3. Specific and Combined Cost of Capital:The cost of cash from a specific source like debt and stock is called the specific cost of capital. Example: The cost of debt is 10%. The total cost of capital is the cost of all kinds of cash. Composite, or blended, cost of capital used for business decisions.

4. Average and Marginal Cost of Capital: The average cost of capital is the weighted average cost of each component of capital hired by the firm. The weights are the contributions of each source to the total capital utilized by a firm. The marginal cost of capital is the cost of capital for extra cash. If the funds are raised from several sources together, the marginal cost of capital is the weighted average cost of capital of the new sources. This type of classification of cost of capital plays a vital role in a successful business.

Importance of cost of capital

The cost of cash is an extremely important idea in financial decision-making. The measurement of the cost of capital is significant for a successful business. The importance of cost of capital is significant for the following reasons:

1. Capital planning decisions: the cost of capital is a basic factor. Needed in investment choices. Under the NPV method, a project is accepted if It has a positive NPV when cash flows are reduced at the cost of capital. Under the IRR method, a project is accepted if it has a profit greater than the cost of cash. Even in the case of Net Present Value and performance index, The cost of capital method is used to lower the cash flows.

2. Designing debt policy: While designing debt policy and finding the debt equity amounts, the business aims to minimize the total cost of capital. The costs of cash from different sources are not the same. Therefore, the firm should always aim to grow the source of cheap finance in an effort to lower the general cost of capital.

3. Performance appraisal: The cost of capital is used as a measure to measure the success of the manager in raising finance. The actual cost of Capital is compared with the normal cost of capital to assess the performance of the management.

4. Dividend decision: The cost of cash is also very useful when making a reward decision. Whether the earnings of the company should be kept or distributed also depends on the cost of cash.

5. Leasing, hire-purchase, working capital management, etc.: The cost of capital is also used in cases of hiring, H.P., and working capital management decisions.

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