Importance and measurement of cost of capital

Importance of cost of capital

The term cost of capital is important for a company basically for the following purposes:
1.    The concept of cost of capital is used as a tool for screening the investment proposals. E.g. In case of the net present value method, the cost of capital is used as the discounting rate for discounting the future inflow of funds. Any project resulting into positive bet present value only will be accepted. All other projects will be rejected. Similarly, in case of Internal Rate of Return Method (IRR), the resultant IRR is compared with the cost of capital. It is expected, that if a project is to be accepted, IRR resulting from the same should be more than cost of capital. If a project generates IRR which is less than cost of capital, the project will be rejected.

2.    The cost of capital is used as the capitalisation rate to decide the amount of capitalisation in case of a new concern.

3.    The concept of cost of capital provides useful guidelines for determining the optional capital structure. Optional capital structure is the one where overall cost of capital is minimum and the overall valuation of the firm is maximum.

Measurement of cost of capital

a.    Cost of debt: the debts may be either short term debts or long term debts. Very naturally, the cost of capital in the form of debt is the interest which the company has to pay. But this is not the real cost attached with debt capital. The real cost is something less than the rate of interest which the company has to pay. This is due to the fact that the interest on debt is a tax deductible expenditure. If the amount of interest is considered as a part of expenses, the tax liability of the company reduces proportionately. As such, while computing the cost of debt, adjustments are required to made for its tax impact. E.G. Suppose a company issues the debentures having the face value of $ 100  and bearing the rate of interest of 10% p.a. If the rate applicable to the company is 50% of 10%, hence the cost of debentures is only 5%. Further the interest payable on the debentures has to be viewed from the angle of the amount actually received on their issue. E.g. A company issues 10,000, thus the company will have to pay the annual interest of $  8000 on the net amount received to the extent of only $ 90,000. Cost of debentures in this case works out to around 8.89% and assuming that the tax rate applicable is 50%, the tax benefit makes the cost of debentures equal to 4.45%. However, the debt capital has a hidden cost also. If the debt content in the capital structure of a company exceeds the optimum level, the investors start considering company as too risky and their expectations from equity shares increase. This is the hidden cost of debt.

b.    Cost of preference shares: the cost of capital preference shares is the dividend rte payable on them. As in case of debentures, the cost of capital is adjusted for the amount excess or less received on the issue of preference shares.


E.g. Suppose a company issues 1000 preference shares of $ 100 each at the value of $ 105 each. Rate of dividend is 10% and the expenses involved with the issue of preference shares amount to $ 10,000. Thus the net amount received works out to $ 95,000 whereas the amount of the dividend is $ 100000. Here the cost of capital works out to
$ 10000 × 100 = 10.52%
$ 95,000
As the amount of dividend payable on preference shares is not a tax deductible expenditure, there is no question of further adjustment for the tax benefit.