MEANING AND ASSUMPTIONS OF COST OF CAPITAL - Accounts and Finance for Managers

  • It is the Minimum rate of return which the firm should or must earn only in order to maintain the value of the shareholders.
    Classification of the cost of capital: The cost of capital can be classified into two categories viz specific cost of capital and weighted cost of capital.

Assumptions

  • It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothing but determinant of influence is Fixed Cost of Operations. The cost of capital is subject to the volume of fixed cost of operations of the firm.
  • On the basis of Financial Risk i.e., with reference to Financial Commitments of the firm which in other words as financial Risk. The Interest on debenture, Preference Dividend on Preference share capital should be paid without fail irrespective of the firms' earnings according to the terms and conditions of the issue. The greater the fixed financial commitments require the firm to earn more and more in order to retain the interest of the shareholders of the firm.
  • Operational Terms - capital structure remain unchanged; unless the cost of capital of the firm would change.
  • For new projects, funds are raised only at same proportion.

How the cost of capital is to be denominated in terms ?
Whether the cost of capital is to be denominated in terms of after tax or before tax. Why it has to be expressed in terms of after tax ? Why not the before tax cost should be taken into consideration?

For appraising the projects, the return of the investments are considered for comparison which are nothing but the resultant of earnings of the firm immediately after the payment of tax. To study the quality of the projects, both factors must be at common at parlance for comparison.

While computing the cost of capital, the cost of specific sources should be to the tune of after tax only in order to have an effective comparison.
Then, the cost of capital is further bifurcated into two categories viz Explicit cost of capital and Implicit cost of capital.
Explicit cost of capital: The discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.

It is further explained that rate of return of cash flow of the financing opportunity. It normally takes place only at the moment of raising of financial resources.

  • Implicit cost of capital: It is nothing but the Opportunity cost of capital of the firm to earn through investing elsewhere by the shareholders themselves or by the company itself. It is rate of return which is associated with the best investment opportunity for the firm and its shareholders that would have to be forgone, which were presently considered by the firm.
  • Specific cost of specific source of capital: Each source of capital has its own cost at the moment of raising which form part of the computation of total cost of capital of the firm.

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