Concept of Cost of Capital - Importance and Calculation

Concept of Cost of Capital

Capital refers to the funds invested in a business. The capital can come from different sources such as equity shares, preference shares, and debt. All capital has a cost. However, it varies from one sources of capital to another, from one company to another and from one period of time to another.

Cost of capital may be defined as the company's cost of collecting funds. This is equal to the average rate of return that an investor in a company will expect for providing funds. It is the minimum rate of return that the project must earn to keep the value of the company intact. The minimum rate of return is equal to cost of capital.

The cost of capital in always expressed in terms of percentage. Proper allowance is made for tax purposes. This is done to get a correct picture of the cost of capital.

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Importance of Cost of Capital

The concept of cost of capital is a major standard for comparison used in finance decisions. Acceptance or rejection of an investment project depends on the cost that the company has to pay for financing it. Good financial management calls for selection of such projects, which are expected to earn returns, which are higher than the cost of capital. It is therefore, important for the finance manager to calculate the cost of capital, which the company has to pay and compare it with the rate of return, which the project is expected to earn.

In capital expenditure decisions, finance managers go on accepting projects arranged in descending order of rate of return. He stops at the point where the cost of capital equals to the rate of return offered by the project. That is, the finance manager finds out the break-even point of the project. Accepting any project beyond the break-even point will cause financial loss for the company.

The cost of capital is a guideline for determining the optimum capital structure of a company.

Calculation of Cost of Capital

In order to calculate the overall cost of capital, a finance manager has to take the following steps:-

1. Determine the type of funds to be raised and their share in the capital structure.
2. Determine cost of each type of funds.
3. Calculate combined cost of capital of the company by giving weights to each type of funds in terms of proportion of funds raised to total funds.