BLOG 2 # COST OF CAPITAL - SIGNIFICANCE, EXPLICIT VS IMPLICIT COST

COST OF CAPITAL

Part 1: MEANING

In simple terms, cost of capital is the cost incurred by an entity or a business or a person to source the required capital in a business.

For example, if a person borrows money from a bank for using the same as capital in his business, he has to pay interest to the bank. This is cost incurred by the borrower for using funds which is known as cost of capital.

In other words cost of capital is the expectation of return on their investment by the providers of finance.

For example, if a person invests some money in the equity shares of a company, it is quite natural that he expects some return on his investment. This is income to him. The company strives to meet the expectation of the shareholder. This is the cost of capital to the company.

So, the money paid by the company in addition to what is borrowed or procured otherwise is cost of capital.

Part 2: IMPORTANCE OF COST OF CAPITAL

Why the company needs to know its Cost of Capital?

What is the necessity of calculation of Cost of Capital?

What role the Cost of Capital plays in decision making?

Let’s understand the above now!!!

1)    Remember the basic rule of acceptance or rejection of a project. It is a good business if the Return on Investment (ROI) is higher than its Cost of Capital (CoC). Unless the company calculates its Cost of Capital, how can they compare it with the Return on Investment for Decision Making?

2)    Remember the concept of Leverage. A company is said to have a favourable financial leverage if its Return on Capital Employed is higher than the interest rate paid on borrowed funds. This is why the company has to calculate the cost of capital.

3)    And here comes the most important usage of cost of capital.

Remember investment decision making or Capital Budgeting. To check whether a machine / a capital asset / business / project is to be accepted or no depends on the Net Present Value of the same. How the NPV of an asset is calculated.

a)      Estimate the expected future cash inflows of the asset

b)      Since they are in future value terms, convert them in to their present values.

c)       For converting the same, use a discount rate.

d)      Then calculate NPV. (If NPV is positive accept the project, else reject it)

e)      In step “c” we used the discount rate right. That discount rate is nothing but the cost of capital of the project / asset.

Cost of Capital plays a significant role in decision making. In finance we have 3 major decisions.

a)      Financing Decisions

b)      Investment Decisions

c)       Dividend Decisions.

In all the above areas cost of capital role is vital.

Part 3: Explicit Vs Implicit cost of capital

The cost of capital can either be explicit cost or implicit cost.

Explicit cost results in cash outflow. For example, interest paid on debentures, dividend paid to shareholders.

On the other hand, implicit cost of capital will not result in cash outflow. It is an opportunity loss or opportunity cost. For example, for carrying on business activities if a person withdraws money from Fixed Deposit account which earns 8% interest, he loses his income on the FD since he has withdrawn it. The income foregone in one alternative due to choosing another alternative is called Opportunity Cost. This is implicit cost.

Another better way of understanding the concept of implicit cost of capital is that, in case of Reserves there is no explicit cost, since dividends or interest need not be paid on reserves. But that doesn’t mean there is no cost of capital on reserves. There is an opportunity cost on reserves. This is because; if the profits earned by the company are distributed to shareholders as dividends they can invest that money somewhere else to earn some income on that investment. However, since the company is retaining some portion of earnings, it becomes reserves. Therefore, reserves have the opportunity cost of the income foregone by the shareholders. This is an implicit cost.