Introduction of cost of Capital
Cost of capital of a firm is the minimum rate of return expected by its investor. The capital used by a firm in form of equity , preference ,debt and retained earning
According to M.j Gordon Cost of capital is rate of return (ROI) that a company must earn on investment to maintain the value of company.
Importance of the cost of capital
Cost of capital is very important in making all the financial decision of the firm
- . Helpful in designing the capital structure- the concept of cost of capital plays a important role in designing the capital structure capitalstructure is the purpose net relationship between among different factors of long term borrowings such as dept equity retained earning
- Helpful in taking capital budgeting decision. capital budgeting is the process of decision making regarding the investment of fund in terms of project of company
Two methods are
. Net present value
Interest rate of return
- Helpful in evaluation of financial efficiency of top level management-cost of capital can be used to evaluate the financial efficiency of top management such as in such as revaluation will in all comparison project overall cost of capital with the actual cost of capital in cut by management
- Helpful in comparative analysis of various source of finance-cost of capital to be raised from various source by changing time to time calculation of cost of capital is helpful in analysis of usefulness of various source of finance
- Helpful in taking financial decision-the cost of capital concept is useful in financial financial decision making such I didn't put the policy right issue working capital
Factor affecting the cost of capital
There are various factors which affect the cost of capital
- Risk free interest rate-risk free interest rate is determined by the demand and supply of such security in financial market higher the demand of such security and lawyer of supply higher would be the risk-free interest rate Eg- security issue by government of India
- Business risk-it refers to the variability in operating profit earn before interest and text due to change in sale if they form a SAP project that is considered only more risky than the average
Hint more risk assessment more returned by the investor
- Financial risk -company can be a take amount from dept aur equity share holder
Dept in cheapest source of fund and this it is very risky
Equity the highest source of fund and this is not risky
Interest is tax deductible item but didn't is not tax deductible undetectable item
Nature of business-Long term funds are more costly than short term phone since the fixed assets are financed through long term funds the farm which require heavy investment in fixed assets bare high cost of fund
Attitude of management -If the management of firm is enterprising and aggressive it will require a lower amount of liquid fund thereby reduce the cost of capital
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