Cost of Capital
The cost of capital is a term employed in the field of financial investment to refer to the cost of a company's funds i.e both debt and equity or from an investor's point of view "the shareholder's needs return on a portfolio of all the company's existing securities". It is employed to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus defining a bench mark that a new project has to encounter.
For an investment to be worthwhile, the anticipated return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be anticipated to earn in an option investment of equivalent risk. If a project is of similar risk to a company's average business process it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must thus compute both the cost of debt and the cost of equity to determine a company's cost of capital. On the other hand, a rate of return larger than the cost of capital is In general needs.
Factors Affecting the Cost of Capital
These are the elements affecting cost of capital that the company has control over:
1. Capital structure policy
2. Dividend policy
3. Investment policy
1. Capital Structure Policy
A business firm has control over its capital structure, aiming an optimal capital structure. As to a greater extent debt is issued, the cost of debt raises, and as more equity is issued, the cost of equity raises.
2. Dividend Policy
Given that the business firm has control over its payout ratio, the break point of the MCC schedule can be changed. For instance, as the payout ratio of the company increases the break point between lower cost internally brought forth equity and newly issued equity is lowered.
3. Investment Policy
It is presumed that, when attaining investment decisions, the company is attaining investments with similar degrees of risk. If a company alters its investment policy relative to its risk, both the cost of debt and cost of equity change.
Uncontrollable Factors Impacting the Cost of Capital: These are the factors impacting cost of capital that the company has no control over:
1. Degree of interest rates
2. Tax rates
1. Degree of Interest Rates
The degree of interest rates will impact the cost of debt and, potentially, the cost of equity. For instance, when interest rates raise the cost of debt raises, which in turn raises the cost of capital.
2. Tax Rates
Tax rates impact the after-tax cost of debt. As tax rates raise, the cost of debt decreases, which in turns decreasing the cost of capital.
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