Question

Define the term cost of capital. Why is it important for a firm to know its cost of capital? In computing the cost of capital, which sources of capital should be included? How do income taxes affect the cost of capital? Explain the procedure used for computing the cost of equity and debt.

Answer 1

Cost of capital is the opportunity cost of funds. It is the rate of return that the business would have owned by investing the funds with equal risk. It can be perceived as the cost of funds used for financing the business and depends upon the mode of Financing used. A company needs to know its cost of capital to assess whether capital budgeting projects such as building a new factory are worth while. Businesses use cost of capital to determine the trade-off between the cost and payoffs from an investment.

In computing the cost of capital the company needs to consider the cost of equity and also the cost of debt. Generally a weighted average of all the capital sources is used to compute the cost of capital. This cost represents a hurdle rate that a business needs to overcome before it can generate value for the business. Taxes should be taken into consideration for determining the actual cost of capital. This is because when a business borrows money it pays interest on it which is tax deductible and hence the cost of capital for borrowed funds decreases.

Cost of equity is computed using the CAPM model as

k= Risk free rate + Beta * Risk premium

cost of debt is computed as the interest cost - tax saving on interest paid