Cost of Capital and its Relevance in Financial Decision Making

Question No.3. (a) Define cost of capital. Explain its relevance in financial decision making of a firm.

Solution: The term cost of capital refers to the minimum rate of return which a firm must earn on its investments so that the market value of the company's equity shares does not fall.

Meaning of Cost of Capital

Hampton, John defines the term as "the rate of return the firm requires from investment in order to increase the value of the firm in the market place". The following are the basic characteristics of cost of capital:

i) Itl is a rate of return, It is not a cost as such. ii) This return, however, is calculated on the basis of actual cost of different components of capital. iii) A firm's cost of capital represents minimum rate of return that will result in atleast maintaining (If not increasing) the value of its equity shares. iv) It is related to long term capital funds. v) It consists of three components: a) Return at Zero Risk Level. (R0) b) Premium for Business Risk (b) c) Premium for Financial Risk (f) vi) The cost of capital may be put in the form of the following equation : K = R0 + b + f Where K = Cost of Capital R0 = Return at Zero Risk Level b = Premium for Business Risk f = Premium for Financial Risk

A firm's cost of capital has mainly three risks:

Click Here to Read full ANSWER for FREE