The cost of capital means that rate of return, which a company has to earn on investments to maintain its value intact. In other words, the cost of capital is the minimum rate of return, which maintains the per-share market price (at the current level).
The cost of capital may be defined as the rate that must be earned on the net proceeds to provide the burden of cost elements at the time they are due.
The cost of capital is that the minimum rate of return which a company should essentially earn through its investments so that payment of the cost of various economic sources procured by the company can be made easily.
Features of Cost of Capital
Based on aforesaid definition following characteristics of the cost of capital may be observed regarding the cost of capital:
- This is no cost, rather it is the minimum profit-earning rate to be received on various projects.
- It expresses the minimum rate of return.
- The cost of capital is a reward for business and financial risks.
- The cost of capital of any institution has three parts: 1. Return at zero risk level, 2. The premium for business risks, and 3. The premium for financial risks.
Importance of Cost of Capital
The cost of capital has particular importance in the capital structure.
Hence, no important decision relating to the capital structure may be taken without keeping it in view.
Its importance may be understood as follows:
- The concept of cost of capital helps the management to determine optimum capital structure along with ideal debt-equity ratio, based on minimum cost.
- These criteria for the approval of investment projects.
- It is helpful in the assessment of the financial efficiency of higher management.
- The decision regarding the use of a particular source at any particular time may be done by the comparative study of the costs of various sources to meet capital requirements.
- The cost of capital helps keep the control of ownership.
- Decisions regarding the quantity of working capital, selection of its sources and dividend policy may be taken, on its basis.
- The investors get information regarding expected income and implicit risks of the firm, through the cost of capital.
If the capital cost of any institution is high, it will imply that the present rate of income is low, business involves risks and the capital structure is imbalanced.
In such conditions, investors expect higher rates of Return.
Income, Risk, and Control
While determining the capital structure of any business institution, particular attention is paid on three points namely income, risk, and control.
The real problem of industrial finance management is the problem of coordination of three variables, income, risks, and control.
Hear, the important question is, whether income, risk, and control are interrelated. In response, it may be said that these three are closely related, the reason being that the general rule is, more risk, more gain, and ultimately more controlling powers.
In the company, equity shareholders take the maximum risk.
Hence, they have the right to operate the business, to cast vote, to select the directors and to determine the policy of the enterprise.
On the contrary, the rate of interest of the creditors also remains low and they also have no share in operation and management of the enterprise, because their original money and interest both remain secured.
The capital paid by the shareholders acts as the strongest defensive line for them.
Thus, now you know the features and importance cost of capital.