Measurement of cost of capital

1. Introduction

The cost of capital, as a decision criterion, is an overall or combined cost, representing the composite cost of various sources of financing. Measuring it involves two key steps:

1. Specific Costs: Calculating the cost of each individual source of finance (e.g., debt, equity, preference shares, retained earnings).
2. Overall Cost: Combining the specific costs into a composite or weighted average cost of capital.

2. Specific Costs of Capital

The first step in measuring the cost of capital is to calculate the specific cost of each source of funds. This is crucial for determining the relative cost-effectiveness of different financing options. For capital budgeting decisions, the focus is primarily on long-term sources of funds, as they primarily finance fixed assets.

The main specific costs that need to be calculated are for:

1. Long-Term Debt: This includes debentures and other long-term borrowing.
2. Preference Shares: These represent a hybrid form of financing with characteristics of both debt and equity.
3. Equity Capital: This refers to funds raised by issuing common stock.
4. Retained Earnings: This is the portion of the company's profits that is not distributed as dividends but is reinvested in the company.

3. Importance of Specific Costs

Calculating the specific cost of each source of financing is important for two reasons:

1. Component of Overall Cost: These specific costs serve as the building blocks for calculating the overall cost of capital.
2. Relative Cost Comparison: Understanding the specific costs of different sources allows firms to compare the relative costs of each source and choose the most cost-effective financing options.

4. Focus on Long-Term Funds

• Capital Budgeting Decisions: In capital budgeting, the primary focus is on long-term sources of funds because they are the major source for financing long-term assets.
• Short-Term Funds: While short term funds are critical for operations, they are not used to finance long term investment projects.
• Specific Calculations: It is important to calculate the cost of each type of long-term funding option such as debt, preference shares, equity, etc.

5. Steps in the Process

The two-step process for measuring the cost of capital involves:

1. Compute Specific Costs:
   • Determine the explicit or implicit cost of each source of funds, which represent the various components of capital.
2. Calculate Overall Cost:
   • Combine the specific costs into a composite or weighted average cost of capital. This involves taking into account the proportion of each component in the overall capital structure of the firm.

6. Conclusion

Calculating the cost of capital is a two-step process that begins by understanding the individual cost of raising funds from different sources, which allows an understanding of the relative cost of different financing options. The specific costs can be combined to form the overall cost of capital that is a key input into capital budgeting decisions.