The Importance of Cost of Capital in Financial Management
This article discuss the concept of cost of capital and how to determine the weighted average cost of capital. It also discuss the issues realting to the models used to estimate the cost of equity in particular and the other cost of capital components such as debt and preference shares. It explores these concepts by using practical examples. It is useful to students learning finance the first time in university.
The Importance of cost of capital in Financial Management
The concept of cost of capital is crucial in financial management. Like any other source of finance has a cost and cannot, therefore, be used in the most effective manner unless that cost can be accurately determined and taken into account.
There are many misconceptions about the cost of capital which must be carefully avoided. If, for example, a business has large amount of cash which it proposes to invest in a project, it might appear that the finance in this case is free of charge because no payment has to be made for its use to outside suppliers. It should be remembered, however, it does have an opportunity cost, ie the cost of foregoing which the cash might have earned in some other use even if this only be the placing of it on deposit at a bank.
Another cause of difficulty is the notion of the weighted average cost of capital. The fact that debenture is issued in order to raise the cash for a project does not mean that the cost of that debenture is the cost of capital for that project. Finance is not normally project-specific and must be regarded as being drawn from a common pool containing all sources in a desired mix. Many questions will require the calculation of weighted average cost of capital.
In this paper, I will try to illustrate the main variations on the theme of the cost of capital which are likely to be encountered and the main difficulties associated with these. They are:
The cost of individual components of capital, that is equity and debt.
The calculation of the weighted average cost of capital
The concept of marginal cost of capital
The implications of expected growth to the cost of equity.
It should be notices that other topics can creep unto question on the cost of capital. Examples are the calculation of the market prices of securities, ratios and investment appraisal.
Cost of individual components of cost of capital
To illustrate the implications of calculating individual components of cost of capital, I will use an example to explore the issues related to evaluate how debt affects the cost of capital and the concept of marginal cost of capital, to decide what form of finance best suite for a project.
Company X has the following balance sheet as follows: