MGT201 Module 10 Topics 186-199 Preparation

Topic 186: Cost of Capital

We are starting a new discussion which is related to the Cost of Capital.

Capital is a term which is used commonly in accounting and finance, initially when we talk about the basic financial accounting, the term Capital refers to the investment of the owners of the business.

But this term Capital is used in deference ways in accounting and finance. Here the Capital is the amount which is invested by all the people who want to earn some return from the business.

Types of Capital:

Equity: In simple words, Equity is the investment of owners of a business and when we are talking about a corporation, a limited company or public limited company, here we have got Equity capital issued in the form of shares of the company.

So, when we issue the shares as a company to the individuals then they become equity holders and the funds that they provide is called the equity capital.

Debt: Similarly, a business organization or a corporation also generate funds or financing by issuing debt or by taking loans. Debt can be issued to the general public in the form of bonds or debentures or it can be in the form of loan taken from a bank or a financial institution.

So, these two Equity and Debt are collectively called the external types of capital that is capital which is generated externally.

It is very important to remember that when we use the term internal or external, it is with reference to that business organization meaning that those people who are shareholders who provide equity and those people who provide loan or debt, all these people are outside the business and therefore whatever funds they provide we

call it External Capital.

So, in external capital we have Debt and Equity. We also have some internal sources of capital that we will discuss later but that is the profit generated by company itself.

Cost of Capital:

Why would anybody provide funds or finances to any business organization?

It is because that they require some return from that business and that return is to be seen from two different angles.

From the businesses or corporations perspective, this is a Cost and this is what the business has to pay to the equity holders that we call shareholders and to the bond holders that we call debt or loan. And company has to pay return to these both shareholders and bond holders which is a cost or an expense for that company.

But if we see this from these investors or shareholders point of view then it is return for them. When we see that on one side, it is a cost for that company and it is return for shareholders or bond holders.

Required Rate of Return:

The shareholders or bond holders determine their required rate of return which is called Cost of Capital for that company.

Market Rate of Return: It may be the required rate of return that any investor is getting on average return in the market. And this is the easiest and common way to calculate the required rate of return and we said earlier that this becomes the cost of capital for the company.

Opportunity cost of capital: If as an individual, we have such an opportunity to invest anywhere which can earn for us more than the market rate of return then our require rate of return will become increase than market rate of return. It is because of the Opportunity Cost.

Other Benchmarks: There are other ways of calculating required rate of return. For example, we may consider the past returns earned by the company or the business meaning that in the previous or past few years how much return or profit they have been given to the shareholders or bond holders and that may be criteria.

Similarly, if we see that in this industry or sector then what rate of return has given on average which may also be made a Benchmark. So, we can say that required rate of return either will be market rate or may be an opportunity cost behind it or any industry’s average or company’s past record.

So, this required rate of return is then treated as the cost of capital for the company that is the company has to generate this much amount of return for their fund