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📚 Learn/ Paper 6 — Financial Management & Strategic Management/ Cost of Capital
Microlesson · 5-min read

Meaning, Significance, Determination, Factors, BV vs MV Weights

## Cost of Capital

### Introduction

  • Core Objective of Financial Management: Maximize shareholders' wealth
  • Wealth = Performance / Expectations
  • Finance Manager's Role: Procure funds efficiently + select a capital structure that minimizes investor expectations → maximizes wealth
  • Must calculate cost from each source: debt, preference shares, equity, retained earnings → derive overall WACC

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### Meaning of Cost of Capital

Cost of capital = rate of return expected by capital providers as compensation for the use of their funds.

  • Represents interest/dividend paid over and above the principal
  • Expressed as a percentage per annum
  • Also called:
  • Cut-off rate (projects earning below this are rejected)
  • Hurdle rate (minimum return a project must clear)
  • Minimum rate of return

Acts as benchmark for:

  • Debt policy framing
  • Capital budgeting decisions

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### Significance of Cost of Capital

ApplicationHow Cost of Capital Is Used
Evaluation of Investment OptionsDiscount future project cash flows to PV; different projects may use different rates
Financing DecisionCompare costs of different sources; choose lower-cost option (considering risk and control)
Designing Optimum Credit PolicyCompare cost of extending credit to customers vs. profit earned; PV analysis of costs and benefits

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### Determination of Cost of Capital

1. Stakeholder Expectations (not what company plans to pay — what providers expect):

  • Capital providers: shareholders, lenders, debenture holders
  • Intermediaries: brokers, underwriters, bankers
  • Government: tax implications

2. Tax Shield on Debt:

  • Interest on debt is tax-deductible (Income Tax Act)
  • Reduces effective cost of debt for the company
  • After-tax cost of debt = Pre-tax rate × (1 – Tax rate)

3. Cost Expressed as % per annum

4. Cash Flow Identification:

  • Inflow: Proceeds received at the beginning
  • Outflows: Interest, dividends, redemption at maturity
  • Tax adjustments: Tax benefit on interest; tax on dividends as applicable

5. IRR Method (Trial and Error):

  • Find rate where PV of inflows = PV of outflows
  • Here, the initial receipt is the inflow; subsequent payments are outflows → IRR = cost

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### Factors Affecting Cost of Capital

FactorEffect on Cost of Capital
Supply and DemandHigh capital demand (boom) → higher cost; excess supply → lower cost
Investor PreferencesCultural savings habits affect capital pool; higher return potential attracts more savings
Risk and ReturnHigher project risk → higher required return → higher cost
InflationInvestors demand returns above inflation; higher inflation → higher expected return → higher cost
Exchange RatesForex risk for multinationals adds uncertainty → increases capital cost

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### Book Value vs Market Value Weights (for WACC)

PointBook Value (BV)Market Value (MV)
DefinitionHistorical cost from financial statementsCurrent market prices of equity and debt
Reflects Current ConditionsMay not reflect current economic realityAccurately reflects market and investor expectations
StabilityMore stable, less volatileCan be volatile with market fluctuations
Relevance for InvestorsLess relevantMore relevant — reflects investor sentiment
Ease of CalculationEasier — from balance sheet directlyMore complex — requires market data

Theoretically preferred: Market Value weights (reflect current investor expectations)

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### Why Debt is Cheaper than Equity

1. Fixed contractual cost: Interest is pre-set, generally lower than equity return expectations

2. Tax shield: Interest is tax-deductible, reducing effective cost

3. Equity risk premium: Equity holders bear residual risk and demand higher returns as compensation

Worked example

### Example 1

A company borrows at 10% p.a., and the corporate tax rate is 30%. What is the after-tax cost of debt? → After-tax cost = 10% × (1 – 0.30) = 7%. The tax shield reduces the effective cost by 3%.

### Example 2

Two projects: Project A has expected return 12%; Project B has expected return 9%. WACC = 10%. Which projects should be accepted? → Accept Project A (12% > 10% hurdle rate); Reject Project B (9% < 10% — would destroy value).

### Example 3

A company uses book value weights for WACC. Equity is ₹100 at book but trades at ₹250 in the market. What is the problem? → BV weights understate equity's true market proportion, likely underestimating WACC — leading to over-acceptance of projects that actually destroy market value.

### Example 4

Why is cost of capital called a 'hurdle rate'? → Because only projects earning a return above this rate should be accepted; they must 'clear the hurdle' to create value for shareholders.

⚠️ Common exam mistakes

  • Treating cost of capital as what the company decides or plans to pay — it is what providers EXPECT to receive.
  • Forgetting the tax shield on debt — always multiply pre-tax cost by (1 – tax rate) to get after-tax cost of debt.
  • Assuming cut-off rate and hurdle rate are different things — they are two names for the same concept: minimum acceptable return.
  • Using book value weights when market value weights are theoretically more appropriate for computing WACC.
  • Thinking higher inflation is irrelevant to cost of capital — investors demand returns that outpace inflation, so higher inflation directly raises the cost of capital.
Reference:
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