What is the cost of capital? It is the required rate of return a business must earn on its investments (capital budgeting projects) to maintain the market value of the firm’s shares and to attract funds.
It is a measure used to determine whether or not certain project will decrease or increase the firm’s value in the market place and, consequently, whether or not it should be recommended.
If NPV is more than zero and IRR is greater than the cost of total capital, then a proposed project will increase the market value of the firm and it should be recommended.
If, however, NPV is less than zero and IRR is lower than the cost of all capital, then a proposed project will decrease the market value of the firm and it should not be recommended.
Therefore, if a firm’s risk is assumed to be constant, than any projects with the rate of return higher than the cost of all capital will increase the market value of the firm and any projects with the rate of return below the cost of capital of the enterprise will decrease market value of the firm.
In the discussions that follow we assume that the cost of all capital is measured on the after-tax basis and that a firm’s acceptance of the project does not affect FINANCIAL and BUSINESS RISKS.
FINANCIAL RISK is the chance that a firm will not be able to meet its financial obligations, which can result in bankruptcy. Financial risk is directly affected by a firm’s capital structure (its mix of debt and equity financing). The more debt the firm uses in its capital structure mix, the higher the financial risk.
BUSINESS RISK is the chance that a firm will not be able to cover its operating costs. There are three factors that affect business risk. These are increases in operating leverage, revenue instability and cost instability.
1 – Increase in operating leverage refers to higher use of fixed operating costs.
2 – Increase in revenue instability (or decrease in revenue stability) refers to deterioration of stability of sales of the firm.
3 – Lastly, increase in cost instability (decrease in cost stability) refers to how predictable are costs of the firm, such as labour and raw materials’ costs.
Business risk must be taken as is and the capital structure mix the firm chooses does not influence it.
Firms usually try to maintain an optimal mix of financing (debt and equity) referred to as the target capital structure. Firms have various sources of capital and the cost of capital may be different each for each source of financing. When determining the cost of capital, it is helpful to determine an average cost of all sources of capital, which is called the weighted average cost of capital (WACC).