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Debt and Capital Cost

The cost of capital is useful in making and evaluating investment decisions, designing a firm’s debt policy, and Appraising the financial performance of top management. The cost of capital is one of the most difficult and disputed topics in the finance theory.

The cost of capital is used as a financial standard for evaluating the investment and investment projects. In the NPV methods, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting its cash flows by the cost of capital. In this sense, the cost of capital is the discount rate used for evaluating the desirability of an investment project. In the IRR method, the investment project so accepted if it has internal rate of return greater than the cost of capital. Is this context, the cost of capital is the minimum required rate of return on an investment project. It is also known as the cutoff rate, or the hurdle rate.

Designing debt policy

The debt policy of a firm is significantly influenced by the cost consideration. As we shall learn on, debt helps to save taxes, as interest on debt is a tax-deductible expense. The interest tax shield reduces the overall cost of capital, thought it also increases the financial frisk of the firm. In designing the financing policy, that is the proportion of debt and equity in the capital structure, the firm aims at maiming the firm value by minimizing the overall cost of capital.

Performance appraisal

The cost of capital framework can be used to evaluate the financial performance of top management such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected oversell cost f capital, and the appraisal of the actual costs incurred by management in raising the required funds.

The cost of capital also pals a useful role in dividend decision and investment in current assets. The chapters dealing with this decision show their linkages with the cost of capital.

Debt Cost

A company may raise debt in a variety of ways. It may borrow funds from financial institutions or public either in the form of public deposits or debentures (bonds) for a specified period of time at a certain rate of merest. A debenture or bond may be issued at par or at a discount or premium as compared to its face value. The contractual rate of interest of the common rate forms the basis for calculating the cost of debt.