COST OF CAPITAL

Understanding & Evaluating Cost of Capital

Understanding & Evaluating Cost of Capital

Introduction

In an economy, commercial entities play a very critical role in the development of society and social welfare. All organizations are working day in and day out in order to achieve their specific goals. The nature of all businesses is different from one another, but one thing is remain common in all of them, and that is requirement of finance to run and operate business related activities. The required money to manage an organization is called capital, and the cost incurred to acquire such capital is termed as cost of capital. In this review, we discuss analysis of capital, capital structure and cost of capital. Furthermore, paper also contains importance, usage and limits related to cost of capital from an organizations perspective. To elaborate this concept from practical aspect we are selecting an entity named PEPSICO.

Capital and Capital Structure

Before starting our discussion on cost of capital, it is essential to know what capital basically is, “Capital simply refers to short and long term funds which an entity used to finance its asset and to run its business”. Capital can be acquired in many forms such as through the issuance of bonds and equities and also via borrowing a loan amount from a financial institution (Leary & Roberts, 2005, 2575). All kinds of capital have a cost associated with it. Detail of different types of borrowing is given below.

Sound financing decision of a finance manager generally leads an entity to the most favourable capital structure. Capital structure means the ratio in which several components of capital are used. Over the last fifty years, decisions regarding capital structure have been accepted as the most critical decision that an entity has to take. The reason behind the importance of the decisions associated with capital structure is its impact on profits, cost of capital, and liquidity position of the firm, dividend payout ratio, retention ratio and earnings per share. These all factors are very important in determining the value of firm; therefore, one can say that capital structure to some extent determines the value of the firm (Harris & Raviv, 1991, pp 297).

Do changes in capital structure have an effect on an entities value and performance? This question appeared in the minds of financial managers and academia when Modigliani and Miller (M-M) firstly proposed a rational and formal model on the valuation of capital structure in their path breaking article. Relevancy of the model is accepted throughout in the perfect market while it is being criticized from many scholars in the case of imperfect market.

David Durand (1963) argued and criticizes the MM model based on the fact that its implementation in the real world is not possible and the assumptions made in the model are unrealistic. Nobel Laureate Stieglitz (1969) under relaxed assumption proved and supported the validity of MM model (Stiglitz, 1969, pp.784). Smith (1972), Litzenberger (1973) and Scott (1977) under the assumption of costless bankruptcy and risk ...