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BRILLIANT’S Cost of Capital 299

ception of the risk they are undertaking, on the {H$E JE BÝdoñQ>_|Q> go àmßV H$a aho [aQ>Z© Ho$ AmYma na
company's past performance or on the returns {S>{dS>oÝS> Ho$ ê$n _| [aQ>Z© Ho$ EH$ {_{Z__ aoQ> H$s Anojm
they are getting on shares of other companies
they have invested in. H$aZo bJVo h¢Ÿ&
A company's cost of capital is nothing but {H$gr H$ånZr H$s H¡${nQ>b H$s H$m°ñQ>, Cg H$ånZr
the weighted arithmetic average of the cost of Ûmam Cn`moJ {H$E JE \$m`ZoÝg Ho$ {d{^ÝZ gmog}g H$s
the various sources of finance that have been H$m°ñQ> H$m doQ>oS> A[aW_o{Q>H$ EdaoO hmoVm h¡Ÿ& CXmhaU Ho$
used by it. For example, a company has a total
capital base of ` 500 lacs in the ratio of 1:1 of {bE, `{X EH$ H$ånZr H$s Hw$b H¡${nQ>b ` 500 bmI h¡
debt-equity i.e, divided between debt and eq- VWm S>oãQ> Ed§ BpŠdQ>r H$m aoemo 1…1 h¡ Vmo Hw$b H¡${nQ>b,
uity; ` 250 lacs of debt and ` 250 lacs of equity. S>oãQ> Ed§ BpŠdQ>r _| ~am~a AWm©V² àË`oH$ ` 250 bmI
If the post-tax cost of debt and equity are 7% hmoJrŸ& `{X Q>¡Šg Ho$ níMmV S>oãQ> Ed§ BpŠdQ>r H$s H$m°ñQ>
and 18% respectively, the cost of capital to the
company will be equal to the weighted aver- H«$_e… 7% Ed§ 18% h¡ Vmo H$ånZr H$s H¡${nQ>b H$s
age cost i.e. H$m°ñQ>, doQ>oS> EdaoO H$m°ñQ> Ho$ ~am~a hmoJr, AWm©V²

250 250
× 7% + × 18% = 12.5%
500 500
Overall Cost of Capital of the Firm \$_© H$s Hw$b H¡${nQ>b H$s H$m°ñQ>
A company can be viewed as a collection EH$ H$ånZr _| EH$ gmW H$B© àmoOoŠQ> hmo gH$Vo h¢Ÿ&
of projects. As a result, the use of an overall Bg H$maU BÝdoñQ>_|Q> g§~§Yr {ZU©` Ho$ {b`o g^r H$s g§`wº$
cost of capital as the acceptance criterion H¡${nQ>b H$s H$m°ñQ> H$m Cn`moJ Hw$N> {d{eï> XemAm| _|
(hurdle rate) for investment decisions is ap-
propriate only under certain circumstances. Cn`wŠV hmo gH$Vm h¡Ÿ& Eogm V~ hmo gH$Vm h¡ O~{H$
These circumstances are that the current H$ånZr Ho$ dV©_mZ _| g§Mm{bV àmoOoŠQ> g_mZ Omo{I_ dmbo
projects of the firm are of similar risk and that hm| VWm BÝdoñQ>_|Q> g§~§Yr {dMmamYrZ àñVmd ^r g_mZ
investment proposals under consideration are àH¥${V Ho$ hm|Ÿ& \$_© H$s gånyU© H¡${nQ>b H$s H$m°ñQ> Ho$
of the same character. The advantage of using
Cn`moJ H$m bm^ BgH$s gabVm h¡Ÿ& EH$ ~ma BgH$s JUZm
firm's overall required rate of return is its sim-
plicity. Once it is calculated, projects can be H$a boZo Ho$ níMmV² EH$ hr aoQ> H$s ghm`Vm go àmoOoŠQ> H$m
evaluated using a single rate that does not _yë`m§H$Z {H$`m Om gH$Vm h¡ VWm `h aoQ> V~ VH$ n[ad{V©V
change unless there is change in business and Zht hmoVm O~ VH$ {H$ {~OZog Ed§ \$m`ZopÝe`b _mH}$Q> H$s
financial market conditions. If we use a single pñW{V`m| _| n[adV©Z Zht hmoVmŸ& EH$ hr aoQ> H$m Cn`moJ
hurdle rate, it can avoid the problem of com-
puting individual required rates of return for H$aZo go àË`oH$ BÝdoñQ>_|Q> ànmoOb Ho$ {bE AbJ-AbJ
each investment proposal. aoQ> H$s JUZm H$aZo H$s Amdí`H$Vm Zht hmoVr h¢Ÿ&
The Cost of Capital- What is it really? H¡${nQ>b H$s H$m°ñQ>- dmñVd _| `h Š`m h¡?

It is the firm's required rate of return that `h \$_© Ho$ [aQ>Z© H$s dh Ano{jV aoQ> hmoVr h¡ Omo
will just satisfy all capital providers. To un- H$ånZr Ho$ g^r H¡${nQ>b àXmVm H$mo g§VwîQ> H$aVr h¡Ÿ&
derstand better, let’s take a simple example,
Assume that you borrow some money from CXmhaU Ho$ {bE, `{X h_ `h Anoúmm aIVo hþE H$s Hw$N>