The theory of cost of capital is based on certain assumptions. A basic assumption of traditional cost of capital analysis is that the firm’s business and financial risks are unaffected by the acceptance and financing of projects. Business measures the variability in operating profits earnings interest anti taxes (EBIT) due to change in sales. If, a firm accepts 3 project that is considerably more risky than the average, the suppliers of the funds are quite likely to increase the cost of funds as there is an increased probability of committing default on the part of the firm in making payments of their money. A debenture holder will charge a higher rate of interest to compensate for increased risk. There increased uncertainty from the point of equity holders of getting dividend from the firm. Therefore, they will also require a higher return as a compensation for the increased risk. In analyzing the cost of capital in this chapter, we assume there would be no change whatsoever in the business risk complexion of the firm as a result acceptance of new investment proposals.
The capital budgeting decision determines the business risk complexion of the firm. The financing decision determines its financial risk. In general, the greater the proportion of long-term debt in the capital structure of the firm, the greater is the financial risk because there is a need f a larger amount of periodic interest payment and principal repayment at the time of maturity. As such a situation, obviously, the firm requires higher operating profits to cover these charges. In fails to earn adequate operating profits to cover such financial charges, it may be forced into insolvency. Thus, with the increase in the proportion of debt commitments and preference shares in its capital structure, fixed charges increase. All other things being the same, the probability the firm will unable to meet these fixed charges also increases. As the firm continues to itself, the probability of cash insolvency, which mar lead to legal bankruptcy, increases therefore, as a firm’s financial structure shifts towards a more highly levered position, the increase financial risk associated with the firm is recognized by the suppliers of funds. They compensate increased risk by charging higher rates of interest or requiring greater returns. In short, react in much the same way as they would in the case of increasing business risks. In the cost of capital in this Chapter, however, the firm’s financial structure is assumed to fixed. In the absence of such as assumption, it would be quite difficult to find its cost of capital the selection of a particular source of financing would change the cost of other financing. In operational terms, the assumption of a constant capital structure implies that additional funds required to finance the new project are to be raised in the same proportion as firm’s existing financing.
For the purpose of capital budgeting decisions, benefits from undertaking a proposed are evaluated on an after-tax basis. In fact, only the cost of debt requires tax adjustment as paid on debt is deductible expense from the point of view of determining taxable income is paid either to preference shareholders or to equity-holders are not eligible items sure of deduction to determine taxable income.
To sum up, it may be said that cost of capital (k) consists of the following three components:
(i) the riskless cost of the particular type of financing. r1
(ii) the business risk premium, b; and
(iii) the financial risk premium, f
Or k = r + b + f
Since the business and financial risks arc assumed to be constant, the changing cost of each type of capital, j. over lime should be affected by the change in the supply of, and demand for, each type of funds.