Explicit and Implicit Costs
The cost of capital can be either explicit or implicit. The distinction between explicit and implicit costs is important from the point of view of the computation of the cost of capital.
The explicit cost of any source of capital is the discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.
When firms raise funds from different sources, there is a series of cash flows. Initially, there is cash inflow to the extent of the amount raised. This is followed by a series of cash outflows in respect of interest payments, repayment of principal, Dr payment of dividends. For example, a firm raises Rs 5,00,000 through the sale of 10 per cent perpetual cerebrums. There will be a cash inflow of Rs 5,00,000 followed by an annual cash outflow of Rs 50.000. The rate of return that equates the present value of cash inflows (Rs 5,00,000) with the present value of cash outflows, (Rs 50,000) would be the explicit cost.
The determination of the explicit cost of capital is similar to the determination of the one difference. While in the computation of the IRR, the cash outflows (assuming conventional flows) are involved in the beginning, followed by cash inflows subsequently is,exactly opposite with the explicit cost of capital. Here as shown above, the cash flows take place only once and there is a series of cash outflows subsequently.
The general formula for the explicit cost of capital of any source of raising finance would be as follows:
It is evident from the above mathematical formulation that the explicit cost of capital is the rate of return of the cash flows of the financing opportunity. In other words it is the internal rate of return that the firm pays to procure financing. On the basis of the above formula, we can easily find out that the explicit cost of an interest-free loan is zero per cent because the discount rate that equates the present value of a future with an equivalent sum received today is zero. The cost of capital of a loan bearing interest is that discount rate which equates the present due of the future cash outflows with the net amount of funds initially provided by the loan. The explicit cost of capital of a gift is minus 100 per cent. The explicit cost of capital derived from the e of an asset is a discount rate that equates the present value of the future cash flows foregone the cash sale with the net proceeds to the firm resulting from its liquidation. The explicit cost funds supplied by increases in certain liabilities such as accounts payable and accrued taxes is zero per cent unless, of course, penalties are incurred or discounts lost owing to the increase in these liabilities.
The explicit cost of capital is concerned with the incremental cash flows that result directly from raising funds. Retained earnings used in the firm involve no future cash flows to, or from, the firm. Therefore, the explicit cost of retained earnings is minus 100 per cent. There are no future interest or principal payments imposed by the retention of earnings. There are no additional shares created and sold to outsiders on which, dividends will be paid. From this, it should, however, not be concluded that retained earnings have no cost. (In fact, they also have costs like other sources of raising finance have). The retained earnings are undistributed profit of the company belonging to the shareholders. Given the ultimate objective of the firm to maximize the wealth of shareholders, the cost of retained earning would be equivalent to the opportunity cost of earning by investing elsewhere by the shareholders themselves or by the company itself. Opportunity costs are technically referred to as input cost of capital. The input cost of capital of funds raised and invested by the firm may, therefore, be defined as ‘the rate of return associated with the best investment opportunity for the firm and its shareholders that would be foregone, if the projects presently under consideration by the firm were accepted. The cost of retained earnings is an opportunity cost or implicit capital cost, in the sense that it is the rate of return at which the shareholders could have invested these funds had they been distributed to them.? However, other financing also have implicit cost once they are invested. The explicit cost arises when funds are raised, whereas the implicit costs arise when funds are used. Viewed in this perspective, implicit costs are ubiquitous. They arise whenever funds are used no matter what the source.