Cost of Capital Misconceptions

1422 Words6 Pages
QN 4 The cost of capital is a central concept in financial management linking the investment and financing decisions. Hence, it should be calculated correctly and used properly in investment evaluation. Despite this injunction, we find that several errors characterize the application of this concept. The more common misconceptions, along with suggestions to overcome them are discussed below; The concept of cost of capital is too academic or impractical. Some companies do not calculate the cost of capital because they regard it as academic or impractical or irrelevant or imprecise. These misgivings about capital appear to be unjustified. Such reservations can be dispelled by emphasizing the following points * The cost of capital is an…show more content…
Sometimes firms impute a negligible or low cost to retained earnings under the influence of wrong notions like “retained earnings have no cost because shareholders are satisfied with dividends” or “retained earnings are already with firm and hence some nominal returns on them may suffice. The error in such reasoning stems from ignoring the opportunity cost associated with retained earnings. When a firm retains a portion of its earnings, equity shareholders are denied dividends to that extent. If the same were distributed as dividends, equity shareholders can invest elsewhere to earn a rate of return comparable to the cost of equity. Hence opportunity cost of retained earnings is more or less equal to the cost of equity funds. The other error associate with cost of capital is that depreciation has no cost. Similar to the misconception that retained earnings are more of less cost free is the notion that depreciation – generated funds are also virtually cost free. As one manager puts it “Depreciation is capital already in the company. Since it does not have to be raised, even in an indirect sense of retained earnings, it clearly has no cost. To guard against such as error, invoke the opportunity cost principle once again. Theoretically, the firm can return the depreciation-generated funds to its shareholders and lenders (the parties which provided the finance for asset

More about Cost of Capital Misconceptions

Open Document