The hidden constituents of cost of capital

Abstract

The concept of capital has been a much debated issue throughout economic, accounting and finance history. In economics it was defined as the financial resources utilised by companies while other definitions indicated it represented the actual capital goods themselves. This dualistic meaning of capital has led to various interpretations of the concept of capital and these different interpretations can also be found in the cost of capital model. The cost of capital model is a decision-useful financial tool employed by management to make decisions regarding the financing of projects, performance measurement and risk and return management. The two main forms of funding are debt and equity resources. The cost of capital model was built on the accounting interpretation and classification of the different debt and equity sources of funding. As time went by the financial markets became more sophisticated and new innovative instruments were introduced to help raise financing for companies. Some of these sophisticated instruments and accounting book entries are normally not included in discussion on capital structure and the cost of capital model. The aim of this research is to unbundle and understand the different dimensions of the cost of capital with special focus on the impact of accounting classification on hybrid financial instruments and certain accounting book entries. The balance sheet items that have revealed themselves as grey areas of the accounting classification and the hidden constituents of the cost of capital include accounting book entries such as deferred tax and accumulated depreciation, hybrid financial instruments and the effect of cash. Currently these instruments pose questions as to their proper debt-equity classification or can have an impact on the capital structure of an organisation. An adjusted model will be presented that will incorporate any hidden areas related to the debt-equity accounting classification schema. The introduction of these items into the cost of capital model will make it more robust and it will become an even more decision-useful tool for management and analysts a like.