COST OF CAPITAL

PRESENTED BY, NEETHU MOHAN BATCH 1 MBA MGT 1005226 IMK ALAPPUZHA

Meaning
Cost of capital is defined as the minimum rate of return that a firm must on its investement.So that market value per share remain.

Definition
Cost of capital is the minimum required rate of earning or the cut off rate of capital expenditure. SOLOMAN EZRA

Importance of cost of capital

Capital budgeting decisions :

In capital budgeting decisions, the cost of capital is often used as a discount rate on the basis of which the firms future cash flows are discounted to find out their present values.Thus,the cost of capital is the very basis for financial appraisal of new capital expenditure proposals.

 Capital structure decisions :

The cost of capital is also an important consideration in capital structure decisions. The finance manager must raise capital from different sources in a way that it optimises the risk and cost factors.The sources of funds which have less cost involve high risk.

Classification of cost capital

Cost of capital can be classified as follows: Explicit cost & implicit cost The explict cost of any source of finance may be defined as the discount rate that equates the present value of the funds received by the firm net of underwriting costs, with the present value of expected cash outflows.

The implicit cost may be defined as the rate of return associated with the best investement opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted.

 Future cost & historical cost

Future cost refers to the expected cost of funds to finance to project, while historical cost is the cost which has already been incurred for financing a particular project. Historical costs are useful in projecting the future costs and providing an appraisal of the past performance when compared with standard or predetermined cost.

 Specific cost & combined cost

The cost of each component of capital (equity shares, preference shares, debentures, loans,etc.) is known as specific cost of capital. The composite or combined cost of capital is inclusive of all cost of capital from all sources (equity shares,preference shares, debentures and other loans.

 Average cost & marginal cost

The average cost of capital is the weighted average of the costs of each component of funds employed by the firm. The weights are in proportion of the share of each component of capital in the total capital structure. Marginal cost of capital,on the other hand ,is the weighted average cost of new funds raised by the firm.

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