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Cost of capital

The various sources which the long term requirement of the capital can be met are discussed here and one of them is cost of capital. Each of these sources involves some cost. The cost of capital can be defined as “the rate at which an organisation must pay to the supplient of capital for the use of their funds”.

In economic terms, the cost of capital is viewed two different angles.
1.    The cost of raising funds to finance a project. This cost may be in the form of the interest which the company may be required to pay the suppliers of funds. This may be explicit cost attached various sources of capital.
2.    The cost of capital may be in the form of opportunity cost of the funds of company i.e. the rate of return which the company would have earned if the funds are not invested. E.g. Suppose that a company has an amount of $ 100,000 which may either be utilised for purchasing a machine or may be invested with a bank as fixed deposit carrying the interst 10% p.a. If the company decides to use the amount for purchasing the machine, obnviously it will have to forgo the interest which it would have earned by investing the same in fixed deposit with the bank. Thus, the cost of capital of this capital of $ 100,000 is 10%.

Concepts of cost of capital

Besides the general concept, the following concepts are also used frequently.

a.    Components cost and composite cost
Components cost refers to the cost of individual components of capital viz. equity shares, preference shares, debentures and so on. Composite cost of capital refers to the combined or weighted average cost of capital of the various individual components. For capital budgeting decisions, it is the composite cost of capital which is considered.

b.    Average cost and marginal cost
The average cost refers to the weighted average cost of capital. Marginal cost refers to the incremental cost attached with new funds raised by the company.

c.    Explicit cost and implicit cost
Explicit cost is one which is atached with the source of capital explicitly or apprently. Implicit cost is th ehidden cost which is not incurred directly. E.d. In case of the debt capital, the interst which the company is required to pay on the same is explicit cost of capital. However, if the company introduces more and more doses of debt caital in overall structure, it makes the investment in the company a risky position. As such, the expectations of the investors in termsof return on their investment may increase and share prices of the company may decrease. These increased expectations of the investors or the decreased share prices may be considered to be implcit cost of debt capital.

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