Explicit And Implicit Cost Of Capital

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The cost of capital of affirm can also be analyzed as explicit cost and implicit cost of capital. The explicit cost of capital of a particular source may be defined in terms of the interest or dividend that the firm has to pay to the suppliers of funds. There is an explicit flow of cash payable by the firm to the supplier of fund. For example, the firm has to pay interest on capital, dividends at fixed rate on preference share capital and also some expected dividends on equity shares. These payments refers to the explicit cost of capital.

 However, there is one source of funds which does not involve any payment or flow i.e., the retained earning of the firm. The profits earned by the firm but not distributed among the equity shareholders are ploughed back and reinvested within the firm. These profits gradually result in a source of funds to the firm. Had these profits been distributed to equity shareholders, they could have invested these funds (return for them) elsewhere and would have earned some return. This return is foregone by the investors when the profits are ploughed back. Therefore, the firm has an implicit cost of these retained earning and this implicit cost is the opportunity cost of investors. Thus, the implicit cost of retained earning is the return which could have been earned by the investors, had the profit been distributed to them.

Except the retained earning, all other sources of funds have explicit cost of capital. In capital budgeting situation, it is only the explicit cost of capital which is relevant.
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