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Specific and Overall Cost of Capital

At a particular point of time, the firm might have raised funds from various sources i.e., short term as well as long term. Conceptually, the cost of capital as a measure represents the combined cost of total funds being used by the firms. However, the short term sources of funds are kept out side the calculation of  cost of capital as these short term sources e.g. bank credit, trade credit, bill etc., are generally considered to be temporary in nature and are subjected to repayment in the short run. Therefore, the cost of capital of a firm is calculated as the combined cost of long term sources of funds.
Moreover, all these long term sources have their own specific costs. The combined cost of capital depends upon these specific costs. The combined cost of capital is in fact, known as the overall cost of capital of the firm, while the specific costs are known as the specific cost of capital of a particular source. The long term source of funds can be broadly categorized into

i)    long term debt and loans
ii)    preferences share capital
iii)    equity share capital
iv)    the retained earnings.

The firm has a specific cost of capital for each of these sources and on the basis of these specific cost of capital, the overall cost of capital of the firm can be determined.
Normally, the capital funds come from a pool of different sources, none of the elements of which can or should be specifically identified with the particular proposals under review. Instead, any use of capital funds should reflect a firm’s overall cost of capital. The capital expenditures are backed by the long term capital structure of a company, which may include different degrees of leverage. Thus, an overall cost of  capital is an important criterion in the capital budgeting evaluation procedure. 
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