The cost of capital is the cost that the company has to pay to the market for different source of finance.Such cost would simply be the interest rate in case of borrowed funds, specific rate of dividend in case of preference share capital,expected ‘cash dividend’ during current year and growth dividends plus capital gain in future in case of equity share holder.
Concept of Cost of Capital.
Cut -off-Rate :- Cost of capital is minimum required rate of return or earnings from any given project needed to justify the use of capital.In other word is the rate that must be paid to obtain funds for the operation of the firm.
Lending or borrowing Rate :- Borrowing rate is the rate at which a given firm will have to pay for obtaining capital from the market, whether it is from shareholder of other lenders.As between these two rates whichever rate is higher is to be used for discounting purpose while making investment decision.
Opportunity cost:-This is an alternative concept of cost of capital.It is the value of the alternatives foregone by adopting a particular strategy or employing resources in specific manner.
Explicit cost and Implicit cost:- The explicit cost of any source of capital may be defined as ” the discount rate that equates the present value of the cash inflows Thus explicit cost of capital is the internal rate of return of the financial opportunity.Implicit cost is the opportunity cost.
Although the determination of cost of capital in case of borrowed funds and preference share capital is easy.The estimation of the cost of equity and retained funds is quite difficult as the later depends upon relative change in the market price of share.
The cost of debt is simply the explicit interest rate,cost of preference share is the coupon rate of dividend, cost of equity however is the expected dividend as well as the growth in it commensurate to the market going rate.The overall cost is nothing but the combined cost of each of these source of capital structure and averaging is to be done based on the their relative proportions.