2. 2
Cost of Capital: Definition
Cost of capital is the minimum required rate of return which
a firm requires as a condition for undertaking an
investment. - Milton H. Spencer
The cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure.
-Ezra Solomon
The rate of return a firm must earn in its investment so the
market value of the firm remains unchaged.
- L. J. Gitman
4. 4
Classification of Cost of
Capital
1. Explicit Cost: Discount rate which equates the present
value of investment. Thus, internal rate of return which
a firm pays for procuring the finances.
2. Implicit Cost: The rate of return which can be earned
by investing the funds in the lternative investments
opportunity cost.
3. Historical Cost: Cost which has already been incurred
for financing a project, based on past data.
4. Specific Costs and Composite Cost: Specific costs
refer for obtaining any other sources i.e. equity shares,
preference shares, debentures, retained earnings etc.
Composite Cost: Combined cost of various sources of
finance.
5. 5
Classification of Cost of
Capital
5. Average Cost : WACC, weights are assigned
to the component of the funds to total capital
funds.
6. Marginal Cost: Additional cost which incurred
in the production of one more unit of a good or
service.
6. 6
Capital Components
A firm’s Capital Components are
○ Debt
• Borrowed money, either loans or bonds
○ Common equity
• Ownership interest
○ Preferred stock
• A hybrid security, a cross between debt and equity
Capital structure is the mix of the three capital
components - generally expressed in percentages
7. 7
Capital Structure
Target Capital Structure
○ A mix of components that management
considers optimal and strives to maintain
Raising Money in the Proportions of the
Capital Structure
○ In cost of capital calculations, we assume
money is raised in a constant proportion of
debt, preferred and common equity
• Usually either the current or a target structure
• Idea used despite being somewhat unrealistic
8. 8
Returns on Investments and the
Costs of Capital Components
Investors provide capital by purchasing securities
○ Returns paid to investors adjusted for taxes and administrative
expenses are the firm’s costs
The risk levels of Capital Component securities differ
○ Leads to different investor returns for each component
• And different costs to the issuing firm for each component
○ Equity is the riskiest investment, earns the highest return, and has
the highest cost
○ Debt is the safest investment, earns the lowest return, and costs
the firm least
○ Preferred Stock offers investors intermediate risk and return levels
and has a cost between that of equity and debt
