1. what is the role o the cost of capital in the aluation process, and what is one of the primary uses the cost of capital (meaning in what area of chance is the ost often applied)? why is itd important for financial managers to understand the cost of capital? Solution In simple terms, Cost of Capital refers to the discount rate that is used in determining the present value of the estimated future cash proceeds of the business/new project and eventually deciding whether the business/new project is worth undertaking or now. It is also the minimum rate of return that a firm must earn on its investment which will maintain the market value of share at its current level. It can also be stated as the opportunity cost of an investment, i.e. the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected. For example, when an investor purchases stock in a company, he/she expects to see a return on that investment. Since the individual expects to get back more than his/her initial investment, the cost of capital is equal to this minimum return that the investor expects to receive (also termed as investor opportunity cost). The cost of each source of capital (Equity Share or Debt) is called specific cost of capital. When these specific costs are combined for all the sources of capital for a business, then we arrive at overall cost of capital for a business. We will first discuss the specific cost of capital for each source of capital before discussing and defining the overall cost of capital. Measurement of Cost of Capital In order to calculate the specific cost of each type of capital, recognition should be given to the explicit and the implicit cost. The cost of capital can be either explicit or implicit. The explicit cost of any source of capital may be defined as the discount rate that equates the present value of the funds received by the firm net of under writing costs, with the present value of the expected cash out flows. These outflows maybe interest payment, repayment of principal or dividend. It can also be stated as the internal rate of return a firm pays for financing. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm was accepted. Opportunity costs are technically referred to as implicit cost of capital. The distinction between explicit and implicit costs is important from the point of view of the computation of the cost of capital. The first step in the measurement of the cost of the capital of the firm is the calculation of the cost of individual sources of raising funds. From the viewpoint of capital budgeting decisions, the long term sources of funds are relevant as they constitute the major sources of financing the fixed assets. In calculating the cost of capital, therefore the focus is on long-term funds which are:- i. Long.