What is meant by cost of capital?

What is meant by cost of capital?

Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building. Cost of capital encompasses the cost of both equity and debt, weighted according to the company’s preferred or existing capital structure.

What is the cost of capital approach?

The cost of capital method adjusts future cash flows for changes in the cost of capital as the firm reduces its outstanding debt. The second method, adjusted present value, sums the value of the firm without debt plus the value of future tax savings resulting from the tax deductibility of interest.

What are the methods of calculating cost of capital?

The most common approach to calculating the cost of capital is to use the Weighted Average Cost of Capital (WACC). Under this method, all sources of financing are included in the calculation, and each source is given a weight relative to its proportion in the company’s capital structure.

What is cost of capital and its importance?

The cost of capital is very important concept in the financial decision making. Cost of capital is the measurement of the sacrifice made by investors in order to invest with a view to get a fair return in future on his investments as a reward for the postponement of his present needs.

What are the objectives of cost of capital?

The primary objective of determining the cost of capital is to evaluate a project. Various methods used in investment decisions require the cost of capital as the cut-off rate.

What are the components of cost of capital?

The three components of cost of capital are:

  • Cost of Debt. Debt may be issued at par, at premium or discount.
  • Cost of Preference Capital. The computation of the cost of preference capital however poses some conceptual problems.
  • Cost of Equity Capital. The computation of the cost of equity capital is a difficult task.

What are the different types of cost of capital?

Various types of cost of capital are described below:

  • i. Explicit Cost of Capital:
  • ii. Implicit Cost of Capital:
  • iii. Specific Cost of Capital:
  • iv. Weighted Average Cost of Capital:
  • v. Marginal Cost of Capital:

What is cost of capital in NPV?

The cost of capital represents the minimum desired rate of return (i.e., a weighted average cost of debt and equity capital). The net present value (NPV) is the difference between the present value of the expected cash inflows and the present value of the expected cash outflows.

What are the factors of cost of capital?

Fundamental Factors affecting Cost of Capital

  • Market Opportunity.
  • Capital Provider’s Preferences.
  • Risk.
  • Inflation.
  • Federal Reserve Policy.
  • Federal Budget Deficit or Surplus.
  • Trade Activity.
  • Foreign Trade Surpluses or Deficits.

What are the three components of the cost of capital?

Is cost of capital same as WACC?

Cost of capital is the total of cost of debt and cost of equity, whereas WACC is the weighted average of these costs derived as a proportion of debt and equity held in the firm.