The cost of each component of capital is known as specific cost of capital. A firm raises capital from different sources such as equity, preference, debentures, etc. Specific cost of capital is the cost of equity share capital, cost of preference share capital, cost of debentures, etc., individually.
What are the characteristics of cost of capital?
(i) The specific cost of each source of funds (i.e., cost of equity, preference shares, debts, retained earnings etc.) is to be calculated. (ii) Weights (i.e., proportion of each, source of fund in the capital structure) are to be computed and assigned to each type of funds.
What are the different 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.
Which is the best definition of cost of capital?
Definition of Cost of Capital. Cost of Capital is the rate of return the firm expects to earn from its investment in order to increase the value of the firm in the market place. In other words, it is the rate of return that the suppliers of capital require as compensation for their contribution of capital. Source of Cost of Capital
How is the rate of return used to determine cost of capital?
A simpler cost of capital definition: Companies can use this rate of return to decide whether to move forward with a project. Investors can use this economic principle to determine the risk of investing in a company.
How does the cost of capital affect a business?
Cost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of funding its operation.
What does it mean to exceed cost of capital?
Investors want to put money into companies that exceed the cost of capital, thus generating returns that are proportionate with the risk. The cost of capital is used to compare different investments with equal risk. In a nutshell, the cost of capital is the rate of return required to persuade the investor to make an investment.
