Cost of Capital

Posted in Finance, Accounting and Economics Terms, Total Reads: 3854
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Definition: Cost of Capital

Cost of Capital is the expected rate of return that a capital would earn had it been invested in another project/security of equivalent risk. I.e. it is the cost of company’s funds.

If the project risk is similar to that of company’s average risk, then company’s weighted average cost of capital is used for the basis of evaluation. But if there is a difference in the risk of firm and risk of division/project, then “RISK-ADJUSTED-DISCOUNT-RATE” approach should be adopted. The company must at least earn this rate of return in order to cover the cost of funds generated for financing the company’s securities.

The investors would supply further funds only if they are compensated adequately for the risk taken for investing in Company’s shares and bonds. I.e. the rate of return must be higher than the cost of capital. The various capital budgeting decisions are also taken by the firm on the basis of cost of capital of the projects.

Cost of Capital



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