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Concept of Cost of Capital

Cost of Capital forms to be a fundamental aspect in regard to the theory of financial management. However, it is regarded as one of the most controversial concepts in finance. It guides towards the formulation of capital structure for an organization. This capital cost is used as an important element to assess the profitability of capital investment proposals. Further, it is even used for finding the other alternative sources for a firm’s capital.

Cost of Capital: Concept

This capital cost in regard to an organization, is the average return rate which the investors need for providing long-term funds. A company’s capital cost is the average cost in regard to various long term finance sources.

If considered from a company’s point of view, it is the assessment of effectiveness of an investment. This is an essential factor to decide if it is wise to move ahead with the investment or not.

Defining Cost of Capital

If defined in simple terms, it is an opportunity cost before making any investment. It is that rate of return which would have been incurred if the money was put into some other investment having same level of risk.

It can be further defined as-

According to James C. Van Horne, this capital cost indicates a cut-off rate for allocating capital to various investments. He further states that it is the rate of return on an investment which will have no effect on the market value of that company’s stocks.

G.C. Philippatos has defined this capital cost as the cut-off rate or minimum rate of earnings for capital expenditures in regard to a company.

Haley and Schall believe that this cost of capital is a discount rate which is used to determine the value of cash streams.

 

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