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Concept of Cost of Capital

Cost of capital is one of the corner stones of the theory of financial management but it is a controversial topic in finance. And at the same time it provides suitable guidance for the formulation of capital .’structure of the firm. In the present fmancial world, it is used as a sophisticated technique of evaluating the profitability of capital investment proposals and also to examine the alternative sources of capital. In order to meet out the modern financial decision making process, in this chapter, it is proposed to discuss the concept and implications of the firm’s cost of capital, procedure for the measurement of different sources of capital and also to explain its uses. 

 

CONCEPT OF COST OF CAPITAL

The term cost of capital is the rate of return a firm must earn on its investment for the market value of the firm to remain unchanged. From the company’s point of view, cost of capital is the measurement of profitability of investments and a yardstick to decide whether to make investment in particular project or not.

 

DEFINITIONS OF COST OF CAPITAL

 

(i) “The cost of capital is the minimum required rate of earnings or the cut-off rate

for capital expenditures”.                                                        -G.C. Philippatos

 

(ii) “The cost of capital represents a cut-off rate for the allocation of capital to

investment of projects. It is the rate of return o n a project that will leave unchanged

the market price of the stock”                                                 – james C. Van Horne

 

(iii) “In a general sense, the cost of capital is any discount rate used to value cash

streams”.                                                                                  -Haley and Schall.

 

From the above definitions, it is clear that the cost of capital is otherwise called as cut

off rate. Because it is the suitable test of validity of committing a capital expenditure.