The cost of capital

The cost of capital is an important element in capital expenditure management. The cost of capital is a discount rate that is used in determining the present value of future cash flows. It is the minimum rate of return that the firm must earn on its investments to keep its market value unchanged. It consists of three elements:

i.                    The riskless cost of a particular form of financing;

ii.                  The business risk premium; and

iii.                The financial risk premium.

There are four types of specific costs:

i.                    Cost of debt;

ii.                  Cost of preference shares;

iii.                Cost of equity capital; and

iv.                 Cost of retained earnings.

The cost of capital means the weighted average cost of capital of all long- term sources of finance. It can be explicit or implicit. The explicit cost of capital is associated with the raising funds. When funds are internally used, the cost of capital is known as implicit cost in terms of the opportunity cost of the foregone alternatives.