The long-term investments made today will determine the value of the business tomorrow. In order to make long-term investments in new product lines, new equipment and other assets, managers must know the cost of obtaining funds to acquire these assets.
The cost associated with different sources of funds is called the cost of capital. Cost of Capital represents the rate a business must pay for each source of funds - debt, preferred stock, common stock, and retained earnings. This is from the firm’s point of view; where the cost of capital is what the firm must pay for the funds needed to finance an Investment.
Also, the cost of capital represents the return that must be provided for the use of an investor’s funds. If funds are borrowed, the cost is related to the interest that must be paid on the loan. If the funds are equity, the cost is the return that investors expect, both from the stock’s price appreciation and dividends. So, from the investor’s point of view, the cost of capital is the same as the required rate of return.
The cost of capital may be an explicit cost (for ex., the interest paid on debt) or an implicit cost (for ex., the expected price appreciation of shares of the firm’s common stock).
The Cost of Capital
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2010-10-11, 00:00
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2025-09-29, 16:58
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Florin Anghel
