The cost of capital is also known as the “discount rate” or the “hurdle rate” in contemporary financial terminology. It is one of the most of important concepts of present day corporate finance. It could be described as a total of the cost of debt and cost of equity.
Description of Cost of Capital
It is normally assumed that any capital invested in a business would accrue the concerned person a certain amount of profit as a reward for risking the money that they might have utilized for other purposes.
For the particular investor to make profits from his business it is almost mandatory that the approximate return on the capital is greater in value than the cost of capital. As stated above the cost of capital consists of the cost of equity and cost of debt.
Cost of Debt
The cost of debt is an integral part of the cost of capital. It is normally easy to find out the cost of debt. The main reason behind this is that the cost of debt is made up of the rate of interest or the interest that has been paid. It includes the cost of risk. The cost of risk could be defined as the risk that there might be a default in the debt.
In the practical domain the amount of interest that is being paid by a particular company would be comprised of a risk component and a rate that is free of risk. The risk-free rate is made up of a possible default rate.
Cost of Equity
The cost of equity is another constituent of the cost of capital. It is normally difficult to find out the cost of equity, as the amount of equity paid by any company is never same or consistent.
Application of Cost of Capital
The cost of capital is often employed as a discount rate. It is used as a rate at which the cash flow that has been figured would be discounted in order to provide a net present value or a present value.
Last Updated on : 27th June 2013