Basic Aspects on the Capital Cost Concept
The cost of capital in operational terms refers to the discount rate that would be used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. It is defined as “the minimum rate of return” that a firm must earn on its investment for the market value of the firm to remain unchanged.
The above definitions indicates, that the following are the three basic aspects of the Capital Cost Concept :
1. Rates of Return: Cost of capital is not a cost as such, in fact, it is the rate of return that a firm requires earning from its investment projects.
2. Minimum Rate of Return: Cost of capital of any firm is that minimum rate of return that will at least maintain the market value of the shares.
3. The cost of capital comprises three components:
(a) The risk less cost of the particular type of financing (RJ)
(b) The business risk premium, (b) and
(c) The financial risk premium (f)
Symbolically cost of capital may be represented as Ko = rj + b + f
The above three components of the cost of capital may be put in the form of the following equation:
K = r0 + b + f
K = Cost of capital
B = Premium for business risk
f = Premium for financial risk
[ Basic Aspects on the Capital Cost Concept ]