Question

Part 1--Define the term cost of capital.

Part 2--What might we expect to see in business practice in the relative costs of different sources of capital?

Answer 1

Cost of capital is the required rate of return which is needed for capital budgeting process. It is actually the hurdle rate for the company to overcome so as to make the project valuable. It is thus the return which investors seek taking in to account the risk associated with the project..It is used to judge whether the expenses related to the company's project is worth or not. This is calculated by various project budgeting process such as NPV which uses the cost of capital to find out the worth of the project. Therefore, it is the minimum target return for the company to accept the project.

2. The cost of capital is actually the weighted average cost of capital of the company and is a combination of debt, common stock and preferred shares. Different component of financing have different cost associated with it which is proportional to the risk involved. The cost of capital for each source increase with the in crease in risk and on comparing historical data it is seen the after tax cost of debt is less than the cost associated with common stock and preferred stock. This is because interest on debt are tax-deductible whereas dividends paid on equity are not. Thus, cost of debt are usually lower than equity. In comparing the common stock and preferred equity cost, it is again seen that preferred stock carries lower cost as compared to common stock. Thus, it is the common stock equity which carries higher risk and hence the required rate of return on the same is the highest.