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Management of Cost of Capital

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UNIT V
Cost of Capital
5.1 Introduction
The cost of capital is an important financial concept. It links the company's long-
term decisions with the wealth of the shareholders as determined in the market place.
Whenever, a business organization raises funds, it has to keep in mind its cost. Hence
computation of cost of capital is very important and finance managers must have a close
look on it. In this unit, we shall discuss the concept, classification, and importance of cost
of capital the process of computing cost of capital of individual components, weighted
cost of capital, importance of cost of capital and a few misconceptions.
5.2 Meaning and Importance
The term cost of capital refers to the minimum rate of return which a firm must earn
on its investments so that the market value of the company's equity shares does not fall.

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5.2.1 Meaning of Cost of Capital
Hampton, John defines the term as "the rate of retur n the firm requires from investment
in order to increase the value of the firm in the market place". The following are the basic
characteristics of cost of capital :
i) Cost of capital is a rate of return, It is not a cost as such.
ii) This return, however, is calculated on the basis of actual cost of different
components of capital.
iii) A firm's cost of capital represents minimum rate of return that will result in
atleast maintaining (If not increasing) the value of its equity shares.
iv) It is related to long term capital funds.
v) Cost of capital consists of three components :
a) Return at Zero Risk Level. (r0)
b) Premium for Business Risk (b)
c) Premium for Financial Risk (f)
vi) The cost of capital may be put in the form of the following equation :
K = ro + b + f
Where
K = Cost of Capital
ro = Return at Zero Risk Level
b = Premium for Business Risk
f = Premium for Financial Risk

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UNIT V Cost of Capital 5.1 Introduction The cost of capital is an important financial concept. It links the company's long- term decisions with the wealth of the shareholders as determined in the market place. Whenever, a business organization raises funds, it has to keep in mind its cost. Hence computation of cost of capital is very important and finance managers must have a close look on it. In this unit, we shall discuss the concept, classification, and importance of cost of capital the process of computing cost of capital of individual components, weighted cost of capital, importance of cost of capital and a few misconceptions. 5.2 Meaning and Importance The term cost of capital refers to the minimum rate of return which a firm must earn on its investments so that the market value of the company's equity shares does not fall. 5.2.1 Meaning of Cost of Capital Hampton, John defines the term as "the rate of retur n the firm requires from investment in order to increase the value of the firm in the market place". The following are the basic characteristics of cost of capital : i) Cost of capital is a rate of return, It is not a cost as such. ii) This return, however, is calculated on the basis of actual cost of different components of capital. iii) A firm's cost of capital represents minimum rate of return that will result in atleast maintaining (If not increasing) the value of its equity shares. iv) It is related to long term capital funds. v ...
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