Cost of Capital Definition – Formula, Example and Importance

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Cost of Capital Definition and Example

Cost of Capital Definition – The percentage rate a company must pay investors or lenders in return for its capital funding. Companies calculate their WACC by taking into account factors such as the average interest rate on their debt, the expected rate of return on their equity, and their tax rate.

In a layman language, it refers to the cost an individual or entity has pay in order to raise the funds. The cost of raising funds depends upon which type of financing the company is using. The cost of raising money from equity is different from cost of raising funds from debts.

However most of the companies capital structure consist of both equity as well as debt. So in such case cost of fund is known as weighted average cost of capital or WACC. One more important point to note is that, with company to company the cost of capital varies. The companies with good credit ratings get credit on easy term basis as well as lower rate of interest.

Cost of Capital Example

Let’s discuss an example in order to understand the cost of capital definition more clearly. Puran & Sons is a proprietor who has the stationary business. New sessions in schools and colleges have started, There is great demand of notebook, books and other stationary items. In order to buy the items, Puran needs 1,00,000 of cash. So he approach the bank. Bank agrees to give Puran a loan @12 %. So here the cost of Rs 1,00,000 capital is 12 % that is Principal amount plus Rs 12,000. Puran has to pay 12,000 extra to get the capital.

Related Financial Terms of Cost of Capital

Importance of Cost of Capital – Why Cost of Capital is Used?

It is very important for the entities to calculate the cost of capital of various sources of funds. This helps the entities in identifying the most cheapest source of raising funds. It act as one of the important tool in making financial decision with respect to investment and raising funds.

Assessing cost of capital is also very important for taking capital budgeting decisions as well. Before rejecting or accepting the investment or projects, it is necessary to calculate the cost of capital first. In addition to this, calculating cost of capital play a vital role in deciding the capital structure of an entity. Companies always tries to minimize their cost and maximize their profits. Even sometimes, the cost of capital is used to measure the financial performance of the capital projects.

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