Cost of Capital in Financial Management

In this course, the students will learn:

• Concept of Cost of Capital

• Cost of Debt Capital

• Cost of Preference Share Capital

• Cost of Equity Share Capital

• Cost of Retained Earnings

• Weighted Average Cost of Capital (WACC)

Cost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to fund its operations. This consists of both the cost of debt and the cost of equity used for financing a business. The cost of capital is heavily dependent on the type of financing used in the business. A business can be financed through debt or strictly through equity. However, most companies employ a mixture of equity and debt to finance their businesses. Therefore, the cost of capital comes from the weighted average cost of all capital sources or the weighted average cost of capital. A company's securities typically debt, preference shares and equity, one must therefore calculate the cost of debt, cost of preference shares and the cost of equity to determine a company's cost of capital. Importantly, both cost of debt and equity must be forward looking, and reflect the expectations of risk and return in the future. This means, for instance, that the past cost of debt is not a good indicator of the actual forward looking cost of debt. Once cost of debt, preference shares and cost of equity have been determined, their blend, the weighted average cost of capital (WACC), can be calculated.