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Financial Management - Capital Budgeting – A Conceptual Framework

Introduction and Definitions of Cost Of Capital

   Posted On :  20.06.2018 12:59 am

Cost of capital plays an important role in the capital budgeting decisions.

Introduction
 
Cost of capital plays an important role in the capital budgeting decisions. It determines the acceptability of all investment opportunities regardless of the techniques employed to judge the financial viability of a project. Cost of capital serves as capitalization rate used to determine capitalisaiton of a new concern. With the help of this very rate real worth of various investments of the firm can be evaluated. Cost of capital provides useful guidelines in determining optimal capital structure of a firm. It refers to the minimum rate of return of a firm which must earn on its investment so that the market value of the company’s equity share may not fall. In the words of Hampton, John J, cost of capital is the rate of return the firm requires firm investment in order to increase the value of the firm in the market place. The concept of cost is perceived in different dimensions that are briefed below:

1. A firm’s cost of capital is really the rate of return that it requires on the projects available.

2. A firm’s cost of capital represents the minimum rate of return that will result in at least maintaining the value of its equity shares.

Definitions
 
Cost of capital is one rate of return the capital funds used should produce to justify their use within the firm.
1. According to Solomon Ezra, the cost of capital is the minimum required rate of earnings of the cut off rate for capital expenditure.

2. In the words of Haley and Schall, in a general sense, cost of capital is any discount rate used to value cash streams.

3. According to James C. Vanhorne, the cost of capital represents a cut off rate for the allocation of capital investment of projects. It is the rate of return on a project that will have unchanged the market price of the stock.   
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