Cost of capital doubt
MPR Sanjay Kumar (3118 Points)
22 July 2024
in financial management what is meant by cost of capital how it works practically and why it is the purpose
1 Replies
Dhirajlal Rambhia
(SEO Sai Gr. Hosp.)
(177713 Points)
Replied 20 October 2024
In financial management, the Cost of Capital (CoC) represents the minimum return required by investors, creditors, and shareholders to compensate for the risk of investing in a company. It's the opportunity cost of funds used by the company.
Components of Cost of Capital:
Cost of Debt (Cd): Interest rate paid on borrowed funds (e.g., loans, bonds)
Cost of Equity (Ce): Return required by shareholders (e.g., dividends, capital appreciation)
Cost of Retained Earnings (Cr): Opportunity cost of reinvesting profits
Cost of Preferred Stock (Cp): Dividend yield on preferred shares
Weighted Average Cost of Capital (WACC):
WACC calculates the overall CoC by weighting each component by its proportion in the company's capital structure:
WACC = (Cd x Rd) + (Ce x Re) + (Cr x Rr) + (Cp x Rp)
Where:
Rd, Re, Rr, Rp = Proportions of debt, equity, retained earnings, and preferred stock
Cd, Ce, Cr, Cp = Costs of debt, equity, retained earnings, and preferred stock
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