Cost of capital refers to the opportunity cost of making a specific investment. Classification of Cost of Capital, and explain their Types. Cost of capital consists of both the cost of debt and the cost of equity used for financing a business. It is the rate of return that could have earn by putting the same money into a different investment with equal risk. Cost of Capital, and explain their Types (With Calculations), PDF Download Full Explanations.
Financial Management in Classification of Cost of Capital and how to explain their Types.
The following points highlight the five types of costs including in the list of the cost of capital. They are 1. Explicit Cost and Implicit Cost, 2. Future Cost and Historical Cost, 3. Specific Cost, 4. Average Cost and Marginal Cost, and 5. Overall Cost or Composite or Combined Cost.
1. Explicit Cost and Implicit Cost:
The explicit cost of any sources of capital may define as the discount rate that equates the present value of the cash inflows. That is incremental to the taking of the financing opportunity with the present value of its incremental cash outflow. When a firm raises funds from different sources, it involves a series of cash flows. At its first stage, there is only a cash inflow by the amount raised which is followed by a series of cash outflows in the form of interest payments, repayment of principal or repayment of dividends.
2. Future Cost and Historical Cost:
Future Costs are the expected costs of funds for financing a particular project. They are very significant while making financial decisions. For instance, at the time of taking financial decisions about capital expenditure. A comparison is to make between the expected IRR and the expected cost of funds for financing the same, i.e. the relevant costs here are future costs.
3. Specific Cost:
The cost of each component of capital, viz., equity shares, preference shares, debentures, loans etc. are termed specific or component cost of capital which is the most appealing concept. While determining the average cost of capital. It requires consideration of the cost of specific methods for financing the projects.
4. Average Cost and Marginal Cost:
The average cost of capital is the weighted average cost of each component of the funds invested by the firm for a particular project, i.e. percentage or proportionate cost of each element in the total investment. The weights are in proportion to the shares of each component of capital in the total capital structure or investment.
According to the Terminology of Cost Accountancy, Marginal Cost is the amount at any given volume of output by which aggregate costs are changed if the volume of output is increasing or decreasing by one unit. The same principle is being followed by the cost of capital. That is, the marginal cost of capital may define as the cost of obtaining another rupee of new capital, and last.
5. Overall Cost or Composite or Combined Cost:
It may recall that the term ‘cost of capital’ has used to denote the overall composite cost of capital or weighted average of the cost of each specific type of fund, i.e., weighted average cost. In other words, when specific costs are combined in order to find out the overall cost of capital. It may define as the composite or weighted average cost of capital.