What is the Cost of Capital? Meaning and Definition

Cost of Capital is the rate that must be earned in order to satisfy the required rate of return of the firm’s investors. Keep Reading What is the Cost of Capital? Meaning and Definition. It can also define as the rate of return on investments at which the price of a firm’s equity share will remain unchanged.

Cost of Capital – Meaning and Definition, define each one, Read this article to learn about the Cost of Capital.

Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn the return at the expected rate, the market value of the shares will fall and it will result in the reduction of the overall wealth of the shareholders.

Meaning of Cost of Capital:

An investor provides long-term funds (i.e., Equity shares, Preference Shares, Retained earnings, Debentures etc.) to a company and quite naturally he expects a good return on his investment. In order to satisfy the investor’s expectations, the company should be able to earn enough revenue. Thus, to the company, the COC is the minimum rate of return that the company must earn on its investments to fulfill the expectations of the investors.

If a company can raise long-term funds from the market at 10%, then 10% can use as the cut-off rate as the management gains only when the project gives return higher than 10%. Hence 10% is the discount rate or cut-off rate. In other words, it is the minimum rate of return required on the investment project to keep the market value per share unchanged.

In order to maximize the shareholders’ wealth through increase price of shares, a company has to earn more than the COC. The firm’s cost of capital can determine by working out the weighted average of the different costs of raising different sources of capital.

Definition of Cost of Capital:

We have seen that the cost of capital is the average rate of return required by the investors.

Various authors defined the term cost of capital in different ways some of which are stated below. Some definitions of financial experts are given below for the clear conception of the COC:

Ezra Solomon defines:

“Cost of capital is the minimum required rate of earnings or cut­off rate of capital expenditure”.

According to Mittal and Agarwal:

“The cost of capital is the minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price”.

According to Khan and Jain, cost of capital means:

“The minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged”.

According to the definition of John J. Hampton:

“Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the marketplace”.

Each type of capital used by the firm (debt, preference shares, and equity) should incorporate into the COC, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. Using the cost a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems.