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Cost of capital

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Definition of Cost of capital

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Cost of capital

The required return for a capital budgeting project.


Cost of capital

The costs incurred by an organization to fund all its investments, comprising the risk-adjusted
cost of equity and debt weighted by the mix of equity and debt.


cost of capital

Refers to the interest cost of debt capital used by a business
plus the amount of profit that the business should earn for its equity
sources of capital to justify the use of the equity capital during the
period. Interest is a contractual and definite amount for a period,
whereas the profit that a business should earn on the equity capital
employed during the period is not. A business should set a definite goal
of earning at least a certain minimum return on equity (ROE) and compare
its actual performance for the period against this goal. The costs of
debt and equity capital are combined into either a before-tax rate or an
after-tax rate for capital investment analysis.


Cost of Capital

The minimum rate of return a company must earn in order to meet
the rate of return required by the investors (providers of capital) of
the company


Cost of capital

The blended cost of a companyís currently outstanding debt instruments
and equity, weighted by the comparative proportions of each one. During a capital
budgeting review, the expected return from a capital purchase must exceed this cost
of capital, or else a company will experience a net loss on the transaction.


Cost of Capital

The discount rate that should be used in the capital budgeting process.




Related Terms:

Average cost of capital

A firm's required payout to the bondholders and to the stockholders expressed as a
percentage of capital contributed to the firm. Average cost of capital is computed by dividing the total
required cost of capital by the total amount of contributed capital.


Opportunity cost of capital

Expected return that is foregone by investing in a project rather than in
comparable financial securities.


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Weighted average cost of capital

Expected return on a portfolio of all the firm's securities. Used as a hurdle
rate for capital investment.


Weighted average cost of capital

See cost of capital.


weighted-average cost of capital

Weighted means that the proportions of
debt capital and equity capital of a business are used to calculate its
average cost of capital. This key benchmark rate depends on the interest
rate(s) on its debt and the ROE goal established by a business. This is a
return-on-capital rate and can be applied either on a before-tax basis or
an after-tax basis. A business should earn at least its weighted-average
rate on the capital invested in its assets. The weighted-average cost-ofcapital
rate is used as the discount rate to calculate the present value
(PV) of specific investments.


Weighted Average Cost of Capital (WACC)

The weighted average of the costs of the capital components
(debt, preferred stock, and common stock)


cost of capital (COC)

the weighted average cost of the
various sources of funds (debt and stock) that comprise a
firmís financial structure


opportunity cost of capital

the highest rate of return that
could be earned by using capital for the most attractive alternative
project(s) available


weighted average cost of capital

a composite of the cost of the various sources of funds that comprise a firmís capital structure; the minimum rate of return that must be earned on new investments so as not to dilute shareholder value


company cost of capital

Expected rate of return demanded by investors in a company, determined by the average risk of the companyís assets and operations.


opportunity cost of capital

Expected rate of return given up by investing in a project.


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project cost of capital

Minimum acceptable expected rate of return on a project given its risk.


weighted-average cost of capital (WACC)

Expected rate of return on a portfolio of all the firmís securities, adjusted for tax savings due to interest payments.



User Cost of Capital

The implicit annual cost of investing in physical capital, determined by things such as the interest rate, the rate of depreciation of the asset, and tax regulations. What would be paid to rent this capital if a rental market existed for it.


Weighted Average Cost of Capital (WACC)

A weighted average of the component costs of debt, preferred shares, and common equity. Also called the composite cost of capital.


Cost of limited partner capital

The discount rate that equates the after-tax inflows with outflows for capital
raised from limited partners.


capitalization of costs

When a cost is recorded originally as an increase
to an asset account, it is said to be capitalized. This means that the outlay
is treated as a capital expenditure, which becomes part of the total
cost basis of the asset. The alternative is to record the cost as an expense
immediately in the period the cost is incurred. capitalized costs refer
mainly to costs that are recorded in the long-term operating assets of a
business, such as buildings, machines, equipment, tools, and so on.


Aggressive Cost Capitalization

cost capitalization that stretches the flexibility within generally
accepted accounting principles beyond its intended limits, resulting in reporting as assets
items that more reasonably should have been expensed. The purpose of this activity is likely to
alter financial results and financial position in order to create a potentially misleading impression
of a firm's business performance or financial position.


Capitalized Cost An expenditure or accrual that is reported as an asset to be amortized against

future-period revenue.


Costs Capitalized in Stealth

A particularly egregious form of aggressive cost capitalization
where inappropriately capitalized costs are hidden within other unrelated account balances.


Capital Cost Allowance (CCA)

The annual depreciation expense allowed by the Canadian Income Tax Act.


Undepreciated Capital Costs

The tax definition of the value of an asset that is eligible for tax deprecation.


Capital rationing

Placing one or more limits on the amount of new investment undertaken by a firm, either
by using a higher cost of capital, or by setting a maximum on parts of, and/or the entirety of, the capital
budget.



Government sponsored enterprises

Privately owned, publicly chartered entities, such as the Student Loan
Marketing Association, created by Congress to reduce the cost of capital for certain borrowing sectors of the
economy including farmers, homeowners, and students.


Growth stock

Common stock of a company that has an opportunity to invest money and earn more than the
opportunity cost of capital.


WACC

See: Weighted average cost of capital.


Discounted cash flow (DCF)

A method of investment appraisal that discounts future cash flows to present value using a discount rate, which is the risk-adjusted cost of capital.


Economic Value Added (EVA)

Operating profit, adjusted to remove distortions caused by certain accounting rules, less a charge
to cover the cost of capital invested in the business.


Internal rate of return (IRR)

A discounted cash flow technique used for investment appraisal that calculates the effective cost of capital that produces a net present value of zero from a series of future cash flows and an
initial capital investment.


Residual income (RI)

The profit remaining after deducting from profit a notional cost of capital on the investment in a business or division of a business.


discounted cash flow (DCF)

Refers to a capital investment analysis technique
that discounts, or scales down, the future cash returns from an
investment based on the cost-of-capital rate for the business. In essence,
each future return is downsized to take into account the cost of capital
from the start of the investment until the future point in time when the
return is received. Present value (PV) is the amount resulting from discounting
the future returns. Present value is subtracted from the entry
cost of the investment to determine net present value (NPV). The net
present value is positive if the present value is more than the entry cost,
which signals that the investment would earn more than the cost-ofcapital
rate. If the entry cost is more than the present value, the net
present value is negative, which means that the investment would earn
less than the businessís cost-of-capital rate.


return on assets (ROA)

Although there is no single uniform practice for
calculating this ratio, generally it equals operating profit (before interest
and income tax) for a year divided by the total assets that are used to
generate the profit. ROA is the key ratio to test whether a business is
earning enough on its assets to cover its cost of capital. ROA is used for
determining financial leverage gain (or loss).


Cost of Common Stock

The rate of return required by the investors in the common stock of
the company. A component of the cost of capital.


Cost of Debt

The cost of debt (bonds, loans, etc.) that a company is charged for
borrowing funds. A component of the cost of capital.


Cost of Preferred Stock

The rate of return required by the investors in the preferred stock of
a company. A component of the cost of capital.


discount rate

the rate of return used to discount future cash
flows to their present value amounts; it should equal or
exceed an organizationís weighted average cost of capital


economic value added (EVA)

a measure of the extent to which income exceeds the dollar cost of capital; calculated
as income minus (invested capital times the cost of capital percentage)


optimal mix of capital

the combination of capital sources at which the lowest weighted average cost of capital is achieved


Hurdle rate

The minimum rate of return that a capital purchase proposal must pass
before it can be authorized for acquisition. The hurdle rate should be no lower than
a companyís incremental cost of capital.


Net present value

A discounted cash flow methodology that uses a required rate of
return (usually a firmís cost of capital) to determine the present value of a stream of
future cash flows, resulting in a net positive or negative value.


carrying costs

costs of maintaining current assets, including opportunity cost of capital.


residual income

Also called economic value added. Profit minus cost of capital employed.


WACC

See weighted-average cost of capital.


Net Present Value (NPV) Method

A method of ranking investment proposals. NPV is equal to the present value of the future returns, discounted at the marginal cost of capital, minus the present value of the cost of the investment.


Accelerated cost recovery system (ACRS)

Schedule of depreciation rates allowed for tax purposes.


Agency cost view

The argument that specifies that the various agency costs create a complex environment in
which total agency costs are at a minimum with some, but less than 100%, debt financing.


Agency costs

The incremental costs of having an agent make decisions for a principal.


All-in cost

Total costs, explicit and implicit.


Bankruptcy cost view

The argument that expected indirect and direct bankruptcy costs offset the other
benefits from leverage so that the optimal amount of leverage is less than 100% debt finaning.


Capital

Money invested in a firm.


Capital account

Net result of public and private international investment and lending activities.


Capital allocation

decision Allocation of invested funds between risk-free assets versus the risky portfolio.


Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security
plus a risk premium.


Capital budget

A firm's set of planned capital expenditures.


Capital budgeting

The process of choosing the firm's long-term capital assets.


Capital expenditures

Amount used during a particular period to acquire or improve long-term assets such as
property, plant or equipment.


Capital flight

The transfer of capital abroad in response to fears of political risk.


Capital gain

When a stock is sold for a profit, it's the difference between the net sales price of securities and
their net cost, or original basis. If a stock is sold below cost, the difference is a capital loss.


Capital gains yield

The price change portion of a stock's return.


Capital lease

A lease obligation that has to be capitalized on the balance sheet.


Capital loss

The difference between the net cost of a security and the net sale price, if that security is sold at a loss.


Capital market

The market for trading long-term debt instruments (those that mature in more than one year).


Capital market efficiency

Reflects the relative amount of wealth wasted in making transactions. An efficient
capital market allows the transfer of assets with little wealth loss. See: efficient market hypothesis.


Capital market imperfections view

The view that issuing debt is generally valuable but that the firm's
optimal choice of capital structure is a dynamic process that involves the other views of capital structure (net
corporate/personal tax, agency cost, bankruptcy cost, and pecking order), which result from considerations of
asymmetric information, asymmetric taxes, and transaction costs.


Capital market line (CML)

The line defined by every combination of the risk-free asset and the market portfolio.


Capital structure

The makeup of the liabilities and stockholders' equity side of the balance sheet, especially
the ratio of debt to equity and the mixture of short and long maturities.


Capital surplus

Amounts of directly contributed equity capital in excess of the par value.


Capitalization

The debt and/or equity mix that fund a firm's assets.


Capitalization method

A method of constructing a replicating portfolio in which the manager purchases a
number of the largest-capitalized names in the index stock in proportion to their capitalization.


Capitalization ratios

Also called financial leverage ratios, these ratios compare debt to total capitalization
and thus reflect the extent to which a corporation is trading on its equity. capitalization ratios can be
interpreted only in the context of the stability of industry and company earnings and cash flow.


Capitalization table

A table showing the capitalization of a firm, which typically includes the amount of
capital obtained from each source - long-term debt and common equity - and the respective capitalization
ratios.


Capitalized

Recorded in asset accounts and then depreciated or amortized, as is appropriate for expenditures
for items with useful lives greater than one year.


Capitalized interest

Interest that is not immediately expensed, but rather is considered as an asset and is then
amortized through the income statement over time.


Carring costs

costs that increase with increases in the level of investment in current assets.


Complete capital market

A market in which there is a distinct marketable security for each and every
possible outcome.


Cost company arrangement

Arrangement whereby the shareholders of a project receive output free of
charge but agree to pay all operating and financing charges of the project.


Cost of carry

Related: Net financing cost


Cost of funds

Interest rate associated with borrowing money.


Cost of lease financing

A lease's internal rate of return.


Cost-benefit ratio

The net present value of an investment divided by the investment's initial cost. Also called
the profitability index.


Dedicated capital

Total par value (number of shares issued, multiplied by the par value of each share). Also
called dedicated value.


Efficient capital market

A market in which new information is very quickly reflected accurately in share
prices.


Equivalent annual cost

The equivalent cost per year of owning an asset over its entire life.


Execution costs

The difference between the execution price of a security and the price that would have
existed in the absence of a trade, which can be further divided into market impact costs and market timing
costs.


Financial distress costs

Legal and administrative costs of liquidation or reorganization. Also includes
implied costs associated with impaired ability to do business (indirect costs).


Fixed cost

A cost that is fixed in total for a given period of time and for given production levels.


Friction costs

costs, both implied and direct, associated with a transaction. Such costs include time, effort,
money, and associated tax effects of gathering information and making a transaction.


Hard capital rationing

capital rationing that under no circumstances can be violated.


Human capital

The unique capabilities and expertise of individuals.


Incremental costs and benefits

costs and benefits that would occur if a particular course of action were
taken compared to those that would occur if that course of action were not taken.


Information costs

Transaction costs that include the assessment of the investment merits of a financial asset.
Related: search costs.


Issued share capital

Total amount of shares that are in issue. Related: outstanding shares.


Legal capital

Value at which a company's shares are recorded in its books.


Long-term debt/capitalization

Indicator of financial leverage. Shows long-term debt as a proportion of the
capital available. Determined by dividing long-term debt by the sum of long-term debt, preferred stock and
common stockholder equity.



 

 

 

 

 

 

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