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cost of capital

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Definition of cost of capital

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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 blended cost of a company’s 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 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

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


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 required return for a capital budgeting project.




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.


company cost of capital

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


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cost of capital (COC)

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


Opportunity cost of capital

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


opportunity cost of capital

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


opportunity cost of capital

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


project cost of capital

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


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

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.


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weighted average cost of capital

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


Weighted Average Cost of Capital (WACC)

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



weighted-average cost of capital (WACC)

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


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.


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.


Capital Cost Allowance (CCA)

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


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.


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

future-period revenue.


Cost of limited partner capital

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


Costs Capitalized in Stealth

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


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.



carrying costs

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


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 organization’s 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.


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 business’s cost-of-capital rate.


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.


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)


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.


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 company’s incremental cost of capital.


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.


Net present value

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


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.


optimal mix of capital

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


residual income

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


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.


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).


WACC

See: Weighted average cost of capital.


WACC

See weighted-average cost of capital.


"Soft" Capital Rationing

capital rationing that under certain circumstances can be violated or even viewed
as made up of targets rather than absolute constraints.


Absorption costing

A method of costing in which all fixed and variable production costs are charged to products or services using an allocation base.


absorption costing

a cost accumulation and reporting
method that treats the costs of all manufacturing components
(direct material, direct labor, variable overhead, and
fixed overhead) as inventoriable or product costs; it is the
traditional approach to product costing; it must be used for
external financial statements and tax returns


Absorption costing

A methodology under which all manufacturing costs are assigned
to products, while all non-manufacturing costs are expensed in the current period.


Accelerated cost recovery system (ACRS)

Schedule of depreciation rates allowed for tax purposes.


Activity-based costing

A method of costing that uses cost pools to accumulate the cost of significant business activities and then assigns the costs from the cost pools to products or services based on cost drivers.


activity based costing (ABC)

A relatively new method advocated for the
allocation of indirect costs. The key idea is to classify indirect costs,
many of which are fixed in amount for a period of time, into separate
activities and to develop a measure for each activity called a cost driver.
The products or other functions in the business that benefit from the
activity are allocated shares of the total indirect cost for the period based
on their usage as measured by the cost driver.


activity-based costing (ABC)

a process using multiple cost drivers to predict and allocate costs to products and services;
an accounting system collecting financial and operational
data on the basis of the underlying nature and extent
of business activities; an accounting information and
costing system that identifies the various activities performed
in an organization, collects costs on the basis of
the underlying nature and extent of those activities, and
assigns costs to products and services based on consumption
of those activities by the products and services


Activity-based costing (ABC)

A cost allocation system that compiles costs and assigns
them to activities based on relevant activity drivers. The cost of these activities can
then be charged to products or customers to arrive at a much more relevant allocation
of costs than was previously the case.


Actual cost

The actual expenditure made to acquire an asset, which includes the supplierinvoiced
expense, plus the costs to deliver and set up the asset.


actual cost system

a valuation method that uses actual direct
material, direct labor, and overhead charges in determining
the cost of Work in Process Inventory


Additional paid-in capital

Amounts in excess of the par value or stated value that have been paid by the public to acquire stock in the company; synonymous with capital in excess of par.


Additional paid-in capital

Any payment received from investors for stock that exceeds
the par value of the stock.


additional paid-in capital

Difference between issue price and par value of stock. Also called capital surplus.


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.


Aggressive Capitalization Policies

capitalizing and reporting as assets significant portions of
expenditures, the realization of which require unduly optimistic assumptions.


All-in cost

Total costs, explicit and implicit.


Amortized Cost

cost of a security adjusted for the amortization of any purchase premium or
discount.


appraisal cost

a quality control cost incurred for monitoring
or inspection; compensates for mistakes not eliminated
through prevention activities


attribute-based costing (ABC II)

an extension of activitybased costing using cost-benefit analysis (based on increased customer utility) to choose the product attribute
enhancements that the company wants to integrate into a product


authorized share capital

Maximum number of shares that the company is permitted to issue, as specified in the firm’s articles of incorporation.


Average-Cost Inventory Method

The inventory cost-flow assumption that assigns the average
cost of beginning inventory and inventory purchases during a period to cost of goods sold and
ending inventory.


Avoidable costs

costs that are identifiable with and able to be influenced by decisions made at the business
unit (e.g. division) level.


backflush costing

a streamlined cost accounting method that speeds up, simplifies, and reduces accounting effort in an environment that minimizes inventory balances, requires
few allocations, uses standard costs, and has minimal variances
from standard


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.


Batch cost

A cost that is incurred when a group of products or services are produced,
and which cannot be identified to specific products or services within each group.


batch-level cost

a cost that is caused by a group of things
being made, handled, or processed at a single time


budgeted cost

a planned expenditure


Capital

Money invested in a firm.


CAPITAL

The money, raised by selling stock or bonds or taking out loans, that you use to start, operate, and grow a business.


Capital

The shareholders’ investment in the business; the difference between the assets and liabilities
of a business.


capital

A very broad term rooted in economic theory and referring to
money and other assets that are invested in a business or other venture
for the general purpose of earning a profit, or a return on the investment.
Generally speaking, the sources of capital for a business are
divided between debt and equity. Debt, as you know, is borrowed money
on which interest is paid. Equity is the broad term for the ownership
capital invested in a business and is most often called owners’ equity.
Owners’ equity arises from two quite different sources: (1) money or
other assets invested in the business by its owners and (2) profit earned
by the business that is retained and not distributed to its owners (called
retained earnings).


Capital

The investment by a company’s owners in a business, plus the impact of any
accumulated gains or losses.


Capital

a) Physical capital: buildings, equipment, and any materials used to produce other goods and services in the future rather than being consumed today.
b) Financial capital: funds available for acquiring real capital.
c) Human capital: the value of the education and experience that make people more productive.


Capital

Expenditures Purchases of productive long-lived assets, in particular, items of property,
plant, and equipment.


Capital

Any asset or stock of assets, financial or physical, capable of producing income.


Capital account

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


Capital Account

That part of the balance of payments accounts that records demands for and supplies of a currency arising from purchases or sales of assets.


Capital allocation

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


capital asset

an asset used to generate revenues or cost savings
by providing production, distribution, or service capabilities
for more than one year


Capital asset

A fixed asset, something that is expected to have long-term usage within
a company, and which exceeds a minimum dollar amount (known as the capitalization
limit, or cap limit).


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 Asset Pricing Model (CAPM)

A model for estimating equilibrium rates of return and values of
assets in financial markets; uses beta as a measure of asset risk
relative to market risk


capital asset pricing model (CAPM)

Theory of the relationship between risk and return which states that the expected risk
premium on any security equals its beta times the market risk premium.


Capital budget

A firm's set of planned capital expenditures.


capital budget

management’s plan for investments in longterm
property, plant, and equipment


capital budget

List of planned investment projects.


Capital budgeting

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


capital budgeting

Refers generally to analysis procedures for ranking
investments, given a limited amount of total capital that has to be allocated
among the various capital investment opportunities of a business.
The term sometimes is used interchangeably with the analysis techniques
themselves, such as calculating present value, net present value,
and the internal rate of return of investments.



 

 

 

 

 

 

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