Page 82 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

4.6 Keywords Notes

Cost of Capital: It is that minimum rate of return, which a firm must earn on its investments so
as to maintain the market value of its shares.

Explicit Cost: It is the discount rate that equates the present value of the cash inflows with the
present value of its increments cash outfl ows.

Future Cost: It is the cost of capital that is expected to raise the funds to finance a capital budget
or investment proposal.
Implicit Cost: It is the cost of opportunity which is given up in order to pursue a particular
action.
Marginal Cost of Capital: The additional cost incurred to obtain additional funds required by a
fi rm.

Opportunity Cost: The benefit that the shareholder foregoes by not putting his/her funds
elsewhere because they have been retained by the management.
Specifi c Cost: It is the cost associated with particular component or source of capital.

Spot Cost: The cost that are prevailing in the market at a certain time.

4.7 Self Assessment

Fill in the blanks:
1. Cost of capital is the ....................... required rate of return expected by investors.

2. Cost of capital, is the measurement sacrifice made by ....................... with regard to capital
formation.
3. According to ....................... cost of capital is the minimum required rate of earnings or the
cut off rate of capital expenditure.
4. Cost of Capital (K ) = r + ....................... +f.
f
o
5. The explicit cost is the ......................., which equates the present value of cash infl ows with
present value of cash outfl ows.

6. An average of the cost of each source of funds employed by the firm for capital formation
is known as ....................... .

7. Cost of capital is not useful in capital budgeting if a firm is depended on .......................
methods.
8. ....................... is the additional cost incurred to obtain additional funds required by a fi rm.
9. Bond yield plus ....................... is one of the approaches available to calculate cost of equity
capital.
10. ....................... is the cost associated with particular component at capital structure.
State whether the following statements are true or false:
11. Cost of capital comprises three components.
12. Cost of capital with minimum required rate of return needs to be justifi ed.

13. There is no cost for internally generated funds.

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