The cost of capital define as the minimum rate of return a firm must earn on its investment in order to satisfy investors and to maintain its market value. It is the investors required rate of return. Cost of capital also refers to the discount rate which is used while determining the present value of estimated future cash flows. The major classification of cost of capital are:
- Historical Cost and future Cost: Historical Cost represents the cost which has already been incurred for financing a project. It is calculated on the basis of the past data. Future cost refers to the expected cost of funds to be raised for financing a project. Historical costs help in predicting the future costs and provide an evaluation of the past performance when compared with standard costs. In financial decisions future costs are more relevant than historical costs.
- Specific Costs and Composite Cost: Specific costs refer to the cost of a specific source of capital such as equity shares, Preference shares, debentures, retained earnings etc. Composite cost of capital refers to the combined cost of various sources of finance. In other words, it is a weighted average cost of capital. It is also termed as ‘overall costs of capital’. While evaluating a capital expenditure proposal, the composite cost of capital should be as an acceptance/ rejection criterion. When capital from more than one source is employed in the business, it is the composite cost which should be considered for decision-making and not the specific cost. But where capital from only one source is employed in the business, the specific cost of those sources of capital alone must be considered.
- Average Cost and Marginal Cost: Average cost of capital refers to the weighted average cost of capital calculated on the basis of cost of each source of capital and weights are assigned to the ratio of their share to total capital funds. Marginal cost of capital may be defined as the ‘Cost of obtaining another dollar of new capital.’ When a firm raises additional capital from only one sources (not different sources), than marginal cost is the specific or explicit cost. Marginal cost is considered more important in capital budgeting and financing decisions. Marginal cost tends to increase proportionately as the amount of debt increase.
- Explicit Cost and Implicit Cost: Explicit cost refers to the discount rate which equates the present value of cash outflows or value of investment. Thus, the explicit cost of capital is the internal rate of return which a firm pays for procuring the finances. If a firm takes interest free loan, its explicit cost will be zero percent as no cash outflow in the form of interest are involved. On the other hand, the implicit cost represents the rate of return which can be earned by investing the funds in the alternative investments. In other words, the opportunity cost of the funds is the implicit cost. Implicit cost is the rate of return with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted. Thus implicit cost arises only when funds are invested somewhere, otherwise not. For example, the implicit cost of retained earnings is the rate of return which the shareholder could have earn by investing these funds, if the company would have distributed these earning to them as dividends. Therefore, explicit cost will arise only when funds are raised whereas implicit cost arises when they are used.