Cost of Capital

COST OF CAPITAL

 

The primary meaning of cost of capital is simply the cost an entity must pay to raise funds. The term can refer, for instance, to the financing cost (interest rate) a company pays when securing a loan.

 

In other words, Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.

 

The cost of various capital sources varies from company to company, and depends on factors such as its operating history, profitability, credit worthiness, etc. In general, newer enterprises with limited operating histories will have higher costs of capital than established companies with a solid track record, since lenders and investors will demand a higher risk premium for the former.

 

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