DETERMINATION OF THE COST OF CAPITAL
The cost of capital can either be explicit or implicit. The cash outflow of an entity towards the utilization of capital which is clear and obvious is termed as explicit cost of capital. These outflows may be interest payment to debenture holders, repayment of principal amount to financial institution or payment of dividend to shareholders etc. On the other hand Implicit cost is the cost which is actually not a cash outflow but it is an opportunity loss of foregoing a better investment opportunity by choosing an alternative option. An entrepreneur for example, uses its bank deposits which earns interest @ of 9% p.a. for the business purpose. Using its bank deposits for business purpose means forgoing interest earnings from the bank on this deposit. The cost of capital in this case will be 9% interest that could have been earned by not investing the deposit for the business purpose. This opportunity loss of 9% is called implicit cost capital or opportunity cost.
The two factors which are considered to determine the cost of capital are:
(i) Source of Finance
(ii) Reciprocal payment of the using finance.
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