what is the meaning of cost of capital?

Answer 1

There are basically two kinds of capital...debt and equity. They both have a cost associated with them. The cost of debt is basically the interest that the company pays for the use of the borrowed funds, expressed as an interest rate. The cost of equity is essentially the rate of return that is expected by the shareholders, given the industry and risk characteristics of the company. This is also expressed as a percentage. Most firms use what is called the "weighted average cost of capital" which, in a nutshell, is the proportion of equity in the firm's capital structure times the expected return on equity, plus the proportion of debt in the capital structure times the interest rate on the debt.

Why is the weighted average cost of capital important? When a firm decides whether or not to take on a project, if it is not expected to return at least the weighted average cost of capital, the stock price will drop and the shareholders are worse off. If the firm can't find any investments or projects that pay more than the cost of capital to invest their excess capital in, they may then just pay it to the shareholders as dividends.

EDIT: When figuring the cost of debt, you have to bear in mind that the firm gets tax deductions for the interest on their debt payments, so the interest rate should be an "after tax" interest rate.

Answer 2

imagine that you all of a sudden have $100,000. you could be stupid and put it in a can and bury it or put it into your mattress. or, you could invest it. you could put it in the bank at say 5% interest, or you could buy a mixture of stocks and hope to make 6-10% per year over a period of years. the cost of capital is the amount of money that other people have to pay to use your money.

Answer 3

I guess it is the consideration for securing the use of capital and it translates to prevailing interest rates/charges plus other related charges.

Answer 4

http://en.wikipedia.org/wiki/Cost_of_capital