Concepts of Cost of Capital

1. Explicit Cost And Implicit Cost

The explicit cost of any source of finance may be described as the discount rate that equates the current value of the funds received by the firm net of underwriting costs, with the current value of expected cash outflows. These outflows may be interest dividend, payments, or repayment of principal.

The implicit cost is the rate of return on the best investment chance for the firm and its shareholders, which will be foregone if the project currently under consideration by the firm is accepted.

2. Future Cost And Historical Cost

Future cost defines the expected cost of funds to finance the proposed project while Historical cost defines the cost already incurred for financing a particular project.

3. Specific Cost And Combined Cost

The Cost of every component of capital (that is equity shares/preference shares/de- bentures/loans/etc) is known as definite Cost of Capital.

The Composite/Combined Cost of Capital is the entire cost of capital from all sources (that is. equity shares/preference shares/debentures/loans/etc).

4. Average Cost And Marginal Cost

The average cost of capital defines the weighted average of the cost of each component of funds employed by the firm.  The weights are in proportion of the share of every component of the share in the total capital structure.

Marginal Cost of Capital is the weighted average cost of new funds raised by the firm.