Cost of capital is the return a business needs to take on a capital project, such as buying new equipment or building a new building. According to Solomon Ezra cost of the capital is the minimum required rate of earnings or the cart-off rate of expenditure. Then according to James C. Vans Horne, the cost of capital represents a cart-off rate for the allocation of capital to investment of project. It is the rate-off return on the project that will leave unchanged the market price of the stock. Companies that develop in industry will face capital costs. However, companies need to find solutions to overcome their problems, and they need to estimate their capital costs. There are several problems to estimating the cost of capital such conceptual controversies regarding the relationship between the cost of capital and the capital structure, historic cost and future cost and so on.
Firstly, the problems that occur in companies are conceptual controversies regarding the relationship between the cost of capital and the capital structure. To estimating by this difference theories were put forward by distinct writers explaining the connection between capital structure, capital cost, and the companys value. This has lead to difference conceptual problems. According to the net income approach and the traditional theories, both the capital cost and the firms value are directly related to the funding technique and level. In their view by using debt funding, a company can minimize the weighted average capital expenses and boost the firms value.
The second issue, however, is estimated by historical costs and future cost. Another issue in determining the cost of capital arises because of the difference of opinion as to the concept of cost itself. It is argue that historical cost are book cost debt are related to the past irrelevant in the decision making process. Future estimated expenses are, in their view, more important to decisions making. Similarly, arguments for particular cost and composite cost as well as explicit cost and implicit cost and marginal cost are put forward.
The others issue is in computation of cost of equity. The price calculation of equity capital relies on its investor anticipated rates of return. But the quantifying equity shareholders expectation is a very challenging job because they are many variables that affect a firms valuation.
However, others problem is in computation of cost of retained earnings. It is sometimes asserted that there is no cost associated with retained earnings. But in fact dividend foregone by their investor are the opportunity cost since various shareholder may have distinct possibilities to invest their dividend the price of retained income becomes very hard to calculate.
Lastly, the others issue is problems in assigning weight. Weighted must be a located to the particular price of individual resources of finance to determine the weighted average cost of assets. Choosing to used the sources book value or sources market value present another issue in determining capital cost.
The conclusion that we can conclude is that by estimating the cost of capital that the company is facing, some issues for the companies will be resolved.
