Question

Why should various concepts of cost of capital be distinguish in financial management?

Answer 1

A firm raises funds from various sources, which are called the components of capital. Different sources of fund or the components of capital have different costs. For example, the cost of raising funds through issuing equity shares is different from that of raising funds through issuing preference shares. The cost of each source is the specific cost of that source, the average of which gives the overall cost for acquir­ing capital.

The firm invests the funds in various assets. So it should earn returns that are higher than the cost of raising the funds. In this sense the minimum return a firm earns must be equal to the cost of rais­ing the fund. So the cost of capital may be viewed from two viewpoints—acquisition of funds and appli­cation of funds. From the viewpoint of acquisition of funds, it is the borrowing rate that a firm will try to minimize.