In simplest terms, the cost of capital is the return necessary to make a capital budgeting project worthwhile. A firm's total cost of capital is based on its cost of debt and cost of equity. This determines how the company can raise funds to invest in new projects or fund expanding operations. It can be raised through debt, equity or a combination of the two. It can also be defined as the rate of return the firm could earn by investing in a project with a similar risk coefficient. Two types of risk are considered; systemic risk is the risk inherent in the market or the system than cannot be diversified away. Will business get better or worse? The second risk category is unsystematic risk or the risk in a specific investment or project. It can be managed by creating a portfolio of projects or investments that bring the overall risk coefficient into line with the market risk. In the CAPM (a formula to relate risk and expected return) the risk relative to the market is the ( coefficient or simply (. (McClure, 2008)
What is marginal cost of capital and how does it differ from weighted average cost of capital?
Weighted average cost of capital is a weighted average of the cost of each component of the firm's capital structure, junior debt, equity, senior debt, and preferred stock. Strictly speaking, the marginal cost of capital is the cost of raising one additional dollar or unit of capital. The marginal cost will vary based on the type of security used to raise the incremental unit of capital. This in turn will vary to reflect the increase risk of subordinated debt to senior debt and the risk of equity to subordinated debt. (Investor Words, 2008) Obviously, as the perceived risk rises, the cost of capital increases. For "growth stocks" the rate of return on the asset calculated on increasing earnings multiples can provide some interesting distortions in bull markets. Average cost melds all the forms of capital source...