Every business requires capital to invest. Therefore, capital is the most important factor of production and the cost of capital is the most significant determinant in investment decisions.

The component cost is the required return of the capital component which varies with investors’ risk. In case of debt financing, creditors’ required return mainly changes with the lending horizon and the credit-worthiness of the borrower.

Managers evaluate capital budgeting decisions according to the firm’s cost of capital. The return from the capital investments should be more than the cost of the capital utilized in financing them. Hence, cost of capital is a major criterion in capital budgeting decisions.

In case of equity financing, stockholders’ required return is altered by the riskiness of the investments undertaken by the firm.

A company may raise debt financing either through bank loans or bond issues.

A company may raise debt financing either through bank loans or bond issues. In both types of borrowing the interest rate may be either fixed or floating. If the rate is floating, then an index is used to determine the interest payments for each period.

In bond issues if the interest rate is floating and not fixed, then it is called as an indexed bond. The index can be any economic indicator but mostly it is a price index, such as the inflation rate, the oil price or the gold price index.

The cost of equity is the return a company requires to decide if an investment meets capital return requirements.

A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities.

Common equity financing is raised either by issuing new shares or by retaining the net income earned. The former is external financing while the latter is an internal source.

The CAPM estimates the required return of a stock investment in relation to its systematic risk which cannot be diversified away in a portfolio context.

The starting point in calculating the required return is the estimation of the risk-free rate (krf). In real life, there is no totally riskless investment. However in any economy, the securities issued by the Treasury are free of default risk.

Secondly, in CAPM applications the estimation of the market return, hence the market risk premium (MRP) which is the expected market return minus the risk-free rate is essential. Thirdly, the beta of the stock in question is determined. As a final step, after the estimation of all the parameters in the CAPM equation, the required return on the stock is computed, which is the cost of the common equity.

The bond-yield-plus-risk-premium approach provides a practical but highly subjective solution to the estimation of the cost of equity. The approach is based upon adding up a risk premium over the firm’s bond yield.

The WACC estimation should be based on the market values of the capital components since investors require to be compensated on the full amount of their investments at stake which is the current market value of the investment.

In order to estimate the marginal cost of capital, firstly the amount of the additional new capital that raises the cost of capital is to be determined. Then the weighted average cost of capital is calculated at that amount of new capital raised.