The term cost of capital means the overall composite cost of capital defined as “weighted average of the cost of each specific type of fund. The use of weighted average and not the simple average is warranted by the fact that proportions of various sources of funds in the capital structure of a firm are different.
Therefore the overall cost of capital should take into account the weighted average. The weighted cost of capital based on historical weights takes into account a long-term view.
The term cost of capital, as the acceptance criterion or investment proposals, is used in the sense of the combined cot of all sources of financing. This is mainly because focus is on the valuation of the firm as a whole. It is related to the firm’s objective of wealth maximization.
Thus, the weighted average cost of funds of a company is based on the mix of equity and loan capital and their respective costs. A distinction is usually drawn between the average cost of all funds in an existing balance sheet and the marginal cost of raising new funds.
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