Components of Cost of Capital
Cost of capital or discount rate or the required rate of return is an annual compounded percentage rate of return, which is used to discount back each increment of expected future return to a present value (Pratt, 2004). It is forward looking and also represents the expectations of the investors. There are three basic components of cost of capital. The first component is the real rate of return that is expected by the investors in exchange for allowing other people to use their money on a riskless basis (Pratt and Grabowski, 2010). The another component is expected inflation, which relates to the anticipated decrease in the purchasing power while the money is tied up. The third component is the risk, which represents to the uncertainty in relation to the cash flow or other economic income in terms of how and when the cash flow will be received (Pratt, 2004).
It is assessed that the combination of first two components such as expected return and inflation presents the term time value of money that remains same for all investment projects of the same expected duration (Pratt, 2004). Although, for different investors, these expectations may vary, however the market inclines to form an opinion. Additionally, to determine the cost of capital for investments of different risk levels, the evaluators analysis different factors causing uncertainty of returns. It is found that a firm's overall cost of capital is determined by estimating the cost of debt capital, cost of equity capital and cost of preference share capital (Pratt and Grabowski, 2010).
References
Pratt, S. P. (2004) Business Valuation Body of Knowledge: Exam Review and Professional Reference. John Wiley & Sons.
Pratt, S. P., and Grabowski, R. J. (2010) Cost of Capital: Applications and Examples. USA: John Wiley & Sons.