Chapter 9, Problem 1RQ

Define the term cost of capital.

Summary Introduction

To determine: The term cost of capital.

Explanation of Solution

The cost of capital is the rate of return that the company should earn on its investments in order to satisfy the required rates of return of all the company’s foundations of financing (comprising creditors who credit the corporation’s money and owners who acquire shares of stock in the corporation).

 This rate is a function of the essential rates of return for all the company’s sources of financing, the company’s tax rate, and the initiation costs suffered in issuing new securities. Thus, the cost of capital regulates the rate of return that should be achieved on the corporation’s investments to make the target return of the company’s investors.