Cost of Capital Part I

You may have heard a lot of people talking about the cost of capital of running a business. With consideration of the number of people who use the term on an off-hand basis every day, one would think that they understand the meaning of the term very clearly. But the the truth is quite contrary. Which is why this post will clear all your doubts and misconceptions about cost of capital.

Now before we dive into the main concept, first let’s clear the basics up. A business which is run by a company usually gets the money to run the business from other people. In other words, the company borrows the money from ordinary people like you and me and uses it pay for its expenses of running and buying stuff it needs for the business.

But why would we give the company our money? Why, in return for a guarantee of either a share in the profits of the company, or a share in the management and ownership of the company or for the guarantee of getting more money back than originally lent. The company issues securities or declarations in proof of these promises. These securities are almost as valid as money and can be used by you to take loans for yourself or to pay off some of your own debts.

The money that the company takes from us is its capital and the guarantee is gives us (whether of greater return, or share of profits or ownership) is the cost of that capital to the company. Now, if you have been paying attention this far, then you would have noticed that we have talked about three different types of capital and the three different costs associated with them. Now it’s time to delve deeper.

Firstly, the three types of capital have names by which they are known universally. These are:

          Preference Share Capital: Obtained in exchange of Share of Profit

          Equity Share Capital: Obtained in exchange of Share in Ownership and/or Management

          Debentures and Loans: Obtained in exchange of Greater Returns, usually in the form of Interest compounded at a determined rate for a determined term.

It’s also important to know that the first two types are considered to be owned capital of the company while the last represents borrowed capital. But wait! I just told you that all capital is borrowed! So what’s all this? Watch out for my next post! In the meantime, any comments and questions will be appreciated and answered.