Ex. 17. Read the text quickly to find the sentences giving a definition of the cost of capital:
Capital Structure and Cost of Capital
The capital structure refers to the weight which different types of capital have in the total capital employed. The question of capital structure becomes particularly significant when a choice of debt and equity capital is made. The relationship between the long-term debt and equity capital invested in the business is called gearing.
Gearing is the indicator of the relative proportion of debt capital and equity capital. The higher the proportion of debt, the more highly geared is the company. The degree of gearing affects the overall cost of capital.
The conventional view is that at very low levels of gearing debt capital will be cheaper than equity capital because the level of risk is low, with debt interest being a prior charge. The overall cost of capital is thus brought down with the use of debt. As the debt-equity ratio increases, interest becomes a bigger proportion of expected profits. The higher the gearing, the more exposed the company is at times of economic difficulty.
The concept is difficult to measure in practice. The most elementary measure is nominal value of fixed-interest capital versus nominal value of equity capital.
The ratio has limitations as it ignores some types of interest-bearing finance such as bank loans and mortgages.
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Cost of capital is the cost measured as a percentage rate of the various sources of capital required to finance capital expenditure. All sources of capital have a cost which can be a direct one as, say, with a loan or an opportunity cost as, say, with retained earnings. At any time a company's cost of capital will be the weighted average of the cost of each type of capital: ordinary shares, preference shares and long-term debt.
Companies have a choice of the capital structure which they adopt and will generally try to minimize the overall cost of capital in making their choice.
Ex. 18. Read the text quickly to find the answer to the following question: