Explain a company's cost of capital and how it is calculated Essay

Explain a company's cost of capital and how it is calculated - Essay Example This means that since the investor provided the capital, there is a rate of return that would be demanded by them to compensate them for the time value of their money and the risk that they have to incur in investing. For this risk, cost of capital is sometimes called as hurdle rate. And for a project to be considered approved, it must earn more than its hurdle rate. The cost of capital determines how a company can raise money through issuing bonds, borrowing or both (Invetopedia.com, 2011). Determining the cost of capital is important in capital budgeting, determination of a company’s Economic Value Added (EVA), deciding when to lease or purchase of assets and regulation of electric, gas and telephone companies. The cost of capital is specific to each particular type of capital that the company uses (Moneyterms.co.uk, 2011). It could be the cost of equity or the cost of debt or the combination of both. The cost of equity is the rate of return on equity required by a company i mplicitly estimated using valuation ratios. The differences in the cost of equity is an important component of differences in the ratings at which different companies and sectors trade. The cost of capital of a security is for the valution of the securities.