CHAPTER 1

Defining Cost of Capital

INTRODUCTION

The cost of capital is the expected rate of return that market participants require in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment is an opportunity cost—the cost of foregoing the next best alternative investment. In this sense, it relates to the economic principle of substitution; that is, an investor will not invest in a particular asset if there is a more attractive substitute available at the same price.

The term market refers to the universe of investors who are reasonable candidates to fund a particular investment. Capital or funds are usually provided in the form of cash, although in some instances capital may be provided in the form of other assets. The cost of capital is usually expressed in percentage terms, that is, the annual amount of dollars that the investor requires or expects to realize from the investment, expressed as a percentage of the dollar amount invested.

As Ibbotson puts it:

The opportunity cost of capital is equal to the return that could have been earned on alternative investments at ...

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