Defining Cost of Capital

In economic terms, the cost of capital for a particular investment is an opportunity cost-the cost of foregoing the next best alternative investment. The cost of capital is the expected return appropriate for the expected level of risk. But often, observed returns do not match expected returns. The primary components of a capital structure include: debt capital, preferred equity capital, and common equity capital. The cost of capital represents the consensus assessment of the pool of investors that are participants in a particular market. It also represents investors' expectations. There are two basic elements to these expectations: risk-free rate and risk premium. The cost of capital is estimated from market data. The essence of the cost of capital is that it is the percentage return that equates expected economic income with present value.