The Cost of Capital

by William Vatter



This article discusses some of the issues and approaches to measuring the "Cost of Capital," with reference to investment proposals. Economic theory views capital as a broad class of productive factors-a collection of stored services held for future rather than present consumption. It thus includes practically every accounting asset-land, building, machinery or equipment, inventories, receivables, even cash-for all of these items are bundles of postponed consumption, used to make production of other goods more efficient. Economic capital includes also the various kinds of intangibles-patents, franchises, good will, or going-concern value-even the structure of an existing organization or the advantages of "know-how" arising from research and development may be viewed as capital. There is a wide and confusing terminology that arises from the notions of capital. We have capital stock, capital surplus, capitalization, invested capital, capital funds, capital expenditures and capital budgets, capital gains and losses, to mention only a few Items. However important the cost of capital may be for theoretical purposes, it remains an imperfect tool for decision-making. But tools do not make decisions, managers do. The imperfections of tools may be offset by exercising caution in calculation, tempering measurement with judgment, and accepting responsibility for the risks that must be taken.

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