The term cost of capital, as a decision criterion, is the overall cost. This is the combined cost of the specific costs associated with specific sources of financing. The cost of the different sources of financing represents the components of the combined cost. The computation of the cost of capital, therefore, involves two steps: (i) the computation of the different elements of the cost in terms of the cost of the different sources of finance (specific costs), and (ii) the calculation of the overall, cost by combining the specific costs into a composite cost.

The first step in the measurement of the cost of capital of the firm is the calculation of the cost of individual sources of raising funds. Apart from its relevance to the measurement of the combined cost, the specific cost will also indicate the relative cost of pursuing one line of financing rather than another. From the viewpoint of capital budgeting decision, the long-term sources of funds are relevant as they constitute the major sources of financing of fixed assets. In calculating the cost of capital, therefore, the focus is on long-term funds. In other words, the specific costs have to be calculated for (i) long-term debt (including debentures); (ii) preference shares; (iii) equity capital, and (iv) retained earnings.

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