 Corporate managers are required to work for the consistent growth of the corporate firm for the longer period of time through the acquisition of profitable investments. Now we know that these investments are acquired through funds derived from both internal and external sources and the usage of funds from these sources is not free as they have to incur a certain cost and borne it by the corporate entity. That cost is generally known as the cost of capital. Now it is primary job of a corporate manager to earn revenue more than this cost of capital as this is the only way to ensure value creation for the corporate owners. By cost of capital we mean the rate of return by capital providers as the compensation for their financial contribution or money contribution to the firm's overall pool of the funds. This cost of capital can also be seen as an opportunity cost of funds for the capital providers. Now it is necessary that this required rate of return demanded by an investor should correspond for the average risk investment in the company which is using these funds. There are as we have seen that there are two sources from where capital can be generated internal and external. Now in other way we can say that there are three forms of components of funds or capital that is equity which is contributed by the owners of a firm or debt that is contributed by persons or institutions external to the firm and third we have another instrument that bears the same features from both equity and the debt. I mean these are the hybrid instruments. By a hybrid we can say that an example of hybrid instrument is the preferred share or profit stock. Now an investment opportunity is always valued at its marginal cost of capital and by marginal cost of capital we means the additional funds required for a potential instrument or for potential investment this means that for any additional investment of a rupee there is an incremental cost for acquiring that additional investment and that incremental cost is termed as the marginal cost. Now the most common way to determine a component cost is the marginal cost then that marginal cost is in fact converted into the weighted average cost of capital of the firm or the WEG. WEG is generally the overall cost of capital of the firm. To determine WEG we have we need to have certain variables like weight of the components of the capital cost of the component of the capital by weights we means the proportion of various sources of capital a company may use to fund its investment. Now while determining weighted average capital of a firm there are certain factors that need to be considered by a firm at first we have taxes and the cost of capital in the list in fact we know that debt is a legal obligation for any business entity and borrowers are required to repay to the lender in form of both principle and the interest there on. Under tax laws in many countries around the globe interest is deductible to determine net income for the firm. Now tax admissibility of interest on debt is allowed in many countries as I have earlier said by allowing interest as an admissible item in fact government is subsidizing the interest cost of the borrower. To determine the cost of debt we use the symbol RD that is the cost of tax before a cost of debt before tax next we need to care of the weights used for determining the weighted value of the components of the sources of finances. By weights as I have said that weight means the proportion of each source of capital a company can use in its financial program to fund its investment plan. Remember that weights are subject to the capital structure of the company. Now what is capital structure or what is target capital structure in fact every company generally has a target capital structure for itself by target capital structure we mean a capital structure that affirm strives to have. Now weights can be developed and determined according to the target capital structure but if the target capital structure is known by the company then it is better to use the target capital structure in order to determine the weighted cost of capital. But if target capital structure is not known by the company are not known by the financial analyst then there are certain possibilities and any of the possibility can be used by the financial analyst. The first option is to use market value weights of capital components as the target capital structure. Then the second option is that examine trend in the company's capital structure or examine the management statement regarding the capital structure of the firm and try to infer the weights using these financial statements. The third option is that to use averages of the capital structure of the comparable companies as the capital structure for the company under consideration. Now in the example we have a given company with market value of its debt and market value of its equity then we have its three competitors with their market value of individual debt and individual equity component. The question is what are the garbage proportion of debt and equity that would be used if estimating these proportions using the company so we need to determine the proportional amount of debt and equity in the overall capital structure at one and then two is the competitor's capital structure so we can use the company's own current capital structure and competitor's capital structure. And in third says that Gavitch announces that a debt to equity ratio of 0.7 reflects its target capital structure then what weight would Anzyl use in the cost of capital computation so we have three options in answer one as we see that we have a capital amounts of the company itself in terms of their market value now using these market values we have a capital structure in the form of 0.45 as debt proportion and 0.54 as the equity portion so their capital structure is 0.45 and 0.54 in option two when we use the competitor's capital structure to determine the company's capital structure proportion so in this regard we first need to determine the average portion of the debt capital and then average portion of the equity capital and we see that here the three competitors are using on average 36% of debt and 64% of equity in their average capital structure in the market and in the third where the company is intended to use 0.7 as a debt then the debt equity ratio using this target capital structure comes to 0.41 and 0.59 how cost of capital can be used for certain business applications the first application that we can see is the capital budgeting in capital budgeting we in fact use the marginal cost of capital as the required rate of return which is used as a discounting factor to determine present value of the cash flows which is then used to determine the net present value of the project or proposal overall in we see that the function of marginal cost of capital how it works we know that with every amount of additional capital the marginal cost of capital goes on increases and as a result the return on investment opportunities goes down so the relationship between these three variables can be graphed under an investment opportunity schedule that we can see that as the investment opportunity schedule says the marginal cost of capital can be increased if the amount of new capital is increased the return on the investment opportunities will be go down now at a point where the marginal cost of capital is equal to the marginal return that point will be termed as the optimal capital budget in other words we can say that optimal capital budget can take place at a point where marginal cost of capital is equal to the marginal return of the investment opportunity a project's work should consider the riskiness of future cash flows and also the project's systematic risk may vary relative to the risk of the company on its overall current project portfolio also the company's work need to be adjusted accordingly now we know that a project risk adjusted vague or MAC that is the marginal average cost of capital if it is in line with the company's average risk then that is much significant for the capital budgeting decisions that are taken place on the basis of project's net present value choosing a company's varied average cost of capital for determining the project's NPV means that the project has same level of riskiness as the company's average riskiness it also means that the project will have a constant target capital structure throughout its economic or useful life the above assumptions may not be realistic or may not be appropriate or these assumptions may have certain drawbacks but the fact is that the company's vague determined in this way is widely accepted and used by financial analysts across the globe the second application or usage of cost of capital is the security valuation model to determine the value of any security there must be a discount factor that is used to determine the present value of the cash flows associated with that particular security now that discount factor is basically the weighted average cost of capital where many discounted cash flow valuation models that are available for a financial analyst but for a particular valuation model if these cash flows are the cash flows to the company's supplier of capital then these cash flows can be discounted at the company's overall vague point and if these cash flows are the cash flows to the owners then these cash flows can be discounted at the company's cost of equity which is the best discount rate for that particular purpose