Explicit and Implicit cost of capital
Explicit cost of capital of any source is the discount rate that equates the present value of cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.It is the internal rate of return cash inflows and outflows.
I=C1/(1+k)n + C2/(1+K)N+CN/(1+K)N
I=net amount of cash inflow at time zero.
C=Cash outflow at different years.
K=Explicit cost of capital
N=Number of years.
Example- A company issues debentures of RS 100 each .The coupon rate of interest is 10%.Maturity period 3 years.The debentures are issued at Rs 100 and redeemable at Rs 100.Calculate the explicit cost of capital.
The discount rate which solves the equation is 10% so K is 10%.
Implicit cost of capital is also known as the opportunity cost of capital.It is rate associated with best investment opportunity.
Eg. Mr X has a choice of investing Rs 1000 in the shares or bank deposits.at 12%.If he invests 1000 in shares implicit cost of capital is 12%