We have tried to explain and distinguish or differentiate between explicit and implicit concepts of cost of capital. In finance both terms are important for students.
Explicit Cost of Capital
Explicit cost of capital is that cut off rate which equates present value of cash inflows to present value of cash outflows. In other words, it is nothing but internal rate of return. In capital budgeting decision, investor will see which investment provides high internal rate of return but which company gets the money at high internal rate of return; it means that company is accepting money at high explicit cost of capital. You should remember:
a) This cost will be in money form.
b) For deciding explicit cost of capital, company will add all sources’ cost of capital and try to minimize it.
For Example:
A company accepts loans by issuing new debentures of $ 500,000. This company also promises to pay $ 5000 per year, company’s total inflow will be $ 500,000 and total outflow of cash will be $ 50000 per year and if there is nothing cost of capital, then this loan can be repaid within 10 years. But it is not possible that company would receive loan without giving interest. So, minimum value of interest which will company pays on the condition that it will equal the present value of $500,000 and $ 50,000 will be explicit cost of capital. This decision will be taken at the time when company gets loan. If company is giving high interest rate on loan, then its net explicit cost will be less because, interest is given out of net profit and company can save tax and if we adjusted this tax rate, explicit cost will be less than actual interest on loan.
Implicit Cost of Capital
Implicit cost of capital is opportunity cost, if money is used one of best alternatives for effective use of resources. Suppose, I have $ 100,000, I can deposit it in bank and earn $ 3500 as bank interest but I did not invested it in saving bank account and invested in the shares of XYZ company. So, my implicit cost of investment in shares will equal to the bank interest. This is not in money form because, it is not necessary that XYZ company give me my cost investment in shares. But, after thinking, I take the opportunity for getting best reward from investment, so I have taken this decision.
Explicit Cost of Capital
Explicit cost of capital is that cut off rate which equates present value of cash inflows to present value of cash outflows. In other words, it is nothing but internal rate of return. In capital budgeting decision, investor will see which investment provides high internal rate of return but which company gets the money at high internal rate of return; it means that company is accepting money at high explicit cost of capital. You should remember:
a) This cost will be in money form.
b) For deciding explicit cost of capital, company will add all sources’ cost of capital and try to minimize it.
For Example:
A company accepts loans by issuing new debentures of $ 500,000. This company also promises to pay $ 5000 per year, company’s total inflow will be $ 500,000 and total outflow of cash will be $ 50000 per year and if there is nothing cost of capital, then this loan can be repaid within 10 years. But it is not possible that company would receive loan without giving interest. So, minimum value of interest which will company pays on the condition that it will equal the present value of $500,000 and $ 50,000 will be explicit cost of capital. This decision will be taken at the time when company gets loan. If company is giving high interest rate on loan, then its net explicit cost will be less because, interest is given out of net profit and company can save tax and if we adjusted this tax rate, explicit cost will be less than actual interest on loan.
Implicit Cost of Capital
Implicit cost of capital is opportunity cost, if money is used one of best alternatives for effective use of resources. Suppose, I have $ 100,000, I can deposit it in bank and earn $ 3500 as bank interest but I did not invested it in saving bank account and invested in the shares of XYZ company. So, my implicit cost of investment in shares will equal to the bank interest. This is not in money form because, it is not necessary that XYZ company give me my cost investment in shares. But, after thinking, I take the opportunity for getting best reward from investment, so I have taken this decision.
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