Capital Has a Cost

The idea of combining capital recovery into measurement of current financial performance isn t new. A method called residual income has been practiced for decades. Residual income subtracts the cost of capital employed from the income statement. For example. Acme s 600,000 NC machine, introduced in Chapter 24, would be charged a capital cost of ownership of 90,000 (15% X 600,000) against the expected benefits. This is because Alpha s hurdle rate is 15%. Because interest is deductible for tax purposes, many adjust the cost of capital to include the impact of taxes and asset life. 

More companies, particularly those traded on stock markets, now report Economic Value Added, or EVA. In EVA application, assets required to run the business are charged to operating earnings at the cost of capital. The cost of capital is commonly a weighted interest rate based on the sources of selected categories of finance — equity (stock) and debt financing (corporate bonds, bank credits, leases, and so forth). 

---