The measurement of cost of capital refers to the process of determining the cost of funds to the firm. Once the cost has been determined, it is in the light of this cost that the capital budgeting proposal will be evaluated. Although the cost of capital selected for discounting the cash flows is merely an estimation of the firm’s true cost of capital, the finance manager of the firm must calculate this estimate as precisely as possible. A haphazard approach to cost of capital measurement may result in gross error of estimation. Just as the firm should carefully estimate the relevant cash flows associated with a proposal, it should also carefully estimate the cost of  capital.
 
Utmost care must be taken in the measurement of cost of capital, otherwise, unacceptable proposals might be selected and acceptable proposals might get rejection. Further, although the cost of capital is measured at a given point of time , it must reflect the cost of funds over the long run because the cost of capital is used in capital budgeting involving involving expenditures providing benefits in the long run.

The measurement of cost of capital is based on the following assumption:
a)    The basic assumption of the cost of capital concept is that the business risk of the firm is unaffected by the proposal being evaluated at the cost of capital. The implications of this assumptions is that every firm has a particular level of business risk as determined by the present composition of its assets. If a new proposal is also accepted then this business risk level is not going to be changed, or , in other , the new proposal accepted by the firm is assumed to possess the same level of risk as those already held. So, the business risk of the firm remains unchanged and the degree of responsiveness of the EBIT to sales revenue is constant.
b)    Another assumption required to be made is that the financial risk of the firm remains unchanged, whether a proposal is accepted or not. The implication is that the financial risk of the firm is assumed to be the same as at present. The financial risk of the firm depends upon the degree of debt financing in the overall capital structure of the firm and this assumption implies that the degree of debt financing will be maintained. The purpose of making this assumption is that for capital budgeting decision situation, the average cost of capital is used. This average cost of capital is calculated for a given capital structure.

 The cash flows relevant for capital budgeting decisions are taken on an after tax-basis. These cash flows are than discounted at the cost of capital to find out their present value. It should be noted that this cost of capital which is used to discount the cash flows (after-tax) should also be after tax only. If the firm is using IRR technique , then the cut-off rate should also be taken on an after-tax basis. This ensures consistency in the evaluation procedure. As discussed in the following sections, it is only the debt financing for which the tax adjustment to the cost of capital is required. The reason being that interest on bonds and debentures is tax deductible. The other sources i.e., the preferences share capital and the equity share capital do not require such a tax adjustment.

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