Cost of capital

The term cost of capital is commonly used in the financial investment field referring the cost of company’s funds involving equity and debt.

This can also be viewed from an investors point as the required return on the shareholders existing securities of all the companies.

The term cost of capital is also employed to evaluate new projects as it involves minimum return expected by investors from the company for providing capital, thereby setting a benchmark for the new project that it has to meet.

Significance

An investment is worthwhile when the return expected on the capital exceeds the cost of capital as it is the rate of return expected to earn and involves equivalent risk.

The average cost of capital of a company can be put to use reasonably for evaluation, if a project entails risk. The securities of a company include debt and equity, and hence calculating both the debt and equity cost in determining the cost of capital of a company becomes of significance.

The cost of debt is composed of the paid rate of interest by the company. This is considered to be a risk-free rate plus risk premium component that incorporates by default a probable rate and by default an amount of recovery is given. Companies with credit ratings or identical risk may not the interest rate as they are not associated to the activities of the company. They are largely exogenous.

The cost of equity is tough to calculate as it fails to pay the investors a set return. The cost of equity is conditional as it is done by comparing investment to other investments facing identical risk profiles in determining the market equity cost.

Once cost of debt and equity are determined, the (WACC) weighted-average cost of capital can be calculated and can be used as a discount rate for projected cash flows.

Expected return

The expected return can be calculated using the dividend capitalization model, Expected
Return = growth rate of dividends + dividend yield. These models indicate that the investors can expect a return as it is risk-free return and entails market risk security.

Weighted average cost of capital

The (WACC) Weighted Average Cost of Capital is used to measure the cost of capital of a firm. This is the raid paid to finance its assets on average by a company to its security holders.

This is the minimum return expected to earn on the asset base of an existing company to satisfy its owners, creditors and other providers, else they will invest in other places. The WACC calculation is done taking the relative weights into account. The WACC calculation is laborious, if the capital structure of the company is complex.