Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Cost of Capital

What it is:

Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.

How it works (Example):

Cost of capital is determined by the market and represents the degree of perceived risk by investors. When given the choice between two investments of equal risk, investors will generally choose the one providing the higher return.

Let's assume Company XYZ is considering whether to renovate its warehouse systems. The renovation will cost $50 million and is expected to save $10 million per year over the next 5 years. There is some risk that the renovation will not save Company XYZ a full $10 million per year. Alternatively, Company XYZ could use the $50 million to buy equally risky 5-year bonds in ABC Co., which return 12% per year.

Because the renovation is expected to return 20% per year ($10,000,000 / $50,000,000), the renovation is a good use of capital, because the 20% return exceeds the 12% required return XYZ could have gotten by taking the same risk elsewhere.

The return an investor receives on a company security is the cost of that security to the company that issued it. A company's overall cost of capital is a mixture of returns needed to compensate all creditors and stockholders. This is often called the weighted average cost of capital and refers to the weighted average costs of the company's debt and equity.

Why it Matters:

Cost of capital is an important component of business valuation work. Because an investor expects his or her investment to grow by at least the cost of capital, cost of capital can be used as a discount rate to calculate the fair value of an investment's cash flows.

Investors frequently borrow money to make investments, and analysts commonly make the mistake of equating cost of capital with the interest rate on that money. It is important to remember that cost of capital is not dependent upon how and where the capital was raised. Put another way, cost of capital is dependent on the use of funds, not the source of funds.