What is cost of capital?
Cost of capital is the expected return to project investors after providing funds for a particular business venture. In a business setup, the end goal always is to earn some profit from any activity or investment. If a business wants to spend on a new project using capital, it expects at least to break-even on the cost of capital. But the ultimate goal is to have returns greater than what was shelved out as capital. In many industries, the benchmark rate used for cost of capital is WACC or Weighted Average Cost of Capital.
There are various items that may have an effect on a company’s cost of capital. Usually these include financial stability of the company, rates of interest in the market, risks involve in the company’s earnings, and the company’s debt to equity ratio. Since the company aims to please shareholders by maximizing stock value, it must earn the approval of investors in providing for funds for new projects, taking consideration all the risks and financial soundness of the company.
In funding new projects, companies may opt for various capital sources. These sources of funding may be in the form of long-term debts, stocks, and earnings. Combining fund sources from debt and stocks will help companies get the Weighted Average Cost of Capital (WACC). In terms of long-term debt, its “cost” is the expense involved in borrowing minus all the taxes. These borrowed funding are in the form of bonds. The borrowing cost after taxes is tax-deductible so it is imperative to declare it in after-tax terms. Cost of common stock equity meanwhile pertains to the value of money a lender is willing to shelf out based on potential future dividends. Other source of funding for capital may be from preferred stocks and the company’s retained earnings.
Careful assessment must be made by all businesses before engaging into capital spending for future investments. There are many ways to calculate the cost of capital and companies have the freedom which computation works for them, as long as the goal is set on increasing shareholder value.