There are high chances that you have got a product line or a new way to revamp your business and its inventory management system or you have got an equipment that will definitely makes your work easier. However, you need to prove to the company leaders that the ideas that you are having is worth investing, as it involves company’s hard earned money. You are going to face a serious question from the top managers that does the return on investment will be better than the company’s cost of capital? Here comes the question of are you sure what exactly is the cost of capital and how the company uses it?
Let’s dive in detail about what is cost of capital and different types of cost of capital.
What is cost of capital?
The cost of capital means a return that is equal to the current investment from the next best alternative investment that an investor can fetch. In simple words, it can be compared as an opportunity cost of investing the same money in different investment having similar risks and other characteristics. Alternatively, the investor gets convinces to invest in a particular project or a company after getting a percentage return on investment.
Types of cost of capital
The term cost of capital is vague in general, as it does not clarify which particular cost of capital people are referring. It may be equity, debt, or any other source of capital. Thus, we can classify cost of capital into different types, which are broadly divided into the following:
- Cost of Equity
- Cot of Debt
Cost of equity
The money used of equity shareholders in the operations is the cost of equity. This cost of capital is incurred in the form of dividends and capital appreciation (increase in stock price).
Cost of equity formula= Risk free rate + Beta * (Market risk premium – Risk free rate)
Cost of debt
The money used of a bank or any financial institution in the business is the cost of debt. The compensation is returned to the bank in the form of interest on their capital.
Cost of debt capital= Interest rate * (1 – tax rate)
Weighted average cost of capital (WACC)
Most of the times the term WACC is interchanged with the cost of capital. It is due to frequent and vast utilization of evaluating existing and new projects. As the name suggests WACC is the weighted average of all types of capital present in the capital structure of a company. We assume two types of capital in the capital structure i.e. equity and debt, we calculate cost of capital as:
WACC= Weight of equity * cost of equity + weight of debt * cost of debt
There are two important uses of cost of capital i.e., the financial managers of a company or the investor.
- Uses by financial Managers
- Uses by Investors
Uses by Financial Managers of WACC
Normally, financial managers use WACC as a benchmark or qualifying criterion for evaluating existing projects or creating new projects as well. There is a diminishing wealth of the investors if a company is accepting or implementing the project with IRR less than WACC. Thus, it means that it is not getting the best use of investor’s capital. It shows an indirect signal to the investors to switch the capital to better investments. There are high chances that the investors won’t get any required rate of return if they remain invested in the company.
Uses by Investors of WACC
The investors use the riskiness of the investment in the stock of a company. Always remember that cost of capital is not an authoritative metric to guide the risk especially when there are other best metrics to get the best view of the risks.
Factors affecting Cost of Capital
Out of various factors, here are some of the fundamental factors affecting the cost of capital, which are as follows:
The most contributing factor available to the entrepreneurs is the market opportunity. The businessman will not need any money if there are no new profitable businesses available in the market and thus the demand of money will fall resulting in a fall in the cost of capital as well.
Capital providers preferences in terms of savings and consumption are other crucial factors that vary from other person-to-person and country-to-country. The supply of capital would reduce and increase the cost of the capital providers bend towards consumption.
The importance of risk is another important factor in determining the cost of capital. The higher the risk, the higher would be the required rate of return and vice versa.
Inflation plays an important role in deciding the cost of capital. Higher the inflation, higher is the expectations of the capital providers. Otherwise, they may opt to consume or invest somewhere else.
Wrapping up
When a financer tells you that your new projects or initiative needs a return that beats the company’s cost of capital, it is helpful to know how to figure out and how it is calculated. With the help of this information, you will be able to make better idea of what is worth investing in a company.
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