cost of capital

(noun)

The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.

Related Terms

Examples of cost of capital in the following topics:

  • The Marginal Cost of Capital

    • The marginal cost of capital is the cost needed to raise the last dollar of capital, and usually this amount increases with total capital.
    • The marginal cost of capital is calculated as being the cost of the last dollar of capital raised.
    • This happens due to the fact that marginal cost of capital generally is the weighted average of the cost of raising the last dollar of capital.
    • Since the cost of issuing extra equity seems to be higher than other costs of financing, we see an increase in marginal cost of capital as the amounts of capital raised grow higher.
    • The Marginal Cost of Capital is the cost of the last dollar of capital raised.

  • Cost of Capital Considerations

    • One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital.
    • For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.
    • A company's securities typically include both debt and equity, so one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital.
    • The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.
    • Describe the influence of a company's cost of capital on its capital structure and investment decisions

  • Impact of the SML on the Cost of Capital

    • The plotted location of an instrument on the SML has consequences on its price, return, and cost of capital it contributes to a firm.
    • The cost of obtaining funds in such a manner is known as a company's cost of capital.
    • The rational investor will require either a higher return or lower price, which will both result in a higher cost of capital for the company.
    • The location of a financial instrument above, below, or on the security market line will lead to consequences for a company's cost of capital.
    • Describe the impact of the SML on determining the cost of capital

  • Weighted Average Cost of Capital

    • In short, the WACC is a measure of what all of these capital inputs will cost the organization in terms of an average interest rate.
    • WACC is a useful calculation, as it shows management what the cost of borrowing capital is overall.
    • This overall cost of capital can then be a minimum required return on any new operation.
    • Calculating the cost of capital is actually quite a simple equation.
    • By calculating the estimated cost of equity, and applying that to the WACC equation with the cost of debt and capital structure, organizations can determine the cost of capital (and thus the required return on projects/assets).

  • Differences Between Required Return and the Cost of Capital

    • The average cost of capital is calculated via combining the overall average required rate on debt stakeholders and equity stakeholders
    • This required amount of return will ultimately equal the cost of capital, as the required rate from the investor is now a cost being put on the borrower.
    • Now, cost of capital for a given investor will always equate to the required return.
    • This is where the concept of weighted average cost of capital (WACC) enters the equation, as there may be more than one investor with varying rates of return.
    • Calculate the weighted average cost of capital by understanding the required rate of various investors

  • Defining the Cost of Capital

    • Risk, return, and the time value of money are central inputs in distilling the cost of capital as an investor or borrower.
    • For the organization borrowing the capital, the cost of capital is the cumulative rate of interest (usually derived as an average rate, combining all capital inputs) applied to the borrowed capital to fund a project.
    • The cost of this capital is calculated as:
    • With the above options in mind, the weighted average cost of capital (WACC) normalizes the cost of capital by combining the interest rates being incurred from both debt and equity.
    • Capital incurs costs due to risk, return, and the intrinsic time value of money.

  • Optimal Capital Structure Considerations

    • One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital.
    • For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.
    • A company's securities typically include both debt and equity; therefore, one must calculate both the cost of debt and the cost of equity to determine a company's cost of capital.
    • The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.
    • Explain the influence of a company's cost of capital on its capital structure and therefore its value

  • The Cost of New Common Stock

    • When it comes to the cost of capital, common stock is one of a few options on the table for raising funding.
    • In order to understand the weighted average cost of capital (WACC) of all of these inputs, the cost of each source of debt and/or equity must be determined.
    • In terms of literal capital spent, the issuance of new common stock incurs a variety of capital costs both at the initial offering and throughout the process of managing this funding source over time:
    • In addition to the tangible capital costs involved, there are also a variety of indirect trade-offs that organizations must understand prior to pursuing this source of funding.
    • Weigh the direct and indirect costs of issuing new common stock as a form of capital

  • Evaluating Interest Rates

    • The interest rate most commonly used in working capital management is the cost of capital.
    • The cost of capital, in a financial market equilibrium, will be the same as the market rate of return on the financial asset mixture the firm uses to finance capital investment.
    • In other words, a company's cost of capital is the cost of obtaining funds for operation through the sale of equity or debt in the marketplace.
    • Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions.
    • Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.

  • The Cost of Retained Earnings

    • Due to the relationship between retained earnings and dividends, the cost of retained earnings as a source of capital is relative to the overall cost of equity.
    • No capital comes without costs, however, and the cost of this capital must be taken into account when calculating the weighted average cost of capital (WACC).
    • Retained earnings are included in the WACC equation as equity, as dividends are a component of the return on capital to equity stakeholders, and thus will have a correspondingly weighted influence on the cost of equity.
    • The relationship between dividends and retained earnings is quite clear when it comes to recognizing the opportunity cost and thus the overall cost of this capital source.
    • Retained earnings is listed under equity, and is thus relative to the cost of equity.