There is no doubt that any investor, to be persuaded to make a given investment, needs to know the minimum rate of return. This exactly what is called the cost of capital. Of course, Investors use this factor as one of the financial metrics they consider in evaluating companies as potential investments.
What is Cost of Capital?
Cost of capital is the rate of return that a business must earn before generating value. It is important because it is used as the discount rate for the company’s free cash flows in the DCF analysis model. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to fund its operations. It consists of both the cost of debt and the cost of equity used for financing a business.
A company’s cost of capital depends to a large extent on the type of financing the company chooses to rely on. The company may rely solely on equity or debt or use a combination of the two. Companies look for the optimal mix of financing that provides adequate funding and that minimizes the cost of capital.
The factors which determine the cost of capital
- Source of finance
- The various risk involved.
- Demand and supply of capital.
- The expected rate of inflation.
- The debt-equity ratio of the firm.
Type of cost of capital
1- Cost of equity
This is the cost of leveraging the capital supplied by company shareholder, repayable in stronger capital gains and a higher share price.
2- Cost of debt
This type of capital represents the cost of a company or individual that borrows money from a bank or financial institution to invest money in a project or other investment opportunity.
The financial institution earns its money back in the form of interest paid, along with any appropriate fees and charges as noted in the loan contract.
Importance of Cost of Capital
– It helps in evaluating the investment options, by converting the future cash flows of the investment avenues into present value by discounting it.
– The cost of capital can be used to evaluate the financial performance of top management. This can be done by comparing the actual profitability of the investment project undertaken by the firm with the overall cost of capital.
– It is helpful in capital budgeting decisions regarding the sources of finance used by the company. Also, in taking leasing decisions of the business concern.
– It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is maximum, and the cost of capital is minimum. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimized.
– It can also be used to appraise the performance of specific projects by comparing the performance against the cost of capital.
– It is useful in framing optimum credit policy, i.e. at the time of deciding credit period to be allowed to the customers or debtors, it should be compared with the cost of allowing credit period.