Cost of Capital refers to the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital encompasses the cost of debt and the cost of equity. It is the return a company needs to earn on its investment projects to maintain its market value and attract funds. Finance managers use cost of capital as a performance benchmark for evaluating investments within their companies.
Examples
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Mortgage Loan & Equity Investment: To purchase a $1 million property, Sue secured a mortgage loan of $750,000 at 7% interest. The remaining amount was raised from a group of investors who expect to make a 12% return. Sue’s cost of capital is a weighted average of the debt and equity yields:
\[(0.75 \times 7%) + (0.25 \times 12%) = 8.25%.\]
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Corporate Funding: A company planning to launch a new product line needs $2 million. It decides to use $1 million from a term loan with a 6% interest rate and $1 million from issuing common stock that investors expect to generate a 15% return. The company’s cost of capital would be:
\[(0.5 \times 6%) + (0.5 \times 15%) = 10.5%.\]
Frequently Asked Questions
What is included in the cost of capital calculation?
Cost of capital typically includes the cost of debt, which is the interest rate on loans or bonds, and the cost of equity, which is the return expected by investors/shareholders.
Why is cost of capital important for businesses?
Cost of capital is vital because it serves as a benchmark for evaluating new projects. A project must generate returns higher than the cost of capital to be considered viable.
How does the cost of debt differ from the cost of equity?
Cost of debt is usually lower than the cost of equity because debt payments are fixed and must be paid regardless of the company’s profitability. In contrast, equity investors demand higher returns for their higher risk.
What is Weighted Average Cost of Capital (WACC)?
WACC is the average rate of return a company is expected to pay to its security holders to finance its assets. It is calculated by weighting the cost of each type of capital (debt and equity) by its proportion in the company’s capital structure.
Why does cost of capital vary between companies?
The cost of capital varies due to factors like the risk profile of the company, market conditions, leverage, and the industry in which the company operates. Companies with higher perceived risks will have higher costs of capital.
Can the cost of capital change over time?
Yes, the cost of capital can change due to variations in market interest rates, company risk profile, economic conditions, or changes in the company’s capital structure.
- Weighted Average Cost of Capital (WACC): The average rate of return required across all of a company’s securities, weighted by their proportional use.
- Return on Investment (ROI): A measure of the profitability of an investment expressed as a percentage of the original cost.
- Internal Rate of Return (IRR): The discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
- Capital Asset Pricing Model (CAPM): A model that describes the relationship between systematic risk and expected return for assets, particularly stocks.
Online Resources
- Investopedia: Cost of Capital
- Corporate Finance Institute: Cost of Capital
- Khan Academy: Cost of Capital
References
- Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance. McGraw-Hill Education.
- Damodaran, A. (2011). Applied Corporate Finance. Wiley.
Suggested Books
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen.
- “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran.
- “Corporate Finance: A Valuation Approach” by Simon Benninga and Oded Sarig.
Real Estate Basics: Cost of Capital Fundamentals Quiz
### Why is cost of capital important for a company's investment decisions?
- [x] It serves as a benchmark for evaluating potential investment projects.
- [ ] It solely determines the net income of a company.
- [ ] It calculates the company's annual revenue.
- [ ] None of the above.
> **Explanation:** Cost of capital is crucial as it serves as a reference point for assessing the viability of potential investments. Projects need to generate returns above the cost of capital to be considered profitable.
### Which of the following best describes Weighted Average Cost of Capital (WACC)?
- [x] The average rate of return a company is expected to pay its security holders.
- [ ] The interest rate on a mortgage loan.
- [ ] The expected return on a single share of stock.
- [ ] None of the above.
> **Explanation:** WACC represents the average rate of return a company is expected to pay its security holders to finance its assets, weighted according to the proportional use of each type of capital.
### How is a company's cost of capital influenced by its risk profile?
- [x] Companies with higher perceived risks have higher costs of capital.
- [ ] Companies with higher perceived risks have lower costs of capital.
- [ ] The risk profile has no impact on the cost of capital.
- [ ] Companies with higher perceived risks have average costs of capital.
> **Explanation:** Companies with higher perceived risks are associated with higher costs of capital because investors demand larger returns for taking on more risk.
### What is the cost of equity?
- [ ] The cost interest rate on loans or bonds.
- [x] The return expected by shareholders or investors.
- [ ] The annual dividend payout.
- [ ] None of the above.
> **Explanation:** Cost of equity is the return that shareholders or investors expect to receive on their investments in the company.
### What must a corporation do to maintain or decrease its cost of capital?
- [x] Lower perceived risk and improve financial stability.
- [ ] Borrow more funds irrespective of cost.
- [ ] Increase short-term debt.
- [ ] None of the above.
> **Explanation:** To maintain or decrease its cost of capital, a corporation should target actions that lower perceived risk and enhance financial stability, thereby making it more attractive to investors.
### In the context of cost of capital, what does return on investment (ROI) refer to?
- [ ] The weighted cost of all debts and equity.
- [ ] The marginal tax rate.
- [x] The profitability of an investment expressed as a percentage.
- [ ] None of the above.
> **Explanation:** Return on Investment (ROI) represents the profitability of an investment and is usually expressed as a percentage of the original cost of the investment.
### How regularly should companies re-evaluate their cost of capital?
- [x] Periodically, to reflect changes in the market and internal conditions.
- [ ] Once during the company's inception.
- [ ] Annually, without reference to any other factors.
- [ ] Never, as it remains constant over time.
> **Explanation:** Companies should regularly re-evaluate their cost of capital periodically to account for changes in the market conditions and internal business circumstances.
### What typically influences the cost of debt?
- [x] Interest rates and credit risk of the company.
- [ ] The initial public offering (IPO).
- [ ] Equity financing.
- [ ] None of the above.
> **Explanation:** The cost of debt is influenced primarily by the prevailing interest rates and the company's credit risk profile.
### How does capital structure impact cost of capital?
- [x] The mix of debt and equity can adjust the overall rate that must be paid.
- [ ] It always increases cost of capital regardless of mix.
- [ ] It eliminates cost of capital considerations.
- [ ] None of the above.
> **Explanation:** The capital structure, which is the mix of debt and equity, significantly impacts the overall cost of capital. The optimal mix can minimize the cost of funding.
### Which of the following is a method used to calculate the cost of capital?
- [x] Weighted Average Cost of Capital (WACC).
- [ ] Net Income Multiplier.
- [ ] Gross Profit Margin.
- [ ] Financial Leverage Ratio.
> **Explanation:** The Weighted Average Cost of Capital (WACC) is one of the key methods used to calculate the cost of capital. It considers the proportions of debt and equity in the capital structure and their respective costs.
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