Definition of cost of capital
It is the weighted average of a firm’s cost of debt and the cost of equity put together. It is described as the opportunity cost of making an investment in a business. It is a metric used by companies to determine whether a capital project is worth the expenditure and use of resources and by investors who wish to know if the investment is worth the risk in light of the return. The idea is to generate more value than the cost that is put into the project.
Understanding Cost of Capital
The cost of capital is dependent on the type of financing that the business resorts to. The cost of capital usually encompasses the cost of both debt and equity of a company. Accounting for this is known as the Weighted Average Cost of Capital (WACC). The computation of WACC would include the summation of the cost of debt, the cost of preference shares, the cost of equity, and the cost of retained earnings. This can be mathematically represented as follows – WACC = (E / V x Re) + ((D / V) x Rd) x 1 - Tc Where, E refers to the market value of the firm's equity; D refers to the market value of the firm's debt; V is the sum of E and D; Re refers to the cost of equity; Rd refers to the cost of debt; Tc refers to the income tax rate.
Components of Cost of Capital
- Zero risk return
- Premium for the business risk (i.e. the capital budgeting risks of the company) undertaken
- Premium for the financial risk (i.e. risk associated with the capital structure of the company) undertaken
Importance or Need for Cost of Capital
- Enables investors to assess their options with care.
- Assists the business in taking important decisions regarding capital budgeting and capital structure of the company.
- It can help evaluate the performance and costs of certain projects.
Difference between Cost of Capital and Discount Rate
These words are used interchangeably. But the cost of capital precedes the setting of discount rate i.e. the discount rate is a product of the calculation of cost of capital. The cost of capital is used to set the discount or hurdle rate to justify the investment that is to be made.
