Cost of capital
The cost of capital refers to the minimum return that a company must achieve on an investment for it to be considered worthwhile. It is influenced by the company's method of financing, which can involve equity (such as issuing stock) and debt (borrowing funds). The cost of equity represents the return demanded by stockholders for the risks they undertake, while the cost of debt corresponds to the interest payments owed on borrowed funds. For an investment to be viable, its expected return must exceed this combined cost, often encapsulated in the weighted average cost of capital (WACC).
When evaluating potential investments, such as purchasing new assets, companies assess the expected return against the WACC, which reflects the average required return on all of a company’s financing sources—both equity and debt. Furthermore, understanding the cost of capital is essential for determining a company's capital structure—the ratio of debt to equity that finances its operations. A favorable capital structure can help lower the WACC, thereby expanding a firm’s investment opportunities and enhancing its growth potential. This interplay between capital costs and investment returns is crucial for informed financial decision-making within a company.
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Cost of capital
The cost of capital is the minimum return on an investment required by a company for the investment to be considered worthwhile. The cost of capital is determined by weighing the costs of financing the purchase of an asset using equity, debt, or a combination of the two. The cost of equity is the percentage return demanded by stockholders for bearing risk in the firm, while the cost of debt is the interest rate paid on borrowed money. For an investment to be deemed cost-effective, it must promise a rate of return greater than a weighted combination of these numbers—the cost of capital.
Overview
When a company is in the process of evaluating an investment in new assets—the purchase of a building, for example—a variety of considerations must be taken into account, one of which is the cost of capital. In order to finance the purchase of assets, a company must raise capital, either through equity—which can be generated by issuing common or preferred stock—or by borrowing money, thus acquiring debt.
The combined equity and debt are a company’s securities and stand as the lodestar by which all investments must be measured. In evaluating a potential investment, the asset’s expected return on capital is compared to the total required return on a company’s securities—its equity and debt. This required return is called the weighted average cost of capital, and represents the required return on the firm as a whole. It is determined by averaging the cost of equity—the return rate a company must deliver to investors—and the cost of debt—the rate of interest on borrowed money—with each number weighted as called for by its proportional use in a given investment situation.
The weighted average cost of capital is also considered when determining a company’s capital structure. Capital structure is the ratio of debt to equity used to finance a company’s general operations and growth. Because it is in a firm’s best interest to keep its weighted average cost of capital low so as to allow for broader investment options—and because the weighted average cost of capital is formulated on equity and debt—the firm’s capital structure is largely dependent on its resulting cost of capital.
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