Question

What is Cost of Capital?

Answer 1

Cost of capital is the overall cost of the funds needed to finance a company's assets and operations. In other words, it is the opportunity cost of making a specific investment or decision. Thus,  it is the rate of return which could have been earned by making a different investment or decision with equal risk.

Cost of capital can be cost of equity if its a unlevered (equity only) company or might refer to cost of debt if its debt only or a combination of both debt and equity.

Cost of equity is calculated with the following formula = Risk Free Rate of return + (beta * (market rate-risk free rate))

Cost of debt is calculated with the following formula = Interest expense/Total Debt * (1-tax rate)

Cost of preferred stock = Dividend declared / current market price

Majority of the companies have both debt and equity (including common stock and preference stock) as source of finance and the cost of capital for such companies is calculated from the weighted average cost of all capital sources. This method is also known as the weighted average cost of capital (WACC). Thus, under WACC, cost of capital = ((Equity / (Equity+Debt))*Cost of Equity) + ((Debt / (Equity+Debt))*Cost of Debt (after tax)).

Cost of capital is widely used in making capital budgeting decisions such as purchasing a new equipment or continuing with the existing one, building a new factory, etc. Thus, in capital budgeting decisions, this metric will enable the management to examine if the decision to be made is worth the expenditure involved. This rate will act as a hurdle rate which a company must overcome to generate value.Thus, assuming the cost of capital of the company is 10% and a particular project is expected to generate a return of 12%, the company may decide to implement the project as the return expected to be generated is higher than the cost of capital.

From the perspective of an investor, it is a measure enabling an investor to determine whether a certain stock is too risky or would make a good buy. Thus, if an investor has to decide between two investments of equal risk, he will determine the cost of capital and decide on the one that provides the higher return.