Cost of Capital
Cost of Capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a companys funds (both debt and equity), or, from an investors point of view “the shareholders required return on a portfolio of all the companys existing securities”. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a companys average business activities it is reasonable to use the companys average cost of capital as a basis for the evaluation. A companys securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a companys cost of capital. However, a rate of return larger than the cost of capital is usually required.
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely