Cost of Capital

Cost of capital is defined as the required return necessary to make a capital budgeting project. The cost of capital is the opportunity cost of an investment i.e. it is the rate of return that a company would be able to earn otherwise at the same risk level as the investment that has been selected. The cost of capital is also used to refer the cost of a company's funds for both debt and equity, or, from an investor's point of view that the shareholder's required return on a portfolio of all the company's existing securities.

In case an investor purchases a stock in a particular company, he/she expects to see a return on that investment. The individual would expect to get a return of more than his/her initial investment; the cost of capital is equal to this return that the investor receives, or the money that the company misses out on by selling its stock.

The cost of capital would also determine how a company can raise money (through a stock issue, borrowing, or a mix of the two). Therefore to calculate both the cost of debt and the cost of equity to determine a company's cost of capital.

The cost of debt is easy to calculate as the cost of debt is composed of the rate of interest paid. The interest-rate that is paid by the company for the debt can be modeled as the risk-free rate plus a risk component, which itself incorporates a probable rate of default. It is calculated by considering the rate on a risk free bond and then it is matched with the term structure of the corporate debt.

The cost of equity is more challenging and difficult to calculate as equity does not pay a set return to its investors. The cost of equity is also defined as the risk-weighted projected return required by investors, where the return is largely unknown.

Questions

• What is cost of capital?
• How is the cost of capital calculated?