Define Cost of Capital
What is a cost of capital? Cost of capital of an investor, in financial management, is equal to return, an investor can fetch from the next best alternative investment. In simple words, it is the opportunity cost of investing the same money in different investment having similar risk and other characteristics. From a financing angle, cost of capital is simply the cost which is paid for using the capital. Alternatively, a percentage return on investment that convinces an investor to invest in a particular project or company is the appropriate cost of capital for that investor.
Types of Cost of Capital
The term cost of capital is vague in general. Does it not clarify which capital we are talking about? It could be equity or debt or any other source of capital. We can classify cost of capital into following broad classifications.
Cost of Equity Capital
Cost of equity capital is the cost of using the capital of equity shareholders in the operations. This cost is paid in the form of dividends and capital appreciation (increase in stock price). Most commonly, the cost of equity is calculated using following formula:
Cost of Debt Capital
Cost of debt capital is the cost of using bank’s or financial institution’s money in the business. The banks are compensated in the form of interest on their capital. The cost of debt capital is calculated using following formula.
Cost of Debt Capital = Interest Rate * (1 – Tax Rate)
Weighted Average Cost of Capital (WACC)
Most of the times, WACC is referred as a cost of capital because of its frequent and vast utilization especially when evaluating existing or new projects. Weighted average cost of capital, as the term itself suggests, is the weighted average of all types of capital present in the capital structure of a company. Assuming these two types of capital in the capital structure i.e. equity and debt, the WACC can be calculated by following formula:
WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt.
For understanding what capital values (market value or book value) should be used as weights of each capital, visit
Use of Cost of Capital
There are practically 2 important participants relevant for using the Cost of Capital i.e. the Financial Managers of a Company or the Investor.
How and Why Financial Managers use it?
Typically, financial managers use the cost of capital (refer as WACC) as a benchmark or a qualifying criterion for selecting the new projects of a company or evaluating the existing projects also. If a company is accepting or implementing projecting with IRR less than WACC, it is construed as not getting the best use of the investor’s capital and hence diminishing the wealth of the investors. Indirectly, it is a signal to the investors to switch their capital to better investments. If they remain invested in the company, there are chances that they may not earn their required rate of return.
How and Why Investors use it?
Investors can use it to judge the riskiness of the investment in the stock of a company. Note that the cost of capital is not a very authoritative metric to guide on risk especially when there are other good metrics to get a better view of risk.
Factors Affecting Cost of Capital
There are various factors that can affect the cost of capital. Some fundamental factors are as follows:
Primarily, the market opportunity available to entrepreneurs is the most contributing factor. If there are no new profitable businesses available in the market, a businessman would not need money and therefore the demand for money fall resulting in fall in the cost of capital as well.
Preferences of capital providers in terms of consumption or savings are other important factors which vary from person to person and country to country. If the capital providers are bent towards consumption, the supply of capital would reduce and thereby increase in cost.
We already discussed the importance of risk. Higher the risk, higher would be the required rate of return and vice versa.
In economics, it is said that inflation plays an important role in deciding the cost of capital. Higher the inflation, higher would be expectations of the capital providers else they may opt to consume or invest somewhere else.