8.1 : Concept of Cost of Capital

The cost of capital represents the average rate a company must pay its investors to use capital.

It includes the cost of equity and the cost of debt.

The cost of equity is the return shareholders expect on their investment in the company's stock.

The cost of debt is the interest rate paid on borrowed funds.

Understanding the cost of capital is essential because it is a benchmark for making investment decisions.

When a company undertakes a new project, it aims to earn a return that exceeds its cost of capital.

This difference between the return on investment and the cost of capital is what generates profit and increases shareholder value.

For example, suppose a company has a cost of capital of eight percent but invests in a project that returns only six percent.

In that case, its value will be reduced as the project returns less than what investors expect for the risk taken.

Conversely, if the project returns ten percent, it exceeds the cost of capital, thereby adding value to the company.

Calculating and managing the cost of capital helps businesses allocate resources efficiently, ensuring they undertake projects that enhance value.