Cost of Capital

The cost of this capital is an important ingredient in both investment decision making by the company's management and the valuation of the company by investors. If a company invests in projects that produce a return in excess of the cost of capital, the company has created value; in contrast, if the company invests in projects whose returns are less than the cost of capital, the company has actually destroyed value. Therefore, the estimation of the cost of capital is a central issue in corporate financial management. For the analyst seeking to evaluate a company's investment program and its competitive position, an accurate estimate of a company's cost of capital is important as well.

 

Cost of Capital as Discount Rate

The cost of capital is the rate of return that the suppliers of capital-bondholders and owners-require as compensation for their contribution of capital. Another way of looking at the cost of capital is that it is the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk.

Cost of Capital Components

Cost of capital has several components. A company typically has several alternatives for raising capital, including issuing equity, debt, and instruments that share characteristics of debt and equity. Each source selected becomes a component of the company's funding and has a cost (required rate of return) that may be called a component cost of capital. Because we are using the cost of capital in the evaluation of investment opportunities, we are dealing with a marginal cost-what it would cost to raise additional funds for the potential investment project. Therefore, the cost of capital that the investment analyst is concerned with is a marginal cost.

Weighted Average Cost of Capital

The cost of capital of a company is the required rate of return that investors demand for the average-risk investment of a company. The most common way to estimate this required rate of return is to calculate the marginal cost of each of the various sources of capital and then calculate a weighted. average of these costs. This weighted average is referred to as the weighted av~~age cost of capital (WACC). The WACC is also referred to as the marginal cost of capital (MCC) because it is the cost that a company incurs for additional capital.