Understanding the cost of capital

Cost of capital is the cost of the funds used to finance a business. The cost of capital would depends on the method of financing used relative to the company financial standing. Most companies use a combination of debt (such as short-term notes or long-term bonds) and equity to finance their businesses. Such companies often derive their overall cost of capital from a weighted average of all capital sources. This is called the weighted average cost of capital (WACC), because each type of capital (common stock, preferred stock, bonds, other long-term debt) is weighted according to its proportion in the company’s capital structure. WACC is determined by the external market, not the company.

The WACC represents a “hurdle rate,” or minimum acceptable return rate, that the company would have to earn before the investment generates value. So it is extensively used in the capital budgeting process to determine whether the company should proceed with an investment.

The cost of capital sources varies from company to company. It depends on various factors such as a company’s

  • Riskiness
  • Operating history
  • Profitability
  • Credit history

Newer enterprises with limited operating histories tend to have higher costs of capital than established companies with a solid track record. That’s because lenders and investors consider newer businesses to be a greater risk, and demand a higher return in compensation.

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Categories: Personal Finance

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