Understanding Cost of Capital: How Companies Determine the Cost of Funds to Finance Operations and Investments

Cost of capital

The average rate of return, a company must pay to his long-term creditors and shareholders for the use of their funds

The cost of capital is the required rate of return that a company needs to generate in order to compensate its investors for the investment risk. In other words, it is the cost of the funds that a company uses to finance its operations and investments.

There are different sources of capital, such as debt and equity, and each source has its own cost. The cost of debt is the interest rate that a company pays on its debt obligations, while the cost of equity is the return that investors expect to receive in exchange for their investment.

To calculate the cost of capital, a company typically uses a weighted average cost of capital (WACC) formula. This formula takes into account the proportion of each source of capital in the company’s capital structure and the cost of each source.

For example, if a company has 60% of its capital from debt at an interest rate of 5%, and 40% of its capital from equity at an expected return of 10%, the WACC can be calculated as:

WACC = (0.6 x 5%) + (0.4 x 10%) = 7%

Therefore, the cost of capital for this company would be 7%. This means that the company needs to generate a return of at least 7% on its investments in order to compensate its investors for the risk associated with their investment.

More Answers: