Cost of Capital
Posted by Luke Shepherd in Sep, 2014
What is the cost of capital?
The cost of capital is the cost of obtaining funds used to finance a business. It refers to the two different types of funds, equity and debt.
What is cost of capital like?
Cost of capital is like a receipt that you get from the future, it gives you outlines for how long and how much you will have to pay for the money that you want borrow.
What is the purpose of cost of capital?
The cost of capital has different purposes depending on who you are. As an investor, the cost of capital is used to find the rate of return on an investment that would make it worthwhile. From a business point of view, the cost of capital is used to evaluate if proceeding with a project is sustainable. The cost of capital is the minimum return that investors will expect on their ventures into a business.
What are the different types of cost of capital?
There are two different types of capital, debt and equity, both of these have different costs involved with them. Equity capital financing is capital that is taken from the business owners own personal finances, things such as life savings and family wealth are commonly used for this. By using their own finances for the business, the business owner is believing that the return he will get form the business, is greater than the return he would get from investing it elsewhere. Debt capital is financing that a business owner would receive from a bank or financial institution, this loan must be paid back with interest. Debt capital is advantageous because the business owner doesn’t have to give up part ownership of the company, like they would if it was from an investor. The cost of debt capital financing is the interest you will pay and that your future income is lessened because of repayments for the loan.
What is involved with calculating the cost of capital?
When calculating the cost of capital for a business, there are several other details that must be worked out before the actual cost of capital can be calculated. Firstly the cost of debt and equity for the company must be worked out separately, once worked out they must be weighted by how much use they are to the businesses situation. Once all this information is gathered then the WACC formula is used to determine the ‘weighted average cost of capital’. Appendix 1 shows how the WACC formula is used.
Where does calculating the cost of capital fit into the management of a business?
Calculating the cost of capital fits into the management of a business at different times. It has its first effects on a business when the owner is deciding whether they want to open a business or not. If the owner wants to use investors to fund the business, then he would need to have worked out the cost of capital, to see if it is worthwhile for the investors to finance him. Calculating cost of capital again comes into use when the business owner is thinking about expanding the business, it would be used internally in the business to determine if expanding the business would be financially possible compared to the cash flow they currently have.
How does calculating the cost of capital impact on different areas of the business?
Calculating the cost of capital has a low impacted on most areas of the business. Staff members of the business would not be effected by the calculation and use of cost of capital. The only area of the business that calculating cost of capital has an impact on is the owner, or the directors who control the business, calculating the cost of capital is used primarily to determine if investors will support the businesses decision to expand.
What terms are used when calculating cost of capital?
- Cash flow: cash flow is the movement of money in and out of the business i.e. wages and sales
- Debt financing: acquiring money to use on the business by taking out a loan, have to pay back with interest
- Equity financing: using money from the business owner’s personal finances to fund the business.
- Rate of return: the gain or loss on an investment over a period of time
Where can I find more information about calculating cost of capital?
http://www.investopedia.com/terms/w/wacc.asp
http://www.inc.com/ed-powers/the-real-cost-of-capital.html
Who would most benefit from this knowledge?
This article would most benefit someone who already knows a lot about business and is looking to improve their knowledge and possibly master the skill. This article would benefit someone who is either looking to start their own business after working somewhere for a period of time. Although, it would be most beneficial to someone who already owns a small business and is thinking about expanding the business and is thinking of ways to generate capital. No jurisdiction has influence on this area as it has nothing to do with any laws, there are also no cultural or climate impacts on cost of capital.
Appendix
Appendix 1
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