What is the cost of capital?
The cost of capital (COS) is the cost of funding a project that needs a lot of capital from its own reserves or borrowings. Businesses and investors use the cost of capital to measure and justify the equity or debt financing needed for such projects.
The cost of capital shows the potential return and risks of an investment. Businesses get the funds for such projects through debt or equity financing, which becomes a company’s cost.
Explanation of Cost of Capital
One of the most important financial concepts is the cost of capital, the minimum rate of return a project must earn to pay for its funding. Before investing in a major project, a company needs to know how much cash flow the project will generate compared to the cost of financing it and how much profit it will make for the company.
From an investor's point of view, the cost of capital is an evaluation of the expected return from buying shares or other investments. This is not an exact number but a range of possible outcomes. An investor might use a company's earnings variability (beta) to decide if a stock's price is worth its potential reward.
Importance of Cost of Capital
It helps to evaluate the cost and the performance of a particular project.
Allows investors to access alternatives
Assist businesses in decision-making to form capital structure and capital budgeting.