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What Is Cost of Capital?

Learn about cost of capital

Most of us are familiar with “capital,” which is often interchangeable with words like money, assets or funds. The phrase “cost of capital” however, is a much more complex, layered term that is incredibly important in the high-stakes world of business and investment.

To Invest or Not to Invest

In basic terms, when a company is evaluating if funding a new project or investment is fiscally worthwhile, the cost of capital is the rate of return potential investors require.

To figure out the cost of capital, an organization must calculate how much the funding will cost based on the cost of debt and the cost of equity. Usually, companies secure funding with a combination of equity (such as equity from stockholders) and debt (such as loans from banks). Before taking on any new project, an organization must ensure it keeps its stockholders happy by maintaining a respectable return on its stocks. It must also be confident that it can repay any debt holders. Figuring out the cost of debt and the cost of equity is a complex calculation known as the weighted average cost of capital (WACC).

Figuring out the cost of capital usually falls to the accountants in an enterprise’s finance department. The results of the calculation tell executives what minimum amount of return they will need on a new project to ensure it’s in the company’s economic interest to pursue it.

It is important to note that the cost of capital is sometimes referred to as a discount rate (or hurdle rate). However, there is often a significant distinction between the two. While an organization’s accountants may calculate the cost of capital, it is usually up to a company’s executives to determine the discount rate.

This rate is higher than the actual cost of capital and acts as a cushion of sorts to give the business some flexibility. So, for example, if the cost of capital is 5 percent, then the discount rate may be 5.5 or 6 percent. This gives the company a bit of breathing room to accommodate unforeseen factors not accounted for in their initial calculations.

How much a company increases or decreases the discount rate depends on a number of factors, risk tolerance being foremost: Is the company risk-averse or comfortable with risk? A risk-averse company would likely raise its hurdle rate even higher, whereas a company that is confident in its fiscal returns and looking for new investments may set a lower discount rate.

Honing Your Financial Acumen

Understanding of the cost of capital, how to calculate it and how it may affect an organization’s decision to pursue or reject new endeavors is critically important for anyone hoping to take on a leadership role.

For people seeking top-tier positions in the business world, an MBA in Finance is likely one of the best ways to prepare for the complex fiscal considerations facing companies today.

One university offering a respected MBA in Finance is Texas A&M University-Corpus Christi. The program provides students with the foundational knowledge necessary to excel in business. It accommodates working professionals who want to advance their careers and increase their earning potential without interrupting their existing careers. Furthermore, because the program addresses the needs of working professionals, Texas A&M University-Corpus Christi’s MBA in Finance is available online, and you can complete the program in as few as 12 months.

Understanding a company’s cost of capital to assess the feasibility of new projects can ensure career success as a management executive.

Learn more about the Texas A&M-Corpus Christi online MBA in Finance program.


Sources:

Investing Answers: Cost of Capital

Harvard Business Review: A Refresher on Cost of Capital

Investopedia: Cost of Capital


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