Cost of Capital Explained!

The cost of capital is an important factor in both management's investment decisions and investors' valuation of the company

A business expands by making investments that are expected to increase revenue and profits. It obtains the capital or funds required to make such investments through borrowing (debt financing) or by using funds provided by the owners (equity financing). The company is creating value today by directing this capital toward long-term investments. How much worth is there? The answer is determined not only by the expected future cash flows of the investments, but also by the cost of the funds. Borrowing is not free and neither is using the funds of the owners.  

The cost of capital is an important factor in both management's investment decisions and investors' valuation of the company. If a company invests in projects that generate a return greater than the cost of capital, the company has created value; if the company invests in projects that generate returns less than the cost of capital, the company has destroyed value.   

Estimating the cost of capital is a difficult task. As previously stated, the cost of capital is not observable and must be estimated. A cost of capital estimate necessitates a slew of assumptions and estimates. Another challenge is that the appropriate cost of capital for a specific investment depends on its characteristics: the riskier the investment's cash flows, the higher the cost of capital. In reality, a business must estimate project-specific capital costs. What is often done, however, is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward, to reflect the risk of the contemplated project relative to the company’s average project.