The
cost of
capital
is a term used in the field of financial investment to refer to the cost of a
company's funds (both
debt
and
equity
), or, from an investor's point of view "the shareholder's
required return on a portfolio of all the company's existing securities".
[1]
It is used to evaluate
new projects of a company as it is the minimum return that investors expect for providing capital
to the company, thus setting a benchmark that a new project has to meet.
For an investment to be worthwhile, the expected
return on capital
must be greater than the cost
of capital. The cost of capital is the rate of return that capital could be expected to earn in an
alternative investment of equivalent risk. If a project is of similar risk to a company's average
business activities it is reasonable to use the company's average cost of capital as a basis for
the evaluation. A company's securities typically include both debt and equity, one must
therefore calculate both the cost of debt and the cost of equity to determine a company's cost of
capital. However, a rate of return larger than the cost of capital is usually required.
The
cost of debt
is relatively simple to calculate, as it is composed of the rate of interest paid.
In practice, the interestrate paid by the company can be modelled as the riskfree rate plus a
risk component (
risk premium
), which itself incorporates a probable rate of default (and amount
of recovery given default). For companies with similar risk or
credit ratings
, the interest rate is
largely
exogenous
(not linked to the company's activities).
The
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 Spring '11
 ProfKinney

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