Cost of Capital
Cost of capital is the minimum rate of return that a company must earn on its investments. This return helps the company satisfy its investors and maintain its market value. Think of it as the price a company pays for using money from different sources. If a company takes a loan at 10% interest, its cost of capital for that loan is 10%. If the company earns only 8% from its business projects, it will eventually lose money.
Concepts (3)
This is the return that shareholders expect for investing their money in the company's shares. It is harder to calculate than debt because there is no fixed interest rate.
This is the return that shareholders expect for investing their money in the company's shares. It is harder to calculate than debt because there is no fixed interest rate. It is usually estimated using the Dividend Growth Model or the Capital Asset Pricing Model (CAPM). If a company fails to meet this expected return, its share price will likely drop.
This is the effective rate that a company pays on its borrowed funds like loans or bonds. Since interest is paid before tax, it reduces the company's taxable income. This creates a 'tax shield'.
This is the effective rate that a company pays on its borrowed funds like loans or bonds. Since interest is paid before tax, it reduces the company's taxable income. This creates a 'tax shield'. The actual cost to the company is lower than the interest rate paid to the bank. For example, if the interest is 10% and the tax rate is 30%, the real cost is only 7%.
WACC is the combined cost of all different sources of capital used by a firm. Each source is given a 'weight' based on its proportion in the total capital. For example, if a firm is 60% debt and 40% equity, WACC will be (0.60 × Cost of Debt) + (0.
WACC is the combined cost of all different sources of capital used by a firm. Each source is given a 'weight' based on its proportion in the total capital. For example, if a firm is 60% debt and 40% equity, WACC will be (0.60 × Cost of Debt) + (0.40 × Cost of Equity). It represents the overall risk and cost of the entire business.
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Start Lesson: Cost of Equity (Ke)