Every decision, whether personal, organizational, or business, is not without cost. In our analysis of what needs to be done and when things need to be done, we look at every opportunity or variable. This is the meat of the cost of capital.

 

The cost of capital is the opportunity cost of an investment (Investor Words 2007 [online]). It is the rate of return that a company would otherwise earn in an alternative investment decision for the same risk level that the primary investment decision was made. The cost of capital therefore, is not only an exercise of the monetary cost of a good but also the foregone benefit when a capital good is selected.

 

The opportunity cost of capital can be illustrated in such simple terms. For example, Mr. Sam is peddling shoes. Being hard at work walking around the city, he decided to buy a bicycle. The monetary cost of capital is the price of the bicycle. However, the opportunity cost of capital is the benefit that he could have gotten if he used the money to buy the bicycle for some other things (like a wagon for his shoes). The opportunity cost of capital is therefore, an economic fabric in every business decision.

 

In another viewpoint, the cost of capital is the weighted sum of the cost of equity and the cost of debt. It is also known as the discount rate (Wikipedia 2007 [online]). For an investment to be feasible, the return of capital should be in excess of the cost of capital. These factors are governed by probabilities and projections over a set period of time known as investment appraisals.

 

The cost of equity and the cost of debt are valuable variables in determining the cost of capital. For any business, capital can be acquired by loans (debt) against the value of assets (equity). The cost of debt is calculated with the risk associated or interest rate in giving debts. Meanwhile the cost of equity is the perceived return of a capital investment. This value is taken from other investments with similar risks to arrive at a certain cost of equity.

 

The weighted average cost of capital is used to determine a company’s cost of capital by using different weights of various components such as equity and debt. The equation for weighted average cost of capital uses the cost of equity and cost of debt as coefficients. In this equation, an increase in the cost of equity or the cost of debt increases one’s cost of capital.

 

The cost of capital is therefore, central to different business decisions. In essence, the cost of capital is affected by risk or interest rate, the value of the capital good, and its value in the future. At the same time, the opportunity cost of capital is governed by the different values of alternative investment decisions. Thus, for an executive tasked to make an investment call, approximating an accurate cost of capital can go a long way in making smarter business decisions.

References

 

InvestorWords. (2007). Cost of Capital. Available: http://www.investorwords.com/ 1153/cost_of_capital.html. Last accessed 18 October 2007.

 

Wikipedia. (2007). Weighted Average Cost of Capital. Available: http://en.wikipedia.org/wiki/ Weighted_average_cost_of_capital. Last accessed 18 October 2007.

 

Wikipedia. (2007). Cost of Capital. Available: http://en.wikipedia.org/wiki/cost_of_capital. Last accessed 18 October 2007.