New business ventures ultimately grow companies and provide shareholders a return on their investment. For this reason, financing decisions make or break a company’s future. This article discusses cost of capital and how the metric aids in the decision making process.
What Is Cost Of Capital?
Management makes financing decisions based on the growth opportunities. However, this seems a bit vague- what constitutes growth? The cost of capital is an economic term that defines the minimum expected return from investors for giving the company their capital. Also, consider this the benchmark for each new project.
Additionally, when management engages in projects that far exceed the cost of capital, value emerges for shareholders. This value sometimes comes in the way of stock price appreciation, or dividend growth. In either case, both investors and management are happy.
Breaking Down Cost Of Capital
Given an array of projects, good management picks the highest expected return over the cost of capital. However, risk exists in every business venture. Thus, cost of capital decisions factor in risk when choosing.
Risk measurements are calculated similarly for equity financing and debt financing. Debt is a loan from outside lenders, which requires an interest payment. This interest rate factors in a default premium, which is some level above the risk-free bond rate. Furthermore, as the debt level increases, so does the default premium.
Conversely, equity financing is a bit more subjective. This component infers a cost of capital by comparing the investment to other comparable investments. Also, these investments both need similar risk profiles, as decided by management.
In conclusion, the cost of capital is paramount in management’s decision process. Furthermore, sophisticated investors use this in evaluating the effectiveness of their money. The cost of capital is the benchmark for management, investors, and lenders in agreeing on new projects and evaluating risk .