What are the Meanings of Cost of Capital?

The cost of capital is the required return on the various types of financing. This cost can be explicit or implicit and be expressed as the opportunity cost for an equivalent investment alternative.

In the same way, we can establish that the cost of capital is the return that a company must obtain on the investments it has made with the clear objective of maintaining, in an unalterable way, its value in the financial market.

The concept that concerns us now is also known as the Minimum Acceptable Rate of Return (TMAR). Specifically, in order to calculate it, it is important to take into account two fundamental factors, such as the value of what inflation itself is and the risk premium for the corresponding investment.

The cost of capital is the remuneration that investors obtain for their contribution of funds.

Capital cost and risk estimation

It is important, in this framework, to carry out an exhaustive study of the market. This also means that it is necessary, in order to determine the cost of capital, both total and appropriate, to establish the average cost of capital. To achieve the same, what must be undertaken is the clear exposition and achievement of both what the marginal weights are and the historical weights.

The determination of the cost of capital, therefore, implies the need to estimate the risk of the undertaking, analyzing the components that will make up the capital (such as the issuance of shares or debt). There are different ways to calculate the cost of capital, which depend on the variables used by the analyst.

In other words, the cost of capital assumes the remuneration that investors will receive for contributing funds to the company, that is, the payment that shareholders and creditors will obtain. In the case of shareholders, they will receive dividends per share, while creditors will benefit from interest on the amount paid (for example, they contribute $10,000 and receive $12,000, which means $2,000 interest for their contribution).

The cost of capital can be understood as the return on financing.

Evaluation and fees

The evaluation of the cost of capital informs about the price that the company pays to use the capital. Said cost is measured as a rate: there is a rate for the cost of debt and another for the cost of own capital; both resources form the cost of capital.

It should be noted that the capital of a company is made up of external stockholders’ equity obtained through the issuance of common stock as opposed to retained earnings, internal stockholders’ equity from retained earnings, preferred stock, and the cost of ownership. debt (before and after taxes).

That is to say, when determining the aforementioned cost and also analyzing the capital in depth, we must carry out the establishment and study of issues as extremely important in the matter as would be the case of the tax deductibility of interest, the rate of return that shareholders require on preferred shares, the level of leverage or the minimum return on shares in countries that do not have a stock market.

Cost of Capital