The cost of capital is the amount a company must pay to raise funds, including both debt and equity capital, to support its business activities. This is a key factor in evaluating investment efficiency and managing corporate finance.

Accurately calculating the cost of capital helps businesses make sound investment decisions and maximize profits. In this article, XAUXI will guide you through the concept of cost of capital, how it’s calculated, and how to optimize financial resources. Let’s dive in!

What Is Cost of Capital?

Cost of capital refers to the expense a company incurs to obtain financial resources. It includes both debt (borrowed capital) and equity (owner’s capital), used to fund business operations and investments. This cost is typically expressed as a percentage and reflects the interest rate or return that investors require.

Cost of capital is a crucial metric for businesses.

The Importance of Cost of Capital in Investment Decisions

Cost of capital plays a vital role in evaluating investment performance and making financial decisions. It helps businesses determine the minimum return a project must generate to create positive value. If the expected return on a project exceeds the cost of capital, the project is likely profitable. Conversely, if the return is lower than the cost of capital, the project may be unviable and could result in losses.

Moreover, cost of capital serves as a benchmark to compare different investment opportunities. Businesses tend to prioritize projects with returns higher than the cost of capital to maximize shareholder value.

Example of Cost of Capital

Suppose a company needs to raise VND 1 billion to invest in a project. It decides to use 60% debt at an interest rate of 8% and 40% equity with an expected return of 12%. The weighted average cost of capital (WACC) is calculated as:

WACC = (60% × 8%) + (40% × 12%) = 9.6%

With a cost of capital of 9.6%, the company must ensure that the project's return is higher than this rate to generate added value.

Why Is It Important to Determine Cost of Capital?

Determining the cost of capital is a vital step in financial management for the following reasons: