Cost of Capital: How Businessmen and Investors use it to evaluate investments?

By Trader Pit

July 8, 2021


Cost of capital is simply the rate at which a firm can earn a return on its investments. The actual cost of capital is also referred to as the weighted average cost of capital. This means that the cost of capital for a firm is equal to the weighted average cost of capital for all of its capital sources. The weighted average cost of capital for a firm is equal to the present value of the expected distributions of all the firm’s sources of capital.

Cost of capital is the primary profitability metric used by businesspeople and investors alike. It is a single number that is used to measure the value of a business and is usually calculated using a company’s weighted-average cost of capital, also known as the CAPM. When the cost of capital of a company is greater than its weighted-average cost of capital, there is an excess of funds in the business. In other words, there is more money “invested” in a company’s operations than in its capital. The difference between the cost of capital and the weighted-average cost of capital is known as the “free cash flow.” Investors and businesspeople use these numbers to make decisions regarding capital allocation.

The cost of capital is the cost to a business of the funds it has borrowed to operate. To do business, cash flow must be organized both in the short and long term.

There are two ways to raise funds. The first is through capital. This is done by distributing the assets among the partners or shareholders.

The second is guilt. This is done by borrowing money from banks, NBFCs, issuing bonds etc.

Equity and debt together finance the business, which is called total capital. However, this capital also has a cost, which is called the cost of capital. How can I pay these costs? Make enough profit.

The business model should be such that profitability covers the cost of capital. The company must be able to generate cash flows that sufficiently exceed the cost of capital.

Let’s take a closer look at the cost of capital using some simple examples.

Video: Analysis of the cost of capital

Companies with a simple capital structure

We can understand the usefulness of the WACC from two perspectives. First, from the businessman’s point of view. Second, from the investor’s point of view. Both look at the WACC a little differently. Most of us probably only look at the WACC from an investor’s point of view, but it would be nice to have a perspective from the other side, right?

Businessman (senior manager)

For a businessman, the WACC is the minimum return on investment (ROI) he expects from his new ventures. Let’s say he’s in the food business. He decided to open a new branch at the same location. How do you check if the investment is worth it? It compares whether or not the profitability (ROIC) of the new company is higher than the current WACC.

For a businessman, the WACC is therefore the minimum level of profitability below which the company becomes unprofitable for him. In fact, he should only consider investing in this business if its profitability is at least 1.5 times the current WACC.

Why would a businessman think that? Because he’s worried about whether the new investment will bring in enough money. What is a sufficient amount of money? Investors get their expected returns and lenders get their repayments.

Investor (shareholders)

Also investors or shareholders base themselves on the WACC when making their investments. You will analyze the activity behind their actions in the following steps:

  • #1. Calculate the cost of equity : The investor examines whether the stock can meet his or her return expectations. How do you do that? By calculating the cost of capital using the CAPM formula. The assessment is made after checking whether the beta factor of the share is acceptable or not. Some investors may reject stocks with very high beta factors. Therefore, a beta of less than one should not be accepted. In addition, assumptions are made about the future behavior of the general index (Nifty or Sensex). Explore how the cost of equity is calculated.
  • #2. Compare WACC with RoCE and ROIC : This research is extremely important. Regardless of the quality of the action’s metrics, it is equally important to confirm whether the action can actually achieve those metrics. How do you confirm that? Find out whether the ROIC and RoCE have been higher than the WACC in the past or not.

Equity investors also use the WACC as a discount rate to calculate the present value (PV) of a company’s future cash flows. This gives the share/company an intrinsic value.

Frequently Asked Questions

How do you measure the cost of capital in making investment decision?

The cost of capital is the rate of return required by investors for a given level of risk.

How cost of capital is connected with the investment decision of companies?

The cost of capital is the cost of a company’s capital. The cost of capital is the return that the company expects to receive for its investment. The cost of capital is the interest rate that the company is willing to pay to raise capital. The cost of capital is the return that the company expects to receive for its investment.

How do you determine cost of capital?

The cost of capital is the amount of money needed to finance a project or company. The cost of capital is determined by the riskiness of the project or company’s investment.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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