Cost of Capital

November 3, 20152 min read
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Cost of capital refers to the minimum rate of return a business or company has to generate before a new purchase, or investment starts to make money. The cost of capital is also seen as the cost of a company’s funds, including debt and equity.

For any business or major corporation to achieve profitability, the business will need to generate sufficient capital that covers all its operational costs. Any leftover capital available is considered as the profits of the business or company.

Calculating the cost of capital

For businesses to calculate the cost of capital, three separate calculations will need to be completed first. These calculations are:

  1. Weightage of Debt x cost of Debt
  2. Weightage of preference Shares x cost of preference shares
  3. Weightage of Equity x the Cost of Equity

Once each of these has been individually calculated business owners or financial administrators can then add each set value to find the total cost of capital.

Individual calculations for each of these are relatively complex, thus businesses make use of accountants to assist in the final calculation of the cost of capital.

Cost of Capital and Capital Structure

Determining the final capital structure of a business or company can be difficult to calculate. For this to be determined, both debt financing and equity financing will need to be calculated. These are two different entities and host their advantages and disadvantages.

Capital structure is important to calculate, as this will contribute to the cost of capital currently owned by the business or company.

Costs associated with the expansion of the business, i.e. acquisition of land, commercial property, or construction to enhance operations can be associated with the capital costs of the business. Items, equipment, and other assets that are acquired to benefit the business and employees are also considered capital costs.