The definition of cost of capital refers to the cost that a company incurs to finance its investment projects through its own financial resources.
The concept of cost of capital is of great value for the survival of a company. To calculate the cost of capital, it is necessary to take into account the relationship between the average of the different financial resources used to carry out projects and investments, and the value that each resource has in the total resources.
How to calculate the cost of capital
The formula for calculating the cost of capital is as follows
Ke = Rf + BI (Rm-Rf)
- Ke = cost of capital
- Rf = risk-free rate
- BI = market return
- BI (Rm - Rf) = known as the company's premium
- Rm - Rf = the market premium
Capital cost characteristics
The cost of capital has a number of characteristics, including the following:
- The lower the risk of the assets, the lower the coste of capital.
- Cost not directly appreciable.
- It is generally calculated based on the CAPM (Capital Asset Pricing Model).
- More difficult to calculate than the cost of debt.
The monitoring of the cost of capital should be as rigorous as possible. Among other things, it enables the company's efficiency to be improved by optimizing the cost-benefit ratio, finds the needs of the business, analyzes the unit cost of production and specifies the company's economic model by studying its sources of external financing. and own. The cost of capital is essential to calculate it in the financing plan initial company, to find out which are the sources of financing that interest us the most.
The investment in capital is of great value for the company to function properly, but it is also necessary to study the cost. In a very simple way, it can be said that the meaning of cost of capital is the cost of financing to produce capital.
Among the variables to take into account are market risk, where the higher the risk, the higher the return demanded by investors will also be, and that will imply a higher cost for the business; interest rates and the cost of financing; and the cost of own resources and the opportunity cost to be able to have more capital and face more powerful investments.