When the cost of capital rises, the value of any increase in income is reduced. Companies and financial analysts use this cost to determine if funds are being invested effectively. If the return on an investment is greater than the cost of capital, it will be beneficial to the company's balance sheets. Conversely, an investment whose returns are equal to or lower than the cost of capital indicates that the money is not being spent wisely. The cost of capital is more complex, since the rate of return required by stock investors is not as clearly defined as that of lenders.
It is a calculation of the minimum return necessary to justify carrying out a capital budgeting project, such as constructing a new factory. This indicates how long it will take for the project to amortize what it cost and how much it will return in the future. The cost of capital can also vary depending on the type of project or initiative; a highly innovative but risky initiative should entail a higher capital cost than a project to upgrade essential equipment or software with proven performance. When the cost of capital is high, investors are likely to see less value in owning a portion of that company's capital. An investor could analyze the volatility (beta) of a company's financial results to determine if the cost of a stock is justified by its potential return.
In more extreme cases, issuers whose costs exceed their ability to pay the required coupons could face bankruptcy, hurting the price of bonds for debt holders. The cost of capital can vary depending on the industry. For example, according to a compilation by the Stern School of Business at New York University, housing construction has a relatively high cost of capital of 10.68%, while the retail grocery business is much lower, at 6.37%. The rise in official interest rates of central banks has a direct impact on the cost of capital for companies and other debt issuers. The overall cost of capital is derived from the weighted average cost of all sources of capital. It is used to discount future cash flows from potential projects and other opportunities to estimate their net present value (NPV) and their capacity to generate value.
The cost of capital is generally calculated using a weighted average cost formula that considers both debt and equity capital. When the cost of capital increases, it measures the cost of borrowing money from creditors or obtaining it from investors through equity financing, compared to the expected returns on an investment. The cost of debt can also be estimated by adding a credit differential to the risk-free rate and multiplying the result by (1) - T).
