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Cost of Capital

Candlefocus Editor
When calculating the cost of capital for a company, it is necessary to consider both the cost of debt and equity. The cost of debt has two components, the repayment cost (or effective interest rate) and the default risk premium. The repayment cost is the interest rate a company has to pay on its borrowed money (debt), and the default risk premium is the compensation that creditors require to bear the risk of a company’s default. The cost of equity represents the return that a company needs to deliver its shareholders. More specifically, it is the return shareholders expect to earn on their investment.

The weighted average cost of capital (WACC) is a firm's overall cost of capital, or the rate of return a company needs to pay on its capital in order to make its investors happy. The WACC can be calculated by taking into account a company's capital structure i.e., the mix of debt and equity used to finance its operations. To calculate the WACC, one must multiply the cost of each type of capital (equity and debt) by its respective weight in the capital structure; the weights reflect the proportion of the company’s total capital that is made up of each kind of capital.

The cost of capital is an important concept in business finance and is used to determine the feasibility of investment projects. It is also used to assess the amount of debt a company should carry by comparing the returns obtained from projects with the total cost of capital. Companies must not only earn a return that exceeds its cost of capital, but they must also expect to be able to generate this return over the life of the project.

In conclusion, the cost of capital is a crucial metric for any company to guide its investment decisions. Companies must assess the risk of their projects and weigh the cost of capital against the potential returns to determine the feasibility of a project. The WACC allows companies to calculate their cost of capital in one simple calculation by taking into account the cost of indebtedness and the return expected for equity. The cost of capital is an important factor for all companies to consider before pursuing any capital project.

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