Financial modelling terms explained

Cost Of Capital

Cost of capital is the rate of return that a company must pay to its lenders, investors and owners. It is required for making a company's financial decisions such as whether to finance a new project using debt or equity.

What is Cost of Capital?

The cost of capital is the rate of return that a company expects to earn on its invested capital. This includes both debt and equity capital. The cost of capital is used in financial modeling to calculate the weighted average cost of capital (WACC), which is the rate of return that a company expects to earn on its invested capital.

How Do You Calculate Cost of Capital?

There are a few different ways to calculate cost of capital, but the most common is to use the weighted average cost of capital (WACC). The WACC is a calculation of the average cost of all the company's capital sources, weighted by the relative size of each source. The calculation takes into account the risk of each source of capital, and the cost of debt is typically lower than the cost of equity, so the WACC will usually be lower than the weighted average cost of the individual sources.

To calculate the WACC, you need to know the following:

1. The cost of debt2. The market value of debt3. The market value of equity4. The beta of equity5. The risk-free interest rate6. The expected dividend yield

To calculate the WACC, you first need to calculate the weighted average of the costs of the different sources of capital. This is done by multiplying the cost of each source by its weight, and then adding up the results.

For example, if the cost of debt is 5%, the market value of debt is $100,000, the market value of equity is $200,000, and the beta of equity is 1.5, the weighted average cost of capital would be:

5% x $100,000 = $5,0001.5 x $200,000 = $3,000

$5,000 + $3,000 = $8,000

The next step is to find the cost of each source of capital. This is done by dividing the cost of each source by the weight of that source.

For example, the cost of debt would be $5,000, and the weight of debt would be $100,000, so the cost of debt would be 5%. The cost of equity would be $8,000, and the weight of equity would be $200,000, so the cost of equity would be 8%.

The final step is to multiply the cost of each source of capital by its respective weight, and then add up the results.

5% x $100,000 = $5,0008% x $200,000 = $16,000

$5,000 + $16,000 = $21,000

The weighted average cost of capital is $21,000.

Who Uses Cost of Capital?

The cost of capital is used by a variety of financial professionals in the investment and lending industries. For individual investors, it can be used to measure the potential return of an investment and to make comparisons between different investment opportunities. For businesses, the cost of capital can be used to make decisions about whether to invest in new projects, to measure the profitability of different projects, and to make decisions about how much debt and equity to use in financing projects. Banks and other lenders use the cost of capital to set interest rates on loans and to measure the riskiness of different types of loans.

What Do You Have to Watch out for When You're Performing Cost of Capital?

There are a few things that you need to be aware of when you are performing a cost of capital calculation. The first is that the calculation will be affected by the company's capital structure. The cost of debt will be lower than the cost of equity, so the company's overall cost of capital will be lower if it has a lot of debt in its capital structure. The second thing to watch out for is the use of historical data. The cost of capital calculation will be more accurate if you use projected data rather than historical data. Finally, you need to be aware of the risk of the company's projects. The higher the risk of a project, the higher the cost of capital will be.

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