The cost of capital is a term that is used in corporate finance regularly.
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It means the actual cost for your firm to acquire more money, or capital. This could be through debt financing, venture investments or public offerings of equity. In any case, there is a cost associated with increasing the amount of money your firm has to invest.
The cost of capital determines which projects you can undertake. If the returns on those projects are less than your cost to acquire the funds to invest, then it is not a project worth undertaking.
Several things come into play regarding the cost of capital for a firm. First, if a firm is leveraged with massive amounts of debt, lenders will be less likely to offer low interest terms on debt. This increases the cost to borrow and in doing so, the cost of capital. Also, investors will not want to invest in a firm with such large amounts of debt. The overall cost of capital increases relative to leverage. The opposite is also true.
Firms must compute a cost of capital in order to discount their future cash flows back to a present value. In order to do this, they must create an average cost of capital for the entire firm. An example will demonstrate why this is necessary.
Consider your firm has just received a project offer that will return 12% over the next two years. Your cost to borrow money at the bank is only 10%, so it looks like this is an attractive project. Let's say your firm invests in this project. A few weeks later, you get another project on your table that returns 18%.
This is obviously a significantly larger return than your other project, 50% larger in fact. However, you have already borrowed as much as the bank will let you borrow before paying off your loan. Another option is to produce an equity offering in the open market. However, the cost to do that is 20%. Therefore, you do not accept the 18% project because the cost of capital is too high.
Now, if you had calculated an average cost of capital for your firm, you could have combined the 10% and 20% costs of capital into one 15% average cost of capital. Then, your firm would have rejected the 12% bid and accepted the 18% bid. That is the correct business decision in these cases. Your firm must map out how much it will cost to borrow money in the future, depending on their debt status, and create an average cost of capital.
This is just a basic overview of how an average cost of capital can be a better discount rate for your firm. Just remember a few things.
Debt is usually the cheapest form of capital. This makes sense, since it is usually low risk for both sides and the terms can have stipulations for the company keeping them from making overly aggressive moves.
Equity is the most expensive for of capital. However, once your company reaches a certain size, the influx of equity is most likely the best move. Remember to use an average cost of capital as your discount factor, and your company will be poised to make accurate capital budgeting decisions.