COST OF CAPITAL Meaning and
Definition
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Cost of capital refers to the overall expense that a company incurs in order to fund its operations and expansion through a combination of debt and equity. It represents the average rate of return that a company must earn on its investments in order to satisfy its various sources of financing, such as shareholders and lenders.
The cost of capital is calculated as a weighted average, considering both the cost of equity and debt. Equity represents the funds provided by shareholders through the purchase of stocks, and the cost of equity is the return expected by shareholders for taking on the risk of investing in the company. Debt refers to the funds borrowed from lenders, and the cost of debt represents the interest expense the company must pay for using those borrowed funds.
The weighted average cost of capital (WACC) is the most common measure used to determine the cost of capital. It considers the proportion of debt and equity in a company's capital structure, applying the respective costs to calculate an overall rate. The WACC is used as a benchmark to evaluate potential investments or projects, as any new venture should generate returns higher than the company's cost of capital to be considered profitable.
Determining the appropriate cost of capital is crucial for making sound financial decisions, as it helps companies assess the feasibility of projects and ensure that the returns generated exceed the cost of financing, ultimately maximizing shareholder value.
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