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7.Cost of Capital

Cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment is an opportunity cost, the cost of forgoing the next best alternative investment. In this sense, it relates to the economic principle of substitution— that is, an investor will not invest in a particular asset if there is a more attractive substitute.

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The cost of capital usually is expressed in percentage terms, that is, the annual amount of dollars that the investor requires or expects to realize, expressed as a percentage of the dollar amount invested.

7.1 Pointers regarding Cost of Capital are as follows:

1. Cost Of Capital Is Forward Looking

The cost of capital represents investors’ expectations. There are three elements to these expectations:

  • The “real” rate of return—the amount investors expect to obtain in exchange for letting someone else use their money on a riskless basis
  • Expected inflation—the expected depreciation in purchasing power while the money is tied up
  • Risk—the uncertainty as to when and how much cash flow or other economic income will be received.

2. Cost Of Capital Is Based On Market Value, Not Book Value

The cost of capital is the expected rate of return on some base value. That base value is measured as the market value of an asset, not its book value. For example, the yield to maturity shown in the bond quotations in the financial press is based on the closing market price of a bond, not on its face value.

3. Cost Of Capital Equals Discount Rate

The essence of the cost of capital is that it is the percentage return that equates expected economic income with present value. The expected rate of return in this context is called a discount rate. A discount rate reflects both time value of money and risk and therefore represents the cost of capital.

4. Discount Rate Is Not The Same As Capitalization Rate

Discount rate and capitalization rate are two distinctly different concepts. Discount rate equates to cost of capital. It is a rate applied to all expected incremental returns to convert the expected return stream to a present value.

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