The Importance Of ‘Cost Of Capital’ When It Comes To Evaluating Investments
Cost of capital is critical to capital budgeting, determining capital structure and evaluating financial performance
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When it’s a question of assessing the value of a capital budgeting project, such as systems overhaul, novel plant, equipment updates, etc., one of the major metrics that investors, analysts and stakeholders have their eyes on is cost of capital. Knowing the cost of capital helps in determining the return that a capital project will generate vis-à-vis the project cost.
As much as the cost of capital crucial to a company, it matters to the investors who’ve put their funds into the company’s stock or bonds. Stakeholders want a return on investment, and capital expenditure carries the potential of either giving good returns or putting a dampener to the profitability.
Investment platform Groww helps you understand what exactly is cost of capital and how important it is for evaluating an investment.
What is cost of capital?
From an investor’s viewpoint, cost of capital is an estimated minimum return or profit a company is expected to earn before it’s able to generate value for investors. From the company’s perspective, it is the cost of financing a project from sources (equity, debt) and an evaluation of how much should a project earn to get past these costs and be profitable, justifying the investment.
For a capital expenditure to be worth it, returns should be higher than its cost, calculated as a percentage value. The company should be able to earn more than its capital costs if it aims to deliver good returns to its shareholders and maximise value.
How critical is cost of capital?
Cost of capital has several implications for a business and its stakeholders. From influencing capital structure and dividends, to helping make several financial decisions, it has an important role to play in financial management and leads to direct and indirect implications for investors.
· Capital budgeting decisions: In capital budgeting, cost of capital is used as a potential discount rate for future cash flows from a capital project to determine the present value. This helps companies and investors evaluate all possible investment avenues and take an “accept” or “reject” decision on a venture. If the project’s rate of return is higher than its cost of capital, it has more chances of being accepted.
· Determining capital structure: A business uses an optimal combination of equity and debt in its capital structure or capital budgeting project to reduce financial risk. Considerations such as cost of debt, which is lower than that of equity, and risk of default are accounted for to create a judicious mix. If the company is attempting to minimise the average cost of capital in order to maximise value, it is worth investing in.
· Weighing up companies as potential investments: Cost of capital is a key metric in evaluating whether or not the stock of a company is worth investing in. If the return on investment is higher than the cost of capital, the company will create value and investors will be bullish. On the contrary, RoI equal or lower to cost of capital may indicate that the company doesn’t warrant investment.
· Evaluating financial performance: By comparing the profitability of a capital project with that of its cost of capital, its financial performance can be ascertained. The performance can be deemed satisfactory if the former exceeds the latter.
· Determining dividend policy: Dividend decisions are often taken after factoring in the cost of capital. By comparing the cost of capital with the internal rate of return, a business’ nature can be ascertained (growing, constant or declining), which has an impact on the dividend policy and investor interest.
· Assessing financial health: If a company has a history of projects that have had a higher average cost of capital or has ongoing projects with a similar pattern, it is advisable to stay away from its stock as it carries a risk of lower future returns.