What are the average cost of capital?
Average capital costs are the amount of money that the company has to pay to ensure debt financing or equity. For example, bond coupons are interest payments made by the company to investors holding this tool. The cost of capital for its own capital represents dividends for preferred shares or levels of stock prices for ordinary shares. In order to determine the average capital costs, the company can add bond coupons and dividend payments together and divide the total amount secured for financing. Both figures represent annual payments. The total amount secured for external financing is $ 20,000. The annual average capital costs are 7.5 percent (1,000 + 500 /20,000). Therefore, if the Company agrees with the three -year plan of this financing option, the total cost of capital will have 22.5 percent (7.5*3) per $ 20, 000 USD. Companies compensate for capital costs by investing $ 20,000 in business operations that will generate moreRevenues and profits. This helps to pay capital costs.
Company counts their average cost of capital because these numbers are operating costs. Starting new business operations or purchasing new major operating assets usually require external funds. Large organizations or publicly held companies usually have several financing options. Determination of average capital costs is therefore important because each type of loan or stock funds will have different impacts on their company.
Another common formula for calculating average capital costs is a weighted average formula of capital (WACC). It is a common financial formula that increases the weight of each part of the financing of the debt and the equity used in this process. USD $ 20,000 is $ 1 $ 2,500 in bonds and $ 7,500 USD $ 7,500 in preferred shares. WACC focuses on interest rates paid for exteRNNO funding. Interest rates for each type of financing are 10 percent for bonds and 7 percent for their own capital. WACC for this project is 8.9 percent per year (((12 500/20 000))*. 10) + ((7 500/20 000)*. 07)). This focuses only on interest rates, which is the normal cost of capital used for other financial formulas.
Most companies compare their capital costs with return on investment from various projects. This allows owners and managers to have a quick figure to compare with every new business opportunity. For example, projects with a return of an investment of less than 8.9 percent will be rejected in favor of projects over 8.9 percent.