What are the cost of capital?
The cost of capital is any money that the company risks when it decides to invest its funds in a new project or initiative rather than in investment securities. These costs are calculated by projecting the return level for the project and investment. If the return on investment is higher than on a business project, the opportunity for the opportunity would be the amount of this difference. Business managers use this tool to compare alternatives and consideration of costs and benefits of various business initiatives.
profit of earning is the goal of every business, but knowing what to do with these profits can be the difference between a business that succeeds for a long time and one that after a short period of success. It is essential that managers consider all their alternatives to decide what to do with their excessive means. One concept that can help them are capital costs, which shows the differenity between the levels of return on new projects and investment opportunities.
As an example of how it works, someone can imagine that the company has received $ 100,000 (USD) in a particular year and has to decide what to do with it. It is considering expanding to the new market and predicts the return on investment of $ 10,000 to the original amount per year, which is 10% increase. The second alternative is to invest in shares with blue chips, which is expected to increase by 15%per year. The profit is found by taking 15% of $ 100,000, which is $ 15,000 - by $ 5,000 more than $ 10,000, which would be harvested by the extension project. This $ 5,000 is in this example the cost of capital.
Of course, it is that it is measuring is the fact that the projection is never 100% fulfilled. In the above example, the company issues COULD shares imaginably suffering from a business loss that would significantly change the value of its stock. Such calamity would, in turn, change the cost of investment.
Since such uncertain results are always options, businesses should also assure the risks of investment. If the project has a certain amount of risk associated with its success, the company should compare with an investment with a similar degree of risk. This can help reveal which of these two alternatives is the best choice for the company.