Cost of capital is a calculation to determine how much it will cost a company to finance a project through other people’s money (OPM). The most common sources of OPM are bank loans, bonds, and stock offerings made to investors. The best tips for cost of capital analysis include a review of the sources that charge interest rates on borrowed money, the use of weights when computing the cost of capital, and the comparison of the cost of capital to the company’s internal rate of return. Cost of capital analysis is most often done when a company has a new opportunity or project it is considering. Outside of this capital budgeting process, the analysis does not serve very many purposes.
Capital budgeting typically puts together all costs associated with one or more projects. The company also reviews available cash it has on hand for paying part or all of these costs. The purpose of doing business at times, however, is to find ways to use OPM for business projects. Therefore, finding sources for money to finance these projects is necessary so companies can retain their cash for other uses. Larger businesses may be able to do this better than smaller companies in the capital budgeting and cost of capital analysis process.
Bank loans and bonds represent both short and long-term obligations to outside individuals or financial institutions. Companies must be careful using these sources or money as too much leverage does not help a company look financially viable. Equity sources may be preferable to debt, but the costs associated with issuing stock one or more times may be prohibitive. Current shareholders may also dislike the fact that their shares become less valuable in terms of price.
Once companies have the interest rates in hand for the associated sources of funds, they may decide to weight the interest rates in the cost of capital analysis. These weights may be based on historical or book value figures associated with previous projects. The purpose of using weights is to place more importance on certain types of debt in the cost of capital analysis formula. Using weights may not be necessary, though a company can do so if the process calls for it. A finance analyst may be able to help guide a company in the cost of capital formula.
The internal rate of return is a preset number a company desires of all projects. This figure should be higher than a company’s cost of capital. Once a company computes the cost of capital for each project, a comparison to the internal rate of return is necessary. The internal rate of return may be different for various types of opportunities in some cases.