Understanding the Cost of Capital
The Necessary & Trustworthy Cost Of Capital
Do you know the cost of capital for your company? It is important to understand how the cost of capital impacts your business on a daily basis.
The year of 2020 has made business as usual feel rather unusual. It can be difficult to navigate what payments or costs are going to be worth it in the end. You may need to revamp your inventory management system or purchase equipment that will streamline your work more efficiently. It may be time to find equipment or tools that best suit the health and wellness of your employees. These can feel like non-negotiable assets to your business and daily management, especially during COVID-19.
As with any business, you’ll need to present proof to the company’s managers, board members, and/or leaders that these items or changes are in fact a necessity. One of the aspects in your presentation should include the evidence that the return on the investment can (and will) be better than the cost of capital for your company.
Defining the Cost Of Capital
When it comes down to brass tacks, the cost of capital is the minimum rate of return that your business must earn before generating value. Almost no item or service can provide a profit immediately. Whatever you are purchasing or investing in, it will need to generate sufficient income to cover the costs it uses to fund its operations.
What exactly does that look like? You’ll need to consider the cost of equity and cost of debt that is used when financing your business – its capital structure. Whether the capital structure relies only on equity, only on debt, or a combination; debt holders and/or investors expect to be repaid and/or a return. Knowing your capital structure is a critical piece of information when you are calculating the cost of capital for a service or asset.
Discount Rate & The Use Of Cost Of Capital
If someone was not well-versed in the financial structure of business, they may think that discount rate and cost of capital can be used interchangeably. This is not the case. Typically, your financial department will be the first to know the cost of capital since it is a mechanical calculation. From there, management teams can take the cost of capital and decide a discount rate (also known as a hurdle rate). The discount rate is the number that the company must exceed in order to justify the investment at hand.
Your capital costs are typically used by investors assessing the risk of your company’s equity and/or senior leaders to evaluate individual investments. When the cost of capital and discount rate are known, management teams will want to exceed the goal numbers in order to gain future support from leaders and/or investors for future proposals and projects. If everyone is on the same page within your business when it comes to cost of capital, your company can flourish by investing only in projects that will exceed that number.
Why Understanding Capital is Important
The cost of capital is a critical piece of information for companies to understand inside and out because, without its understanding, the business has no roadmap for success. The way that companies finance a project, piece of equipment, or service needed can determine the needs of the capital structure. This means that you need enough financing to complete an investment or project at the same time limiting and/or reducing your overall costs. Your calculation methods for cost of capital may vary depending on the structure of your company; however, the benefits and importance of the number remains the same:
- Businesses and investors can evaluate all investment opportunities properly with the cost of capital.
- You’ll be able to evaluate the progress of ongoing investments and/or projects by holding that progress next to the cost of capital.
- When key company budget calls take place by using company financial sources as capital, the cost of capital aids heavily in the decision-making process. This is especially true during COVID-19.
Overall, the cost of capital calculation is necessary when making current and future decisions in your business. In order to run a company successfully, you’ll need people on your side that can tell you what investment or project is worth it versus what may drown your company dry. At Transcapital Funding, we are on your side. We are there to assist your business in finding the right fit for your needs. Call us to find out how we can help you and improve your capital today!