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Cost of Capital
The cost of capital is the rate of return that must be reached to satisfy investors. There are two aspects of cost of capital. First, the cost of funds that are raised, and the return that investors expect receive. Second, cost of capital is the minimum return a company expects to make on the investment that it has made. If a company fails to the required return to shareholder and loan holders, then they will most likely take their investment elsewhere.
Additionally, the cost of capital has three parts to it. It requires a risk free rate of return, meaning a return required from a risk free investment. Cost of capital also needs a business risk premium, an increase in the required rate of return because of some uncertainty about the future. Third, the cost of capital requires a financial risk premium. This is in case of any inconsistency in equity earnings after payment is made to debt capital holders.
A company can raise capital by issuing stock, borrowing, or a combination of the two. Either way, raising capital always has its price.
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