All business ventures require capital to grow and expand. This capital usually comes at a cost because whoever is providing the cash needs to be compensated for the risk they are incurring. Capital typically comes in form of equity, debt and grants. Since grants are typically not expected to be paid back we can argue that the cost of grants is zero or negligible. The cost of debt is the interest rate you pay to the lender throughout the loan period. Equity capital is provided by shareholders. Shareholders incur the most risk in a project and therefore demand a higher premium than debt providers. The cost of equity can be approximated by using the prevailing risk free rate on a government security and adding an appropriate risk premium.
A business may use a combination of equity and debt to finance its operations. In this case we can compute a weighted average cost of capital to estimate the company’s cost of capital. The weighted average cost of capital takes into consideration the proportion of debt to equity in a company’s capital structure. Debt is cheaper than equity and it maybe tempting for a business owner to load up on too much debt. However, too much debt leverage increases the risk of default which in turn increases the firm’s cost of capital. A business owner must strive to find an optimum level of debt to equity which minimizes the overall cost of capital.
Knowing your cost of capital can help you determine the viability of the different projects you are considering investing in. For example, it makes little sense to borrow at 20% from a bank and invest in something which is returning say 12%. In this case you are just losing money. If you do decide to borrow at 20% then you must invest in projects which promise a minimum return of 20%. In other words business owners should only invest in projects whose expected returns exceed their cost of capital.