So why do you need to estimate the cost of capital for a business? If you own a business or serve business owners as a professional advisor, you participate in the market. Why is this important? Because the market defines how every participant plays their part.
Guess what part of this game is crucial to the success of any business? If you said money, you are on the right track. You cannot run any business without the funds you need. But to attract the money business owners must compete. In other words, you need to explore the business market to see what it takes to get the required capital.
In terms of economics, you could say that the cost of capital is the price you have to pay in order to get the money you need to run the company. Moreover, since the financial resources are scarce, your business must show the prospective investors that it can pay the price they want. Investors call it the required rate of return.
The opportunity cost
There you have it. The cost of capital to your business represents the return the investors demand to hand you the money you need. Importantly, investors always look at a number of ways to put their money to work. So the cost of capital to your business is the opportunity cost to the investor who passes on alternatives to put the money on your company.
Even the smartest investor can only estimate the opportunity cost. Will the company actually provide the return on investment as expected? Anyone’s guess. So to minimize the risk of making a bad investment, people with money study the opportunities before the cash changes hands. What they want to do is assess the level of risk of each investment they consider.
Cost of capital goes up with risk
The higher the risk investors face, the greater the return they demand. So the business owners must promise the returns consistent with the level of risk their company represents. Be prepared to bear higher costs of attracting and retaining the money you need if your company is seen as more risky.
So that’s what the cost of capital is all about: the competitive return in the market on similar investment opportunities. As a result, you must size up the risk in order to compare alternative investments.