Back to: Financial Management
Hello again, class! Welcome back.
Today we’re going to explore something that links directly to what we discussed last week. When a business wants to invest in a project, it often needs to raise money. But money isn’t free.
Cost of Capital
Whether it’s from loans, shareholders, or savings, there is always a cost. That’s what we mean when we talk about the Cost of Capital.
Simply put, the cost of capital is the price a business pays to use other people’s money. It’s like the interest you pay on a loan or the return investors expect when they put money into your company. A business must know its cost of capital before deciding whether a project is worth doing.
There are different types of capital, and each has its own cost. Let’s look at the main ones:
1. Cost of Debt
This is the cost of borrowing money. For example, if a company takes a loan from a bank at an interest rate of 15%, then the cost of that capital is 15%.
However, interest paid on loans is usually tax-deductible, so the real cost is often a bit lower. We call this the after-tax cost of debt.
2. Cost of Equity
This is the return that investors expect when they buy shares in a company. Since shareholders take a risk (they might not get any dividend), they usually expect a higher return than lenders.
The cost of equity is harder to calculate, but it’s important because it shows how much it costs the business to keep its owners happy.
3. Weighted Average Cost of Capital (WACC)
Most businesses use a mix of debt and equity to finance their activities. WACC is the average cost of all the capital the business uses, weighted according to how much of each type it has.
If a business is 40% financed by debt and 60% by equity, the WACC reflects both costs. Financial managers use WACC as the “hurdle rate”—the minimum return a project must give to be worth doing.
Let’s take a simple example: – A company takes a loan of ₦1 million at 10% interest
– It also raises ₦1 million from investors who expect 15% return
– Total capital = ₦2 million
– WACC = (₦1m/₦2m × 10%) + (₦1m/₦2m × 15%) = 12.5%
So, any project this company takes on should give a return of more than 12.5% to make sense financially.
Understanding cost of capital helps businesses in many ways: – It shows the minimum return expected from investments
– It helps decide whether to use loans or equity
– It helps in valuing the business and setting strategies
Businesses also try to balance their sources of finance. Too much debt can be risky if profits fall and interest must still be paid. Too much equity means giving away control or sharing too much profit. So, the financial manager must find the right mix.
In conclusion, the cost of capital is more than just numbers—it’s a key part of smart decision-making. Knowing how much it costs to use money helps a business avoid waste and focus on projects that truly add value.
Next week, we’ll explore how to manage the everyday money that keeps a business running—Working Capital Management. Until then, see if you can find out the interest rate on any business loan or investment product around you. Try to compare it to what kind of returns people expect. It’s a great way to understand this topic better.