What is Cost of Capital?
The term cost of capital refers to calculating the minimum returns a business expects from an investment to justify the expenses. In other words, if a company is undertaking a capital budgeting project, the cost of capital can help determine whether the project is worth investing in depending on the return value it promises.
Significance of Cost of Capital in E-commerce
The cost of capital is an essential concept in business accounting. It represents the returns a new project promises and whether it can offset the cost that needs to be invested to finance the project. If a business wants to construct a new warehouse or purchase production equipment, both of which require a lot of investment, it will need to generate the cost of capital for the project to see if it’s worth investing in.
Financial and business analysts use the cost of capital to determine whether an investment will bring profit to the company’s balance sheets.
Prerequisites of Cost of Capital and How to Calculate It
The most common method for calculating the Cost of Capital is WACC. To determine the Weighted Average Cost of Capital, analysts also need to consider factors like cost of debt and cost of equity.
WACC = (E/V x Re) + (D/V x Rd) x (1-T)
If the value of WACC is too high, the business’s debt is risky, or the stock is volatile. Investors may demand better returns for their investments in these cases.
Use Case with Cost of Capital
Growing and expanding a business requires a lot of capital, whether buying a new office space or building a new factory. Each proposed project is analyzed, and its cost of capital is determined. As investors wish to invest in these expansions, the company usually chooses the option that promises the highest returns.