Cost of capital is the minimum profit or return that a company must earn before it can generate value. A company's finance department is responsible for estimating the cost of capital while determining the financial risk and viability of an investment.Companies use cost of capital to know how much money a new business stream can generate to offset the costs involve and further achieve profits. This concept is also used to gauge the potential risk that future business decisions may bring.
To operate efficiently and remain profitable, a company will need to have a cost of capital that is lower than or equal to its competitors within the same industry.
Why it matters
Cost of capital indicates a company's financial health and feeds into business decisions. While evaluating a business opportunity’s potential, cost of capital helps companies determine the viability by measuring cost against earnings.Shareholders and business stakeholders may frequently analyze business cost of capital to ensure that the company is taking sound financial decisions. In an ideal scenario, businesses must limit cost of capital while expanding by tapping into viable opportunities.Investors and analysts use a company's cost of capital to determine stock prices and returns they may generate. For instance, if a company’s cost of capital is volatile, there are higher chances that the cost of its shares may drop and creditors may back out in the future.