What Is Cost of Capital?

Cost of capital is a key concept in business and finance that is important for college students to understand. Simply put, it is the total costs incurred when raising capital in order to fund a business venture or project. It is normally expressed as a percentage of the funds raised.

Types of Cost of Capital

Cost of capital can come in different forms and there are numerous sources of capital that a business may use to fund their projects. The main types of costs of capital are equity, debt, and hybrid.

• Equity: Equity represents the portion of funds raised through investment from venture capitalists, stock holders, or angel investors. Equity financing is riskier but also usually cost less to borrow in the long run.
• Debt: Debt financing comes in the form of loans or borrowing from lenders such as banks. Debt has to be paid back regardless of the success of the venture. The cost of debt consists of interest payments.
• Hybrid: Hybrid financing is a combination of both equity and debt. It is usually less risky than pure equity and the cost of capital is normally a blend of both equity costs and debt costs.

Calculating Cost of Capital

The cost of capital is calculated by taking the weighted average of the cost of each form of financing. The percentage of each form of capital needed to finance the venture is used to determine its weight. The higher the cost of capital, the greater the cost to the company as well as the higher the return that investors need to receive.

Conclusion

Cost of capital is an important concept for college students to understand, as it has a major impact on the overall success of a business venture. It is the total cost of raising capital and depends on the sources of capital used, as well as their respective costs. By calculating the weighted average of the costs of each form of financing, companies can more accurately estimate the cost of capital and ensure their sources of capital are not overburdening them.