Cost of Capital vs Cost of Equity
Companies require capital to start up and run business operations. Capital maybe obtained using many methods such as issuing shares, bonds, loans, owner’s contributions, etc. Cost of capital refers to the cost incurred in obtaining either equity capital (the cost incurred in issuing shares) or debt capital (interest cost). The following article takes a closer look at the concept cost of capital and cost of equity; one of the 2 major components that make up the cost of capital. The article clearly explains these concepts and points out their similarities and differences.
Cost of Capital
Cost of capital is the total cost in obtaining debt or equity capital. Cost of capital is the manner in which a company raises cash either through issuing stock, borrowing funds, etc. The cost of capital is the return that is needed by investors for providing capital to the firm, and this acts as a benchmark that new projects need to meet in order for the project to be considered. In order for an investment to be worthwhile, the rate of return on the investment must be higher than the cost of capital.
Taking an example, the risk levels of two investments, Investment A and Investment B are the same. For investment A, the cost of capital is 7%, and the rate of return is 10%. This provides an excess return of 3%, which is why investment A should go through. Investment B, on the other hand, has cost of capital of 8% and rate of return of 8%. Here, there is no return for the cost incurred and investment B should not be taken into consideration. However, assuming that treasury bills have the lowest level of risk, and have a return of 5%, this may be more attractive than both options since risk levels are very low, and a return of 5% is guaranteed since the T bills are government issued.
Cost of Equity
Cost of equity refers to the return that is required by investors/shareholders, or the amount of compensation that an investor expects for making an equity investment in the firm’s shares. Cost of equity is an important measure and allows the firm to determine how much return should be paid to investors for the level of risk taken. The cost of equity can also be compared with other forms of capital such as debt capital, which will then allow the firm to decide which form of capital is the cheapest. Cost of equity is calculated as follows.
Es = Rf + βs (RM – Rf)
In the equation, Es is the expected return on the security, Rf refers to the risk free rate paid by government securities (this is added because the return on a risky investment is always higher than government risk free rate), βs refers to the sensitivity to market changes, and RM is the market rate of return, where (RM – Rf) refers to the market risk premium.
Cost of Capital vs Cost of Equity
Cost of capital is comprised of two components; cost of equity and cost of debt. It is also the opportunity cost (return that could have been earned) in investing in another project with similar risk levels. When deciding between investments of similar risk levels, an investment should only be made if the return is higher and cost of capital is lower than the alternative. The major difference between cost of capital and cost of equity is that, cost of equity is the return required by the shareholders to compensate for the risk taken to invest in shares and cost of capital is the total return required from the investment in securities (debt and equity both).
Summary:
Difference Between Cost of Capital and Cost of Equity
• The cost of capital is the return that is needed by investors for providing capital to the firm, and this acts as a benchmark that new projects need to meet in order for the project to be considered.
• Cost of equity refers to the return that is required by investors/shareholders, or the amount of compensation that an investor expects for making an equity investment in the firm’s shares.
• The major difference between cost of capital and cost of equity is that, cost of equity is the return required by shareholders to compensate for the risk taken to invest shares and cost of capital is the total return required from the investment in securities (debt and equity both).