Cost of Capital vs Rate of Return
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 rate of return refers to the return that can be obtained by investing capital in business activities and growth. The following article describes the cost of capital and rate of return and provides a clear distinction between the two.
What is Cost of Capital?
Cost of capital is the rate of return that can be obtained by investing in another project with similar risk levels; the cost here would be the opportunity cost of the return that could have been earned by making an alternative investment. Cost of capital is calculated by adding up the cost of equity and cost of debt.
Cost of equity refers to the return that is required by investors/shareholders, it is calculated as 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, RM is the market rate of return, where (RM-Rf) refers to the market risk premium.
Cost of debt is calculate as (Rf + credit risk rate)(1-T). Here, the risk free rate of a bond with a matching term structure to the debt is added onto the credit risk rate, or a default premium that increases alongside debt levels, which is then calculated by reducing the tax rate as debt is tax deductible.
What is Rate of Return?
Rate of return refers to the return that is obtained after capital is invested. One of the major deciding factors on whether an investment should be pursued or not depends on the level of return that can be earned from making that investment. This return will depend on the levels of risk undertaken, and the general rule is that higher the risk, higher the return. The rate of return on the capital invested should be compared to an investment with similar risk levels in order to determine whether the investment should be made.
Cost of Capital vs Rate of Return
Cost of capital and rate of return are closely related to one another. Cost of capital is the total of cost of equity and cost of debt, and it is also the opportunity cost (return that could have been earned) in investing in another project with similar risk levels. Rate of return refers to the return, income, or inflow that can be expected by making an investment. 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.
Summary:
• 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 rate of return refers to the return that can be obtained by investing capital in business activities and growth.
• 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.