What is the cost of capital and why is it important?
If you are involved in corporate finance, you need to understand what the cost of capital is and why it is important. The cost of capital is the minimum rate of return that a company must earn on its investments to maintain its market value and attract funds. It reflects the risk and opportunity cost of investing in a specific project or business. In this article, you will learn how to calculate the cost of capital, how it affects capital budgeting decisions, and what factors influence it.
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Optimize capital structure:Adjusting your mix of debt, equity, and retained earnings can fine-tune your cost of capital. For example, not paying dividends and instead boosting retained earnings can decrease your cost of capital, enhancing company value.
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Adjust hurdle rates:When assessing projects with varying risk levels, apply a risk premium to the weighted average cost of capital. This ensures you’re evaluating each initiative’s true potential against the right benchmark, leading to more informed investment decisions.