The primary meaning of Cost of capitalis merely the cost an entity must pay to raise funds. The term can refer, for instance, to the financing cost (interest rate) a company pays when securing a loan.
The cost of raising funds, however, is measured in several other ways, as well, most of which carry a name including "Cost of."
Defining "Cost of" Terms
Seven similar-sounding terms have the following definitions:
1. Cost of Capital
This term refers to the price an organization pays to raise funds, for example, through bank loans or issuing bonds. Cost of capital usually appears as an annual percentage.
2. Weighted Average Cost of Capital WACC
WACC is the arithmetic average (mean) capital cost that weights the contribution of each capital source by the proportion of total funding it provides. "Weighted average cost of capital" usually appears as an annual percentage.
3. Cost of Borrowing
Cost of borrowing refers to the total amount a debtor pays to secure a loan and use funds, including financing costs, account maintenance, loan origination, and other loan-related expenses. "Cost of borrowing" sums appear as amounts, in currency units such as dollars, pounds, or euro.
4. Cost of Debt
Cost of debt is the overall average rate an organization pays on all its obligations. These typically consist of bonds and bank loans. "Cost of debt" usually appears as an annual percentage.
5. Cost of Equity COE
Cost of equity COE is part of a company's "capital structure." COE measures the returns demanded by stock market investors who will bear the risks of ownership. COE usually appears as an annual percentage.
6. Cost of Funds
This term refers to the interest cost that financial institutions pay for the use of money. "Cost of funds" usually appears as an annual percentage.
7. Cost of Funds Index (COFI)
A Cost of Funds Index (COFI) refers to an established Cost of Funds rate for a region. In the United States, for instance, a regional COFI might be set by a Federal Home Loan Bank.
Explaining and Calculating Cost Of Terms in Context
Sections below further explain and illustrate the cost of capital concept and similar terms in context with related ideas and example calculations.
- What is the cost of capital? What do similar "Cost of" terms mean?
- Defining, explaining, and calculating Seven "Cost of" terms.
- Two definitions for Cost of capital.
- Weighted average cost of capital WACC.
- Cost of borrowing.
- Cost of debt.
- Two approaches to Cost of equity.
- Cost of borrowing.
- Cost of funds and the Cost of funds index (COFI).
A firm's Cost of capital is the cost it must pay to raise funds—either by selling bonds, borrowing, or equity financing. Organizations typically define their own "cost of capital" in one of two ways:
- Firstly, "Cost of capital" is merely the financing cost the organization must pay when borrowing funds, either by securing a loan or by selling bonds, or equity financing. In either case, the cost of capital appears as an annual interest rate, such as 6%, or 8.2%.
- Secondly, when evaluating a potential investment (e.g., a significant purchase), the Cost of capital is the return rate the firm could earn if it invested instead in an alternative venture with the same risk. As a result, Cost of capital is essentially the opportunity cost of using capital resources for a specific purpose.
Using Cost of Capital
In many organizations cost of capital (or, more often weighted average cost of capital WACC) serves as the discount rate for discounted cash flow analysis. Note that financial specialists will want to see a discounting study when the entity proposes investments, actions, or business case scenarios. WACC also appears sometimes as a hurdle rate, or threshold return rate, that a potential investment must exceed to receive funding.
The Cost of capital percentage differs significantly between different firms or organizations, depending on such factors as the entity's creditworthiness and prospects for survival and growth. In 2016, for example, a company with an AAA credit rating, or the US Treasury, can sell bonds with a yield somewhere between 4% and 5%. As a result, this percentage is mostly the cost of capital for these organizations. At the same time, organizations with lower credit ratings, whom the bond market views as "speculative," might have to pay 10% - 15%, or more.