Why is the cost of capital important
Cost of capital.
1. Term: Costs that arise from the use (interest, expected return) or use (depreciation) of capital over a certain period of time. They correspond to the desired minimum interest rate for investors or capital providers who, depending on the risk assumed, demand a risk premium in addition to a secure return. The risk premium is influenced both by economic causes, e.g. by inflation or interest rate risks, as well as by individual company factors such as creditworthiness, business or capital structure risks. Therefore, the level of the cost of capital can be influenced by entrepreneurial measures, such as risk management (risk management in insurance companies).
2. Components: In the case of borrowed capital, the cost of capital corresponds to the current borrowing rate; the expected loss of interest on the relevant alternative investment (opportunity costs) with a comparable risk is applied to equity.
3. Total cost of capital: According to the WACC (Weighted Average Cost of Capital) approach, the cost of capital is calculated as the weighted average of borrowing and equity costs.
4. Cost of capital in the event of uncertainty: Return demands of investors under uncertainty can be derived from the Capital Asset Pricing Model (CAPM).
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