Cost of Capital: Flotation Cost, NPV & Internal Equity

Lesson Transcript
Instructor: Josh Castle

Josh teaches business college courses and has a master's degree in business finance.

How does a business figure out the true cost and best means of obtaining capital? In this lesson, we will explore the cost of capital, flotation cost, net present value, and internal equity to help answer that question.

What Is Cost of Capital?

Businesses need capital - or money - to purchase items and manage their operations. For example, manufacturing companies need production plants with machines and people to run them. There are a couple of ways businesses can get the capital they need in order to run the plant. Companies can finance the business exclusively through equity. Or, they can finance the business by using debt. Businesses use either or both methods depending on their financial situation. Each method has pros and cons that need to be taken into account by the organization to determine the best path forward.

The cost of capital is a calculation used to determine the rate of return necessary to justify an investment. Let's say that a manufacturing company has two investment options: they can use their money to buy new machinery, which will bring an estimated 15% return on their money; or they could invest the money in a small start-up that would provide an estimated 10% return on investment. In this example, the decision to invest in new machinery will give the company the better return on its money.

Now that we have a better understanding of the cost of capital, let's look into some of the variables that make up the costs to borrow that capital.

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  • 0:03 What Is Cost of Capital?
  • 1:19 What Is Flotation Cost?
  • 1:43 What Is Net Present Value?
  • 2:46 What Is Internal Equity?
  • 3:11 Lesson Summary
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What Is Flotation Cost?

Publicly traded companies may be subject to flotation costs when raising money through securities, such as to pay for the purchase of another company or investments within the company. Flotation costs reflect fees or expenses involved in issuing securities, and they must be considered in relation to potential returns on investment or associated payments through dividends.

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