Josh teaches business college courses and has a master's degree in business finance.
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.
An error occurred trying to load this video.
Try refreshing the page, or contact customer support.
You must cCreate an account to continue watching
Register to view this lesson
As a member, you'll also get unlimited access to over 84,000 lessons in math, English, science, history, and more. Plus, get practice tests, quizzes, and personalized coaching to help you succeed.
Get unlimited access to over 84,000 lessons.Try it now
Already registered? Log in here for accessBack
- 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
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.
What Is Net Present Value?
Net present value (NPV) is a calculation that determines the present value of a business or another investment (as opposed to its future value). To derive the NPV, subtract the present cost of the investment from the present cash flow that will come in over a period of time. For example, let's say that a manufacturing company is investing in a piece of equipment that will cost $10,000 and save the company $3,000 per year over 3 years.
$9,000 - $10,000 = -$1,000
Since the NPV is -$1,000, it means that the machinery is worth less than it costs. This machinery is a bad investment. Net present value is the change in an investor's potential wealth. Its merit in figuring out the cost of capital is that it's a flexible approach to determining worth that can be applied to an investment of any size, and it provides a snapshot of the present value.
What Is Internal Equity?
Internal equity is a cost of capital based on the idea of paying workers in comparable positions equally, without regard to differences in demographics. Understanding the cost of labor is an important part of the cost of capital; a company whose employees feel like they're paid fairly may experience a lower rate of turnover, making labor costs a more consistent expense.
Cost of capital, flotation cost, net present value, and internal equity are tools for assessing how much money it takes to borrow or raise money to run a business. The cost of capital determines how expensive it will be for a company to borrow money. Flotation costs are fees associated with public companies issuing securities to raise money. Net present value is a calculation that determines the current value of a business; it can help a company decide the amount of money it can borrow. And internal equity is a cost of doing business that ensures employees are paid fairly and equally.
To unlock this lesson you must be a Study.com Member.
Create your account
Register to view this lesson
Unlock Your Education
See for yourself why 30 million people use Study.com
Become a Study.com member and start learning now.Become a Member
Already a member? Log InBack
Cost of Capital: Flotation Cost, NPV & Internal Equity
Related Study Materials
Explore our library of over 84,000 lessons
- College Courses
- High School Courses
- Other Courses
- Create a Goal
- Create custom courses
- Get your questions answered