Required Return vs. Cost of Capital

Required Return vs. Cost of Capital
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  • 0:02 Overview
  • 0:31 Required Return
  • 1:07 Cost of Capital
  • 1:41 Opportunity Cost
  • 2:44 Lesson Summary
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Lesson Transcript
Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Let's take a look at how required return and cost of capital each offer different perspectives in figuring out the opportunity cost of different investment decisions.

Overview

As both a business owner whose company issues bonds to raise capital and a private investor, Roy needs to understand the risks and costs of his investment activities. His required return on his own investments and the cost of capital for his business each express the opportunity cost of investing, but from different perspectives. In this lesson, let's help Roy understand how these different figures work through different perspectives.

Required Return

Required return refers to the rate of return on an investment that Roy desires as an investor. His personal risk tolerance and financial goals determine what kind of instruments he should invest in.

If his reserve emergency funds merely need to keep pace with inflation, investments in U.S. government treasury securities offer relatively risk-free, though low, returns. If, on the other hand, he determines he needs to earn six percent annually on his investment, he would need to look to more risky investments, like stocks or bonds. The higher the risk of a specific investment, the greater the required return has to be in order to adequately compensate investors.

Cost of Capital

Cost of capital refers to Roy's costs of issuing securities, such as bonds and stocks, through his business. The perspective shifts to that of the company. If his company issues a bond at four percent, that is his cost of capital assuming it is the only bond the company has issued. The costs associated with issuing stock are difficult to determine as precisely as with bonds but is theoretically the same as investor expectations of required returns. The combined and weighted sum of all security costs is the weighted average cost of capital (WACC).

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