Cost of Capital and the Capital Asset Pricing Model
The cost of capital is of importance to companies and investors. If a business cannot cover the cost of capital with a reasonable additional margin, people will not invest and the company will grow at a slower rate (or in the worst cases fail completely). The cost of debt is the return on the cash invested. This must be at a rate that is competitive within the industry and reflects the risk (i.e. potential of failure or threat of competition). Much investment is in the form of shares and these pay a dividend when the company is in profit and have a resale value which fluctuates depending on the performance of the company, future customer demand and the external economy. Some investors that are ‘on-board’ from the early days e.g. angels and start-up investment companies demand a higher interest rate on their investment due to the uncertainty and higher risk.
The Capital Asset Pricing Model (CAPM) is used to calculate the cost of capital (i.e. the expected rate of return).
ra = rf + βa(rm – rf)
ra = Rate of return
rf = Risk-free rate
βa = The beta of the company
rm = The expected market return
Beta relates to the specific company risk. See the beta page for more information.