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What is the Cost of Capital?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 21 September 2016
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Cost of capital is essentially another way to identify the opportunity cost that is associated with a given investment. In other words, the cost of capital has to do with the amount or rate of return that can be expected on the investment, in comparison to what would be realized by selling off the investment. Investors routinely consider the cost of capital when projecting the potential profits that may be made by choosing to invest in a given stock or bond issue.

When an investor chooses to make an investment, there is usually an expectation that two specific events will take place. First, the investor will recoup the amount of capital initially used to purchase the bonds or stocks involved in the transaction. Thus, there is anticipation that the investor will not in fact incur a loss as a result of the acquisition. Generally speaking, investors do not invest in securities that offer little to no hope of recouping the initial investment, as this represents negative opportunity costs and defeats the purpose for investing.

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Along with recouping the initial investment, the typical investor also hopes to earn a return on the securities that are acquired. Depending on the strategy of the investor, this may include a short period where the investment actually loses money before the security stabilizes and begins to rise in value. But the ultimate goal is for the investment to generate a positive cost of capital. That is, the investor seeks to realize a rate of return that not only exceeds the initial cost of acquisition, but also earns the investor a significant amount of financial rewards that help to compensate for the time and effort put into the investment strategy.

Because the whole point of investing is to make money rather than lose it, investors and brokers will pay close attention to the history and future potential of a given investment opportunity. By doing so, the chances of realizing a rate of return and thus generating a positive cost of capital are much better than in cases where no research into the potential of the security takes place.

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