Cost of Capital Definition: Day Trading Terminology

Cost of capital is a benchmark rate of return that any project must meet or exceed to justify the internal investment in a company. The exact make-up of the cost of capital measure will vary from company to company, but is usually generated as a weighted average cost of capital (WACC) that represents the optimal mix of a company’s cost of debt financing and cost of equity financing.

The Logic Behind Cost of Capital

It was developed as a simple hurdle for sifting through a company’s investment opportunities. Many large companies face an enormous range of potentially viable projects, and the cost of capital measure allows managers to efficiently eliminate those projects whose profits are not forecasted to meet their funding cost.

Of course, not every investment faced by a company can have costs and revenues so directly attributed, but as a rough measure for sifting through potential revenue sources, cost of capital is extremely effective and popular.

Factors Influencing Cost of Capital

Both cost of debt and cost of equity have a number of different influencing factors. Cost of debt will depend primarily on the company’s past creditworthiness and its existing debt load, while cost of equity will largely depend on the company’s beta (its relation to the overall stock market) and its risk premium (a product of the market’s perception of the company’s viability and prospects).

The Optimal Amount of Debt and Equity

Optimizing the amount of debt and equity in a company will have a significant impact on its overall finances.

When companies are small they have few assets to use as collateral and little past credit history, so they more often rely on equity financing. As companies grow, they tend to prefer debt financing, particularly because of the generally more lenient tax treatment that debt financing receives in most modern countries. However, a company’s debt financing costs grow alongside its debt load, so there is usually a point where some equity financing becomes optimal.

How It Affects Trading

A company’s cost of capital is an important measure to use when evaluating its current stock price.

For example, the cost of capital indicates a company’s prospects for future growth, as a high cost of capital will limit the capacity for future investment and the resulting profits. Therefore, a company whose current stock price is based on expectations of profit growth, yet has a high cost of capital, will likely see a drop in price as the market corrects for this disparity.

Cost of capital decisions can also be used to make short term trades. A significant change in a company’s cost of capital or its mix of debt and equity financing can have an impact on its share price, and traders will use quarterly financial reports to identify potentially tradable cost of capital changes.

Final Thoughts

It is central to contemporary corporate finance. Its use as an internal benchmark for project viability within a company makes it an excellent tool for evaluating the overall short and long term prospects of companies.