Cost of Capital

What should be the cost of capital for any investment we make?

All the financial data of the company and the research reports of many investment banks concentrate on some variables to show up the performance, which are not comparable. 

Say for example, you have invested Rs.100/- in a business in the first year the revenue is Rs.100/- and the net margin on the sales is 10%. In later years due to inflation your revenue and thereby your net income would increase, putting the initial capital investment constant. This is illustrated in the below example.

Initial Investment	100.0
Inflation	2%
Year	Sales	Net Income	Return on investment
Year 1	100.0	10.0	10.0%
Year 2	102.0	10.2	10.2%

This shows an increase in the returns per say, but the return are not adjusted for the inflation of the initial investment.
Thereby when calculating the return on assets employed we would be equating one historical figure (Tangible assets and other assets employed in the business) with another which is inflation adjusted (Revenue and Net income e.t.c). Obviously the return will improve over the earlier years as the initial investment is not in the current terms (No Inflation adjustment).
So what can be the basis for calculating the real return on any investment?
The better approach in calculating the return on investment is “Return on the initial investment – Inflation rate” would give a better picture of the actual return.
This is the reason for the importance of opportunity cost in investment and financial management concepts. This gives a better view of the actual return on the investment.
What factors into the Cost of Capital?
There are many factors which would be involved in the calculation of Cost of Capital and they are as follows:

1)      Cost of Equity

2)      Cost of Debt

3)      Risk Premium

Debt is less costly than Equity because, the debt holders will be enjoying only the interest which but not in the remaining profits of the company. But equity holders on the other hand will enjoy the remaining profits and if the business does not do well then they will suffer the loss also. So Return is directly proportionate to risk.
So to take this benefit every company can finance its operations trough debt so that the weighted average cost of capital would be lower. But if the proportion of debt increases that increases the risk of equity share holders which will increase the cost of equity which will offset the benefit from debt financing. So as these factors are relatively offsetting each other the other major driver of the cost of capital is the risk premium. The following chart shows the comparative yields of the 30 and 10 year treasury bonds and the Moody’s Aaa and Baa credit rated bond yields, which explain the significance of risk premium.

This gives the view that after the burst of any bubble the spread between Fed Bonds Yield and Moody’s Baa Rated would increase. But during the current crisis this has increased significantly. The risk premium is more almost equal to the 30 year bond yield, which will increase the cost of lending significantly in the bust phase through the recovery phase.
To sum up, while calculating the return on investment we need to take into account, inflation factors and the risk premium into account to assess whether the investment is worthy or not.