The required rate of return (RRR) and the cost of capital are key fundamental metrics in finance and investing. These measures—which vary in scope, perspective, and use—can affect critical investment decisions for both corporations and individual investors.
The required rate of return is the minimum return an investor will accept for owning a company's stock, as compensation for a given level of risk associated with holding the stock. Corporations use RRR to analyze the potential profitability of capital projects.
Key Takeaways
- The cost of capital refers to the expected returns on the securities issued by a company.
- The required rate of return is the return premium required on investments to justify the risk taken by the investor.
- These metrics can provide corporations and individuals with insight into key business fundamentals such as their risk/reward profile and opportunity cost.
The cost of capital refers to the expected returns on securities issued by a company. Companies use the cost of capital metric to judge whether aprojectis worth the expenditure of resources. Investors use this metric to determine whether an investment is worth the risk compared to the return.
When the required rate of return is equal to the cost of capital, it sets the stage for a favorable scenario. For example, a company that's willing to pay 5% on its raised capital and an investor who requires a 5% return on their asset likely would be satisfied trading partners.
Understanding the Cost of Capital
Businesses are concerned with their cost of capital. At some point, a company must determine when, and for what purpose, it makes sense to raise capital. In addition to deciding how much cash it needs, a firm must decide which method to use to acquire the money.
Typically, a firm will ask: Should we issue new stock? How about bonds? Or perhaps it makes more sense to take out a loan or line of credit? Which capital-raising option is best for our company economically and strategically?
Theoretically, the required rate of return and cost of capital for a given investment should trend toward one another.
Each option comes with risks and costs, against which a firm must weigh the required return necessary to make a capital project worthwhile.Knowing the cost of capital can help a company to compare its options for raising cash more easily.
Calculating the Cost of Debt and Equity Issues
The cost of debt is simple to establish. Creditors, whether individual bond investors or large lending institutions, charge an interest rate in exchange for their loan. A bond with a 5% coupon rate has the same cost of capital as a bank loan with a 5% interest rate.
However, calculating the cost of equities, or stock, is a little more complicated and uncertain than calculating the cost of debt. Theoretically, the cost of equity would be the same as the required return for equity investors.
Arriving at the Weighted Average Cost of Capital
Once a company has an idea of its costs of equity and debt, it typically takes a weighted average of all of its capital costs. This produces the weighted average cost of capital (WACC), which is a very important figure for any company.
For the cost of a capital project to make economic sense, the profits a company expects to generate should exceed the weighted average cost of capital.
Understanding Required Rate of Return
The required rate of return generally reflects the investor's, not the issuer's, point of view in terms of managing risk. In a nominal sense, investors can find a risk-free return by holding on to their money; or they can find a low-risk return by investing in safe assets—cash, short-term U.S. Treasuries, money market funds, and gold.
Risk Is an Important Factor in RRR
Riskier assets may offer potentially higher returns, thus providing investors with a favorable ratio of risk to return. Many investors use risk/reward ratios to compare theexpected returnsof an investment with the amount of risk they must undertake to earn these higher returns.
Investors who take on greater levels of risk may also reap potentially greater returns.
RRR and Cost of Capital: About Opportunity Cost
Both of these metrics embody the critical concept of opportunity cost—the benefits that an individual investor or businessmisses out onwhen choosing one alternative over another.
For example, when an investor purchases $1,000 worth of stock, the real cost is everything else that could have been done with that $1,000—including buying bonds, purchasing consumer goods, or putting it in a savings account. When a company issues $1 million worth of debt securities, the real cost to the company is everything else that could have been done with the money that eventually goes to repay those debts.
The cost of capital and RRR metrics can help market participants of all types—buyers and sellers—to sort through the competing uses of their funds and to make wise financial decisions.
