Cost of capital is a term that has to do with determining the amount of return that must be generated in order to justify the expenses associated with a given project or activity. With several different approaches to making this assessment, it is necessary to choose the best possible cost of capital approach for the task at hand. With several different approaches in common use, taking the time to explore the merits of each will make it easier to settle on the method that will aid in making a sound business decision.
One common cost of capital approach is known as the weighted average cost of capital (WACC). This strategy calls for identifying the cost of capital by making sure each category or type of capital is weighted in a proportion that is in the best interest of the company and the shareholders. This calls for seeking the optimum balance between any long-term debt held by the business in relation to any stocks or bond issues that are also carried in the company financial records. The idea is to make sure the balance in how company assets are financed points to an operation that is financially stable and not too heavy with debt.
A slightly different cost of capital approach is known as the incremental cost of capital (ICC). With this approach, the focus is on determining how much additional cost the business will take on if one additional unit of debt or equity is assumed. The idea is to measure the impact that the chance in debt or equity has on the overall strength of the business, making it easier to decide if the move is in fact in the best interests of everyone concerned, or if the addition of one more unit of debt or equity produces so little benefit that the activity should be foregone. At the same time, this method can make it possible to ascertain the ideal amount of debt or equity to assume over a period of time and achieve results that help to strengthen the company’s prospects.
The decision of which cost of capital approach to use depends on what type of situation the business faces and the nature of the decisions that must be made in regard to a proposed project. These factors can provide insights into both short-term and long-term benefits that are likely to be realized, as well as reveal potential liabilities that undermine the possibility of making a task or activity worthwhile. It is not unusual for a business to make use of each cost of capital approach in relation to the same project, a strategy that helps to increase the means of evaluating the potential of some new activity, effectively covering more bases and providing insights that make it easier to settle on a final course of action.