In a Nutshell (VII). Finance (III)

COST OF CAPITAL

A business needs to keep track of how much it is paying for the capital it uses, as that is the minimum hurdle rate for any investment it may make.

• Cost of debt: This can be very straightforward. A company takes out a bank loan at a fixed rate of interest then this is the cost before any tax relief, usually the net cost of debt comes down initial bank interest.
• Cost of equity: is the return shareholders expect the company to earn on their money.
  • Dividend valuation model: One approach to finding the cost of equity is to take the current gross dividend yield for a company and add the expected annual growth.
  • CAPM, Capital asset pricing model: http://www.investopedia.com/terms/c/capm.asp
  • WACC, Weighted average cost of capital: http://www.investopedia.com/terms/w/wacc.asp

INVESTMENT DECISIONS

The cost of capital is an important figure as it is in essence the threshold for future investments. Categories:

• Bolt-on investments: These are where an investment will be supporting and enhancing an existing operation. Eliminating bottlenecks.
• Standalone single project: This involves a simple accept or reject decision
• Competing projects: This requires a choice of which produces the best results, either because only one can be pursued or because of limited finance.

Remember that, there may well be other strategic reasons for taking investment decisions, including those that might be more important than finance alone. 

• Payback period: http://www.investopedia.com/terms/p/paybackperiod.asp
• Net present value: http://www.investopedia.com/terms/n/npv.asp
• Discounted cash flow: http://www.investopedia.com/terms/d/dcf.asp
• Internal Rate of Return: http://www.investopedia.com/terms/i/irr.asp