Cost of Capital vs. Required Rate of Return: An Overview
The required rate of return (often referred to as required return or RRR) and cost of capital can vary in scope, perspective, and use. Generally speaking, cost of capital refers to the expected returns on the securities issued by a company, while the required rate of return speaks to the return premium required on investments to justify the risk taken by the investor. Although it is possible the required rate of return is equal to the cost of capital for a given investment, the two should theoretically tend toward one another.
Cost of Capital
Businesses are concerned with their cost of capital. Every company must determine when it makes sense to raise capital and then decide the amount to raise and the method to acquire it. Should new stocks be issued? What about bonds? Should the business take out a loan or line of credit? Each of these decisions comes with certain risks and costs, and the cost of capital can help to compare different methods more clearly.
The cost of debt is simple to establish. Creditors, whether bond investors or large lending institutions, charge an interest rate in exchange for their loan. A bond with a five percent coupon rate has the same cost of capital as a bank loan with a five percent interest rate.
Calculating the cost of equity is a little more complicated and uncertain. Theoretically, the cost of equity is the same as the required return for equity investors.
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 capital expansion to make economic sense, the expected profits generated should exceed the WACC.
Although it is possible the required rate of return is equal to the cost of capital for a given investment, the two should theoretically tend toward one another.
Required Rate of Return
Required rate of return comes from the investor's (not the issuing company's) point of view. In a nominal sense, investors can find a risk-free return by holding on to their money or by investing in short-term U.S. Treasuries. To justify investing in a riskier asset, a risk premium is added in the form of potentially higher returns.
According to this line of thinking, an investor and an issuing company make compatible trading partners when the cost of capital is equal to the required return. For example, a company willing to pay five percent on its raised capital and an investor who requires a five percent return on their asset are likely to do business with one another. Both of these metrics hint at a crucial concept: opportunity cost.
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. Both cost of capital and required return help market participants sort out competing uses of their funds.
- Cost of capital refers to the expected returns on the securities issued by a company.
- Required rate of return is the return premium required on investments to justify the risk taken by the investor.
- Required rate of return comes from the investor's (not the issuing company's) point of view.