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.

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.

  1. What is the difference between cost of debt capital and cost of equity?

    Learn about how the costs of debt and equity capital differ and how to calculate each using interest and tax rates and stock ... Read Answer >>
  2. How do you calculate costs of capital when budgeting new projects?

    Discover how a company should estimate its costs of capital when budgeting for a new business project using the weighted ... Read Answer >>
  3. How does a company choose between debt and equity in its capital structure?

    Learn about the benefits and drawbacks of debt and equity financing. Find out how to compare capital structures using cost ... Read Answer >>
  4. How do interest rates affect the weighted average cost of capital (WACC) calculation?

    The interest rate is one of many external factors that can change the inputs in the weighted average cost of capital (WACC) ... Read Answer >>
  5. What is the difference between financial capital and economic capital?

    Read about the differences between types of financial capital, which companies use to raise money, and economic capital models ... Read Answer >>
Related Articles
  1. Investing

    How to calculate required rate of return

    The required rate of return is used by investors and corporate-finance professionals to evaluate investments. In this article, we explore the various ways it can be calculated and put to use.
  2. Managing Wealth

    Issued share capital versus subscribed share capital

    Learn the difference between issued share capital versus subscribed share capital. Get information about various types of capital.
  3. Managing Wealth

    What Determines Your Cost Basis?

    Understanding the cost basis is critical for tracking the gains or losses of an investment, and what the tax consequences on it are.
  4. Investing

    McDonald's Stock: Capital Structure Analysis (MCD)

    Learn about the importance of capital structure, and what equity and debt capitalization measures can tell us about the performance of McDonald's Corporation.
  5. Investing

    How To Create Capital Protected Investment Using Options? (MSFT)

    Does "Capital-Protection" guarantee in an investment product sound attractive? Wait! Here's how you can create a better one for yourself, at low-cost!
  6. Investing

    Why Real Estate Is a Risky Investment

    You should account for these hidden costs before investing in real estate.
  7. Investing

    Explaining Expected Return

    The expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome.
  8. Investing

    Will Corporate Debt Drag Your Stock Down?

    Corporate debt can mean a leg up for firms, or the boot for investors. How to tell the difference.
  9. Investing

    How Do Interest Rates Affect the Stock Market?

    Interest rates can have a complicated ripple effect through financial markets. Learn more on how it specifically impacts the stock market.
  10. Personal Finance

    What to know for an investment banking interview

    Find out what you need to know and how to prepare for an investment banking interview.
  1. Cost Of Equity

    The cost of equity is the rate of return required on an investment ...
  2. Return Of Capital

    A return from an investment that is not considered income. The ...
  3. Market Risk Premium

    Market risk premium is the difference between the expected return ...
  4. Return On Capital Gains

    The value of an investment in an asset as it matures or is sold ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its ...
  6. Issue

    An issue is the process of offering securities as an attempt ...
Hot Definitions
  1. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  2. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  3. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  4. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  5. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
  6. Hedge Fund

    A hedge fund is an aggressively managed portfolio of investments that uses leveraged, long, short and derivative positions.
Trading Center