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Let's assume Company XYZ is considering whether to renovate its warehouse systems.
The renovation will cost $50 million and is expected to save $10 million per year over
the next 5 years. There is some risk that the renovation will not save Company XYZ a
full $10 million per year. Alternatively, Company XYZ could use the $50 million to buy
equally risky 5-year bonds in ABC Co., which return 12% per year.
The return an investor receives on a company security is the cost of that security to the
company that issued it. A company's overall cost of capital is a mixture of returns
needed to compensate all creditors and stockholders. This is often called the weighted
average cost of capital and refers to the weighted average costs of the
company's debt and equity.
Investors frequently borrow money to make investments, and analysts commonly make
the mistake of equating cost of capital with the interest rate on that money. It is
important to remember that cost of capital is not dependent upon how and where
the capital was raised. Put another way, cost of capital is dependent on
the use of funds, not the source of funds.