Cost of capital is a necessary economic and accounting tool that calculates investment

opportunity costs and maximizes potential investments in the process.

The cost of capital is tied to the opportunity cost of pouring cash into a specific business
project or investment. Once those costs are evaluated, businesses can make better
decisions to deploy their capital to maximize profit potential

How companies will finance a project or make an investment is an important decision,

since that choice will determine a firm's capital structure. Ideally, businesses seek a fair
balance in this scenario, with enough financing to get a project or investment done,
while reducing or limiting the cost of capital.

Cost of capital is especially important in the following ways:

 The cost of capital aids businesses and investors in evaluating all investment
opportunities. It does so by turning future cash flows into present value by keeping it
discounted.
 The cost of capital can also aid in making key company budget calls that use
company financial sources as capital.
 In a cost of opportunity scenario, the cost of capital can be used to evaluate the
progress of ongoing projects and investments by matching up the progress of those
investments against the cost of capital.

In the cost of capital game, there are two main forms of capital - implicit cost of capital
and explicit cost of capital.
 Implicit cost. This represents the opportunity cost cited above, i.e., the cost of
an investment opportunity considered, but ultimately not taken. There is no bottom-line
reduction in revenues - it's implied. But under the cost of capital model, it can be
factored into opportunity costs not earned.
 Explicit cost. The explicit cost of capital is the cost that companies can actually
use to make capital investments, payable back to investors in the form of a stronger
stock price or bigger dividend payouts to shareholders.
Company accountants use the cost of capital to estimate the cost of financing a project
or engaging in a large investment opportunity.

At minimum, any capital used by a company for such initiatives must have a minimum
return that's in line with what shareholders, stakeholders, and lenders expect for the use
of their money. In short form, the cost of capital represents a benchmark which any
company investment or project must meet or exceed in financial returns.
To have clear picture about what we are talking about here we will tell you 2 examples of cost
of capital, one for investing and one for business

Cost of Capital for Investing

In investing, the cost of capital is the variation between an investment that you make
and one that you could have made - but didn't.

Consider a stock market trader or real estate investor that invests $10,000 into a
particular opportunity. The opportunity cost is the difference between any profit actually
earned, and the profit that could have been earned. Let's say the investor earned a 5%
profit on the actual investment but could have earned 10% on the investment
opportunity not chosen.The difference between the profit earned on Opportunity "A" and
Opportunity "B" (5%) is the actual cost of capital.

Cost of Capital for Business

In business, the goal with the cost of capital is to improve on the rate of return that might
have been generated by steering the amount of money into a separate investment, and
with the same amount of risk. After all, companies count on the cost of capital to be the
return rate it earns on business-related investment projects, in order to maximize
opportunities to attract investors, and to stay profitable and competitive in its
marketplace.

While it is essential to calculate the cost of capital for your business, you need to be
aware of some of the pitfalls as well as limitations behind this method. A survey by the
Association for Financial Professionals recently found that many companies don’t use
universal methods for calculating the cost of capital and the assumptions many make
can lead to distorted estimations of the real cost of capital. Naturally, this can have
devastating consequences, as it might mean the company makes investment decisions
based on incorrect information.

In order to avoid these issues with your calculation, here are some of the most common
problems you should try to avoid.

In general, the definition of cost of capital is two-fold: For businesses, it's the cost of an
organization's debt and equity funds. For investors, the cost of capital is the required
rate of return on a particular investment.