The world of finance is very huge, comprising a lot of things like investments, banking, corporate finance, derivatives, metrics, and so on. All of these things are important for running the economy of the country. Cost of Capital and Rate of Return are two of the most important concepts in finance.
Cost of Capital vs Rate of Return
The main difference between the Cost of Capital and Rate of Return is that the Cost of capital is the expected rate of return for an investment in a particular company, and the required rate of return is the minimum gain an investor should get for an investment in a particular company.
When a company issues securities such as equity shares, preference shares or debentures to collect capital. At the time of issuing these, they guarantee to pay back the money along with some interest, which is called the Cost of Capital.
When people are investing in a company by buying shares or securities, they are taking a risk. And because they take a risk, they need to be given a certain minimum interest or a profit on their money or the capital investment. This gain or interest is called the rate of return.
Comparison Table Between Cost of Capital and Rate of Return
| Parameters of Comparison | Cost of Capital | Rate of Return |
| Definition | The cost of capital is the expected rate of return for an investment in a particular company. | The rate of return must be earned by the firm for the satisfaction of the requirements of the different investors. |
| Utility | Capital Structure, Evaluation of investment alternative, Assessment of financial performance. | Minimizing risk and assuring shareholders. |
| Components | Cost of Debt, Cost of equity share capital, Cost of retained earnings and Cost of preference share capital. | Weighted components of cost of capital |
| Terminology | Cost of Capital does not have any other terminology. | The rate of return is also known as WACC or the overall cost of capital. |
| Importance | Maximisation of shareholders’ wealth. | Providing stability to capital structure. |
What is Cost of Capital?
The Cost that is incurred in retaining the funds obtained from various sources and employed in business is referred to as the Cost of Capital of a firm. Cost of Capital is the rate of return that the company must earn for the satisfaction of the investors who have provided long-term finance. It is the rate of return that a firm needs to earn to attract the suppliers of funds to make available the funds to the firm. The goal of the maximization of shareholders’ wealth is achieved with the help of the Cost of Capital.
The Cost of capital is useful in designing a firm’s capital structure, evaluation of investment alternative and assessment of financial performance. A firm’s earnings are less, the risk to investors is more, and capital structure is imbalanced if the Cost of capital is high. The components of Cost of Capital refers to each source from which funds are raised, namely- Cost of Debt, Cost of Equity, Cost Retained Earnings and Cost of Preference Share Capital. There are different formulas for Computing the Cost of Capital.
What is Rate of Return?
When investors invest in a company, they need to be given a minimum required Rate of Return on their Investment. The Rate of Return is the Required Rate of Return, also known as the Weighted Average Cost of Capital- WACC. Companies use different types of capital to finance its activity. The average Cost of capital is to be determined to determine the company’s Cost of capital. Weighted Average Cost of Capital is nothing but the weighted average cost of various sources of finance. The weighted Average Cost of Capital is the rate of return that must be earned by the firm to satisfy the basic minimum requirements of the different investors.
The decision regarding appropriate weights and related aspects is the most crucial part of this process. To determine a single overall cost of capital, all costs of various components of capital after-tax are taken together while calculating the required rate of return or weighted average Cost of capital. The approach is based on various assumptions regarding the future proposals, capital structure, different costs and financing decisions of the company. It helps in minimizing risk, giving assurance to the shareholders and hence providing stability to the capital structure.
Main Differences Between Cost of Capital and Rate of Return
- The Cost of Capital is the expected rate of returns on investment, and the required rate of return is the minimum return on investment.
- Cost of Capital is used in designing the capital structure, evaluation of investment alternative and assessment of financial performance. Whereas, Rate of Returns minimizes the risk for investors and gives assurance.
- The components of Cost of capital are- Cost of debt, Cost of equity, Cost of retained earnings and Cost of preference share capital. The components of WACC are weighted components of Cost of capital.
- The rate of return is called the required rate of return or WACC. On the contrary, Cost of Capital does not have a substitute term.
- Cost of Capital helps in wealth maximization of shareholders, and Rate of Return helps in providing stability.
Conclusion
Earlier finance was looked at as something which is not a common man’s cup of tea. For future planning and investment, Saving and Future Deposits in government banks was the only preferred option. The common man or working middle-class people were scared to invest in shares, debentures or the stock market in general.
Previously, there were also a lot of complicated procedures for entering and working in the stock exchange, because of which there were only a few major players in the industry. It has taken years for people to understand the importance of investing along with saving.
Today investment is something every other individual is interested in. In order to invest money in the right place, people are learning new things or hiring professionals. Cost of Capital and the Rate of Return are the two important elements in Financial Management. This is why investing on your own, based on your knowledge or hiring a professional, both require knowledge about the Cost of Capital and the Rate of Return.
References
- https://www.jstor.org/stable/1809766
- https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1745-6622.1999.tb00027.x