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Cost of Capital

[kost uhv KAP-i-tl]

What is the definition of Cost of Capital?

The rate of return that a business must earn on its investment projects to maintain its market value and attract funds. It represents the opportunity cost of making a specific investment, instead of investing the same funds in an alternative venture with equivalent risk.

Using Cost of Capital in an Example

A company evaluates a new project that requires an initial investment of $100,000. To determine whether the project is viable, it calculates its cost of capital to be 8%. The project needs to generate at least an 8% return to justify the investment, considering the company could achieve similar returns on an investment with comparable risk.

Using Cost of Capital in a sentence

During the board meeting, the CFO discussed the cost of capital, emphasizing its importance in guiding the firm's investment decisions and financial strategy.

Related Terms

CAPM

The Capital Asset Pricing Model (CAPM) is a sophisticated financial model that describes the relationship between expected risk and expected return of an investment. It is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk.

CD

A formal financial instrument issued by a bank, representing a time-bound deposit from which funds cannot be withdrawn until a specified period has elapsed without incurring a penalty.

CEO

The Chief Executive Officer (CEO) is the highest-ranking executive in a company, primarily responsible for making major corporate decisions, managing the overall operations and resources of the company, and acting as the main point of communication between the board of directors and corporate operations.

CFO

The Chief Financial Officer (CFO) is an executive officer responsible for managing the financial actions of a corporation. This includes financial planning, risk management, record-keeping, and financial reporting.

CFP

A Certified Financial Planner (CFP) is a professional who assists individuals, businesses, and organizations in developing and implementing comprehensive financial plans. CFPs possess expertise in areas such as income and estate tax, investments, risk management, and retirement planning. They earn certification through a rigorous process that includes education, experience, adherence to ethical standards, and successfully passing a comprehensive examination.

CIA

Certified Internal Auditor (CIA) is a designation awarded to accountants who conduct internal audits and have passed the examination requirements set by the Institute of Internal Auditors.

CMA

An accreditation conferred by the Institute of Management Accountants that signifies an individual has passed a rigorous examination and met specific education and experience requirements in the field of management accounting and financial management in the private sector.

CMO

A Collateralized Mortgage Obligation (CMO) is a type of security that repackages and directs the cash flows from the collateralizing assets, typically mortgages, to different types and classes of investors. The structure of a CMO can be complex, involving various tranches that prioritize the distribution of payments and risks.

COSO

An alliance of five professional organizations dedicated to providing thought leadership through the development of frameworks and guidance on enterprise risk management, internal control, and fraud deterrence.

CPA

A Certified Public Accountant (CPA) is a professional accountant who has met the educational, experience, and examination requirements of their jurisdiction, thereby earning certification to practice public accounting.

CPE

Educational programs designed for Certified Public Accountants (CPAs) to keep them informed about the latest changes and developments within the accounting profession. These programs are mandated by State Boards for Public Accountancy and the American Institute of Certified Public Accountants (AICPA), each setting their own specific CPE requirements.

Cafeteria Plan

A benefit plan offered by an employer which allows employees to choose from a variety of pre-tax benefit options according to their needs. The plan typically includes options such as health insurance, group-term life insurance, and flexible spending accounts, among others.

Call Loan

A loan that can be demanded for repayment by the lender at any time, also known as a demand loan.

Call Price

A specified price, usually above face value, at which a corporation may, at its option, buy back and retire bonds before their maturity date.

Callable

Refers to securities that can be redeemed by the issuer before their scheduled maturity date under specific conditions and at a predetermined price, often initially set at a premium to par and decreasing over time. This feature is commonly utilized when interest rates decline, allowing the issuer to refinance debt at lower rates.

Callable Instrument

A financial instrument, such as a bond, that grants the issuer the right to redeem the instrument before its maturity date.

Capital Asset Pricing Model (CAPM)

A financial model that describes the relationship between the expected risk of an investment and its expected return, primarily used to determine a theoretically appropriate required rate of return of an asset, adjusting for its risk.

Capital Expenditure

An outlay of money to acquire or improve long-term assets such as buildings, machinery, or equipment, which are intended to be used in the operations of a business and are not intended for resale.

Capital Gain

A capital gain is the profit realized from the sale or exchange of a noninventory asset, such as stocks, real estate, or other investments, where the sale price exceeds the asset's original purchase price. These gains are usually treated favorably under tax laws, often at a lower rate than ordinary income.

Capital Projects Funds

Funds used by governmental entities to finance the acquisition, construction, or renovation of major capital facilities or assets, such as buildings, roads, and parks.

Capital Stock

The total ownership shares of a corporation as authorized by its articles of incorporation, represented by the issued shares and reflected on the balance sheet. This value is often assigned based on the par or stated value of the shares.

Capitalize

To convert a schedule of income into a principal amount, known as capitalized value, by dividing it by a rate of interest.

Capitalized Cost

Expenditures associated with the acquisition of goods or services that are not expensed immediately but are written off over multiple accounting periods. These costs are measured by the amount of cash paid or the market value of any other property, capital stock, or services surrendered.

Capitalized Interest

Interest cost incurred during the construction or production period of an asset, which is included as part of the historical cost of acquiring the asset, bringing it to the condition and location for its intended use.

Capitalized Lease

A lease agreement recorded as an asset acquisition accompanied by a corresponding liability by the lessee, treated similarly to a purchase of the asset.

Carrying Value

The net amount at which an asset or liability is valued on a company's balance sheet, after accounting for depreciation, amortization, and impairment costs, as well as accumulated liabilities. Also known as book value.

Carryovers

Provisions in tax law that allow current losses or certain tax credits to be utilized in the tax returns of future periods.

Cash

An asset account on a balance sheet that includes paper currency, coins, negotiable instruments like money orders and checks, bank balances, and certain short-term government securities.

Cash Account

A brokerage firm account where transactions are settled on a cash basis, meaning that securities must be paid for in full at the time of purchase and proceeds from sales are available only after the transaction has settled.

Cash Basis

A method of accounting in which revenues and expenditures are recorded only when the cash is received or paid, respectively.

Cash Dividend

A distribution of a corporation's earnings to its stockholders in the form of cash, reflecting a share in the company's profits.

Cash Equivalents

Short-term, highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value, typically with original maturities of three months or less.

Cash Flow to Assets

A financial metric used to assess the efficiency with which a company's assets generate operating cash flows.

Cash Flow to Sales

A financial metric that measures the ability of a company's sales to generate operating cash flows, indicating the efficiency with which revenue is converted into cash.

Cash Flows

The net amount of cash receipts and cash disbursements relating to a specific activity over a defined accounting period.

Cash Payments Journal

A multicolumn journal used to record all cash payments made by a business, including payments for expenses, purchases, and other disbursements.

Cash Ratio

The cash ratio is a liquidity ratio that measures a company's ability to pay off its short-term liabilities with its cash and marketable securities.

Cash Receipts Journal

A specialized accounting journal used to record all transactions that involve the receipt of cash, typically structured with multiple columns to capture various details of each transaction.

Casualty Loss

A casualty loss is a financial loss resulting from the damage, destruction, or loss of property caused by an unexpected or sudden event such as a fire, storm, or other natural disasters. This type of loss is typically deductible, whether it occurs in relation to business or personal property.

Certificate of Deposit (CD)

A formal financial instrument issued by a bank that involves the deposit of funds which cannot be withdrawn for a predetermined period of time without incurring a penalty.

Certified Financial Planner (CFP)

A Certified Financial Planner (CFP) is a professional who has completed rigorous training and certification requirements, including education, experience, an exam, and adherence to ethical standards. CFPs are skilled in developing and implementing financial plans for individuals, businesses, and organizations, with expertise in areas such as income and estate tax, investments, risk management, and retirement planning.

Certified Internal Auditor (CIA)

A designation awarded to accounting professionals who have successfully passed the examination requirements set by the Institute of Internal Auditors, demonstrating their competence in internal auditing practices.

Certified Management Accountant (CMA)

An accreditation conferred by the Institute of Management Accountants that signifies the recipient has passed rigorous examinations and met specified levels of education and experience in management accounting and financial management in the private sector.

Certified Public Accountant (CPA)

A professional accountant who has met the educational, experience, and examination requirements set by their jurisdiction, allowing them to be certified to provide accounting services to the public.

Chief Executive Officer (CEO)

The highest-ranking executive in a company, primarily responsible for making major corporate decisions, managing the overall operations and resources of the company, and acting as the main point of communication between the board of directors and corporate operations.

Chief Financial Officer (CFO)

An executive officer responsible for managing the financial actions of a corporation. This includes financial planning, record-keeping, and financial reporting to higher management.

Claim for Refund

A formal request submitted by a taxpayer to a tax authority to receive a refund on overpaid taxes. The claim must be filed within a specified timeframe and usually requires completion of a specific form.

Clean Opinion

An audit opinion that is not qualified for any material scope restrictions nor departures from Generally Accepted Accounting Principles (GAAP), indicating that the financial statements present fairly the financial position and performance of the entity in accordance with GAAP. Also known as an unqualified opinion.

Close

In accounting, to close means to clear the balances of temporary accounts such as revenue, expense, and withdrawal accounts at the end of an accounting period to start fresh in the subsequent period.

Closed-End Mutual Fund

A type of investment fund with a fixed number of shares that are not redeemable from the fund. Unlike open-end funds, new shares in a closed-end fund are not created by managers to meet demand from investors. Instead, the shares can be purchased and sold only in the market, which is typically the stock exchange, where they are traded like stocks.

Closing Entry

A journal entry made at the end of an accounting period to clear the balances of temporary accounts and summarize the period's revenues and expenses, thus preparing the accounts for the next period.

Co-Mingling

The practice of mixing assets owned by a firm with those owned by its clients or customers, often in reference to securities or funds within proprietary accounts.

Collateral

An asset provided to a creditor as security for a loan, ensuring the creditor has a form of protection against the borrower's default.

Collateralized Mortgage Obligation (CMO)

A type of security that derives its cash flows from the payments of principal and interest from a pool of mortgages. These payments are then distributed to investors in a series of classes or tranches, each with different levels of risk and maturity.

Combined Financial Statement

A financial statement that consolidates the accounts of two or more entities into a single set of financials, typically to present the financial position and performance of the combined entities as a single economic unit.

Comfort Letter

A letter provided by a company's independent public accountant to an underwriter, confirming the due diligence of financial information included in an offering statement under Section 11 of the Securities Act of 1933.

Commercial Paper

Commercial Paper refers to unsecured, short-term debt instruments issued by corporations, typically used for the financing of payroll, accounts payable, inventories, and meeting other short-term liabilities. These papers are usually issued at a discount from face value and reflect prevailing market interest rates.

Commission

A fee or percentage of a transaction amount, typically the selling price, paid to an agent or company for facilitating a sale, service, or other transaction.

Committee of Sponsoring Organizations of the Treadway Commission (COSO)

An alliance of five professional organizations dedicated to developing and enhancing frameworks for internal control, enterprise risk management, and fraud deterrence.

Commodities

Bulk goods such as grains, metals, and foods that are traded on a commodities exchange or on the spot market.

Common Stock

A type of capital stock that represents ownership in a corporation, carrying no special preferences in terms of dividends, voting rights, or distributions. Common stockholders typically have voting rights and may receive dividends.

Company

An entity engaged in commercial, industrial, or professional activities, structured as a proprietorship, partnership, corporation, or other form of enterprise.

Company Level Controls

Controls implemented at the company-wide level that influence the effectiveness and efficiency of controls at the process, transaction, or application level, ensuring overall governance and risk management.

Comparative Financial Statement

A financial statement presentation that shows the current amounts and the corresponding amounts for previous periods, enabling a comparison of financial performance over time.

Compensate

To provide payment or remuneration for services rendered, losses incurred, or harm suffered.

Compensatory Balance

Funds that a borrower is required to maintain in a deposit account as a condition for obtaining a loan from a bank, often used to offset the cost of maintaining the loan.

Compilation

A compilation refers to the process in accounting where financial statement data is organized and presented without an accountant's assurance regarding its conformity with Generally Accepted Accounting Principles (GAAP).

Compilation Engagement

An agreement between a CPA firm and its client to prepare and issue a compilation report, which presents financial statements without the CPA expressing an opinion or assurance on them.

Compilation Report

A report prepared by an accountant that presents the financial statements of a company without the accountant offering any assurance on the statements. The report indicates that the accountant has not audited or reviewed the statements and does not express an opinion or provide any assurance on them.

Complex Trust

A complex trust is a type of trust that allows for the accumulation or distribution of current income during the tax year and can make charitable contributions.

Compliance Audit

A compliance audit is a thorough review of an organization's adherence to regulatory guidelines. The audit involves an evaluation of the organization's financial records and operations to ensure that they conform to external laws and regulations.

Compound Interest Principles

Interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods.

Comprehensive Income

Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from sources not shown in the income statement. This includes all changes in equity except those resulting from investments by owners and distributions to owners.

Condensed Financial Statement

A financial statement designed for external reporting that summarizes the key components of a full financial statement by presenting only the major categories of information.

Confirmation

In auditing, confirmation refers to the auditor's receipt of a written or oral response from an independent third party verifying the accuracy of information requested.

Conservatism

An accounting principle that requires recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, but only recognizing revenues and assets when they are assured of being received. This principle directs accountants to anticipate potential losses but not to anticipate potential gains.

Consistency

In accounting, consistency refers to the principle that stipulates an organization should apply the same accounting policies and procedures from one period to the next in the preparation and presentation of its financial statements, unless a change is explicitly noted.

Consolidated Financial Statements

Financial statements that present the assets, liabilities, equity, income, expenses, and cash flows of a parent company and its subsidiaries as a single economic entity.

Consolidation

In accounting, consolidation refers to the process of combining the financial statements of two or more entities into one, typically in the context of a business combination where all net assets are transferred to a newly created entity.

Constructive Receipt

A tax accounting concept where a taxpayer is considered to have received income even if the funds are not physically in hand, but have been made available to them or set aside for their use.

Consumer Goods

Goods that are purchased for personal or household consumption, as opposed to capital goods or producer's goods, which are used to produce other goods.

Contingency

An event or condition that is possible but cannot be predicted with certainty, often requiring special consideration or planning in finance and accounting.

Contingent Liability

A potential financial obligation that may arise in the future, depending on the outcome of a past transaction or event.

Continuing Operations

The segments or parts of a business expected to continue functioning and contributing to the entity's ongoing financial performance.

Continuing Professional Education (CPE)

Educational programs designed to maintain and enhance the professional competence of Certified Public Accountants (CPAs). These programs ensure CPAs stay informed about changes within the accounting profession and meet the requirements set by State Boards for Public Accountancy and the American Institute of Certified Public Accountants (AICPA).

Contra Account

A contra account is an account used in a general ledger to reduce the value of a related account. It has a balance opposite to the normal balance of the associated account.

Contra-Liability Account

A contra-liability account is an account used in accounting to reduce the balance of a related liability account directly. It typically appears as a deduction from a liability, such as discounts on notes payable, which reduces the total amount of the notes payable.

Contract

A legally binding agreement between two or more parties that creates mutual obligations enforceable by law. The contract typically involves the exchange of goods, services, money, or a promise of any of those.

Contributed Capital

The financial resources that shareholders invest in a corporation by purchasing shares of its stock, representing the stockholders' ownership stake in the company.

Contribution Margin

The excess of revenues over all variable costs associated with a specific level of production or sales volume.

Control Deficiency

A control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.

Control Risk

Control risk is the measure of risk that errors exceeding a tolerable amount will not be prevented or detected by an entity's internal controls.

Controls Tests

Tests directed toward the design or operation of an internal control structure policy or procedure to assess its effectiveness in preventing or detecting material misstatements in a financial report.

Conversion

The process by which a holder of a convertible security, such as a bond, exchanges it for another type of security, typically a fixed number of shares of the issuing corporation's common stock.

Convertible Stock

A type of security that holders can convert into a predetermined number of other securities, usually common stock, of the issuing company.

Copyright

An exclusive legal right granted by the federal government, allowing the creator or possessor to publish, reproduce, and sell an original work of authorship, such as literary, musical, or artistic works, including computer programs. The copyright protection typically lasts for the author's lifetime plus 70 years in the United States.

Corporate Bond

A debt instrument issued by a private corporation to raise capital, which is distinct from securities issued by government entities or municipalities.

Corporate Income Tax

A tax imposed on the net income of a corporation by the federal government and often additional state and city governments.

Corporation

A corporation is a legal entity formed under state or federal statutes that is characterized by limited liability, perpetual existence, transferable shares, and centralized management.

Cost Accounting

A branch of accounting that involves the recording, classifying, and allocating of costs associated with a specific product or production process, aimed at helping management make informed financial decisions.

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