How can you align cost of capital with long-term goals?

1 What is cost of capital?

Cost of capital is the weighted average of the costs of different sources of financing that you use to fund your business operations and growth. It consists of two main components: cost of debt and cost of equity. Cost of debt is the interest rate that you pay on your borrowings, such as loans, bonds, or leases. Cost of equity is the return that you need to offer to your shareholders, who invest their money in your business in exchange for ownership and dividends. To calculate your cost of capital, you need to multiply each source of financing by its proportion in your capital structure, and then add them up.

3 How to adjust cost of capital for risk and uncertainty?

However, comparing cost of capital and expected returns is not always straightforward, as there are many factors that can affect both variables, such as risk, uncertainty, inflation, taxes, and market conditions. Therefore, you need to adjust your cost of capital and expected returns to account for these factors and ensure that you are making realistic and consistent comparisons. One way to adjust your cost of capital is to use the capital asset pricing model (CAPM), which estimates the cost of equity based on the risk-free rate, the market risk premium, and the beta coefficient of your business. The risk-free rate is the return that you can earn on a riskless investment, such as a government bond. The market risk premium is the difference between the return that you can earn on the market portfolio, which represents the average return of all risky investments, and the risk-free rate. The beta coefficient measures the sensitivity of your business to the market movements, and indicates how much riskier or safer your business is compared to the market average. The higher the beta, the higher the cost of equity, and vice versa. To adjust your expected returns, you can use techniques such as scenario analysis, sensitivity analysis, or Monte Carlo simulation, which allow you to estimate the range and probability of different outcomes based on various assumptions and variables.

4 How to align cost of capital with long-term goals?

Finally, you need to align your cost of capital with your long-term goals, which are the strategic objectives that you want to achieve in the future, such as increasing your market share, expanding your product line, or entering new markets. To do so, you need to consider how your cost of capital affects your ability and willingness to pursue your long-term goals, and how your long-term goals affect your cost of capital. For example, if your cost of capital is too high, you may be reluctant to invest in risky or uncertain projects that could help you achieve your long-term goals, as you may not be able to cover your financing costs or generate sufficient returns. On the other hand, if your cost of capital is too low, you may be tempted to invest in too many projects that may not be aligned with your long-term goals, as you may have excess funds or low opportunity costs. Therefore, you need to find the optimal balance between your cost of capital and your long-term goals, and adjust your capital structure, financing mix, and investment criteria accordingly.

5 How to monitor and review your cost of capital and long-term goals?

Lastly, you need to monitor and review your cost of capital and long-term goals regularly, as they are not static or fixed, but dynamic and changing. You need to track your performance and progress towards your long-term goals, and measure the impact of your investment decisions and projects on your value creation and stakeholder satisfaction. You also need to update your cost of capital and expected returns based on the latest data and information, and reflect any changes in the risk and uncertainty levels, inflation and tax rates, and market conditions. By doing so, you can ensure that you are always aligning your cost of capital with your long-term goals, and adapting to the changing environment and opportunities.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?