Understanding Cost of Capital and Required Rate of Return for Smart Financing Decisions

When making financing decisions for our training center, it's important to understand two key financial concepts: Cost of Capital and Required Rate of Return.

Cost of Capital

The Cost of Capital is the cost the company incurs to obtain funds, either through equity (own funds) or debt (borrowed funds). This represents the rate of return we must offer investors (for equity) or the interest rate we must pay lenders (for debt).

For example, if we borrow $100,000 to expand our training center and the interest rate on the loan is 5%, our cost of debt would be 5%. On the other hand, if we raise money by selling ownership shares in the business, we need to offer our investors a certain return on their investment, say 8%, which is our cost of equity.

The overall cost of capital is a weighted average of both the cost of equity and debt, known as the Weighted Average Cost of Capital (WACC). The goal is to keep our cost of capital low so that we can finance our growth efficiently.

Required Rate of Return

The Required Rate of Return is the minimum return we expect from our investments or projects to justify the cost. This rate is influenced by the risk involved in the project and the cost of capital. It helps us decide whether an investment is worth pursuing.

For example, if we are considering buying new IT equipment for the training center, we will evaluate the potential income or savings it could generate. If we estimate that the equipment will help us earn 10% more revenue annually, but our cost of capital is 8%, this project meets the required rate of return because it provides a 2% gain above the cost of capital.

Example

Let’s say we want to open a new course on cybersecurity training. To do this, we need to invest $50,000 in equipment and marketing. If our WACC (overall cost of capital) is 7%, we would only go ahead with this investment if we expect the new course to generate a return of at least 7% or more. If we forecast a 10% return, it means the project is likely profitable, and we would proceed.

This simple breakdown helps to make clear financing decisions for our training center, ensuring every investment we make generates returns greater than our cost of capital.