You’ve got an idea for a new product line, a way to revamp your inventory management system: Finance Assignment, NU, UK

You’ve got an idea for a new product line, a way to revamp your inventory management system, or a piece of equipment that will make your work easier. But before you spend the company’s hard-earned money, you’ve got to prove to your company’s leaders that it’s worth the investment.

You’ll likely be asked to show that the return on the investment will be better than your company’s cost of capital. But are you sure you know exactly what that is? And how your company uses it

What is the cost of capital?

“The cost of capital is simply the return expected by those who provide capital for the business, ” says Knight. There are two groups of people who may put up the capital needed to run a business: investors who purchase stock and debt holders who buy bonds or issues loans to the company. Any investment a company makes has to earn enough money that investors get the return they expect and debt holders can be repaid.

You may be wondering if this is the same as the discount rate and the terms are sometimes used interchangeably, explains Knight. Though there is typically a distinction.

“At most companies, the cost of capital is a mechanical calculation done by the finance people. Then the management team takes that number and decides on the discount rate, or hurdle rate, that you have to exceed to justify an investment, ” he says.