The cost of capital is the expected rate of return compared to the amount obtained by selling the investment. Investors aim for a positive cost of capital and avoid securities with negative opportunity costs. Researching investment opportunities increases the chances of earning a rate of return.
The cost of capital is essentially another way of identifying the opportunity cost associated with a given investment. In other words, the cost of capital has to do with the amount or rate of return that can be expected from the investment, compared to what would be obtained by selling the investment. Investors routinely consider the cost of capital when projecting the potential earnings that can be realized by choosing to invest in a given stock or bond issue.
When an investor chooses to make an investment, there is generally an expectation that two specific events will occur. First, the investor will recover the amount of principal initially used to purchase the bonds or shares involved in the transaction. Therefore, there is an expectation that the investor will not incur a loss as a result of the acquisition. Generally speaking, investors do not invest in securities that offer little or no hope of recovering the initial investment, as this represents negative opportunity costs and defeats the purpose of the investment.
Along with recovering the initial investment, the typical investor also expects a return on the securities purchased. Depending on the investor’s strategy, this may include a brief period where the investment actually loses money before the security stabilizes and begins to increase in value. But the ultimate goal is for the investment to generate a positive cost of capital. That is, the investor seeks a rate of return that not only exceeds the initial cost of acquisition, but also earns the investor a significant amount of financial rewards that help offset the time and effort invested in the investment strategy.
Because the goal of investing is to make money rather than lose it, investors and brokers will pay close attention to the history and future potential of a given investment opportunity. By doing so, the chances of earning a rate of return and thus generating a positive cost of capital are much better than when no research is done on the potential of the security.
Smart Asset.
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