The cost of capital refers to the cost of debt and capital associated with a financial effort. It affects project financing and the required return on investment. Various means of managing the high cost of capital include business loans and factoring accounts receivable. Accurate projections of costs and returns are crucial to offset the high cost of capital.
The cost of capital is a term used to describe both the cost of debt and the cost of capital associated with a financial effort. Essentially, this means that for the project to be profitable and worth the resources and risk that investors are assuming, that project must produce at least a certain minimum return. With a high cost of capital, this can have an effect not only on how investors secure project financing, but also on the amount of return that needs to be generated to make the effort worthwhile.
Since the high cost of capital has to do with what it takes to finance a project, the number will also have some influence on how those resources are generated to cover costs. Depending on how much capital is required, the endeavor may require the issuance of some type of bond issue that provides the money up front to finance the project, with the expectation that it will become self-sustaining and produce income within a certain period of time. . Here, the cost of paying principal is just one consideration as part of the high cost of capital. It is also necessary to project the amount of interest payments that must be made to investors, as well as the costs of managing the bond issue from the date of creation to the date of maturity.
Other means of managing the high cost of capital can be used, such as using a business line of credit, obtaining a business loan, or even factoring an existing business’ accounts receivable to secure the funds needed now rather than later. With each solution, the effect of the high cost of capital is that those solutions may or may not be feasible, depending on the projected performance of the project and the amount of expenses the borrower will incur. For this reason, it is very important to accurately project not only the costs associated with the loan, but also when and how much return will be earned to service that debt.
Ideally, the high cost of capital is offset by returns that cover all capital expenditures and still leaves a considerable amount of profit for investors and business owners. Since only those directly involved can decide how much return is considered acceptable in terms of the risk and expense associated with the effort, it is necessary to set specific targets for those returns. If the projected returns do not cover the high cost of capital or are not likely to produce what is considered a reasonable level of profit, it is worth considering abandoning the effort and finding a different project.
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