- 1 Serena would like to calculate the total cost of a car loan. She should _____.
- 2 Cost of Capital, Cost of Borrowing, and Similar Terms
Serena would like to calculate the total cost of a car loan. She should _____.
B) use this formula: P x (J / (1 – (1 + J)N))
C) use an online calculator or the formula: P(1+R/12)N
D) call a bank and talk to a loan officer
For the answer to the question above asking if Serena would like to calculate the total cost of a car loan. She should calculate the total cost of a car loan. She should multiply the amount of the loan by the APR.
Cost of Capital, Cost of Borrowing, and Similar Terms
Definitions, Meaning Explained, Example Calculations
Borrowing costs can have a major impact on a company's financial performance, financial position, and prospects for growth.
Corporate officers, owners, and investors all take a keen interest in borrowing costs.
What is cost of capital? What do similar "Cost of" terms mean?
The primary meaning of Cost of capital is simply the cost an entity must pay to raise funds. The term can refer, for instance, to the financing cost (interest rate) a company pays when securing a loan.
The cost of raising funds, however, is measured in several other ways, as well, most of which carry a name including "Cost of."
Seven similar-sounding terms have the following definitions:
This term refers to the cost an organization pays to raise funds, for example, through bank loans or issuing bonds. Cost of capital usually appears as an annual percentage.
WACC is the arithmetic average (mean) capital cost, that weights the contribution of each capital source by the proportion of total funding it provides. Weighted average cost of capital usually appears as an annual percentage.
Cost of borrowing simply refers to the total amount a debtor pays to secure a loan and use funds, including financing costs, account maintenance, loan origination, and other loan-related expenses. Cost of borrowing sums appear as amounts, in currency units such as dollars, pounds, or euro.
Cost of debt is the overall average rate an organization pays on all its debts. These typically consist of bonds and bank loans. Cost of debt usually appears as an annual percentage.
Cost of equity COE is part of a company's capital structure. COE measures the returns demanded by stock market investors who will bear the risks of ownership. COE usually appears as an annual percentage.
This term refers to the interest cost that financial institutions pay for the use of money. Cost of funds usually appears as an annual percentage.
A Cost of Funds Index (COFI) refers to an established Cost of Funds rate for a region. In the United States, for instance, a regional COFI might be set by a Federal Home Loan Bank.
Explaining and calculating "Cost of" terms in context
Sections below further explain and illustrate cost of capital and similar terms in context with related terms and example calculations.
- What is cost of capital? What do similar "Cost of" terms mean?
- Defining, explaining, and calculating Seven "Cost of" terms.
- 1. Two definitions for Cost of capital.
- 2. Weighted average cost of capital WACC.
- 3. Cost of borrowing.
- 4. Cost of debt.
- 5. Two approaches to Cost of equity.
- The Cost of equity from the dividend capitalization model approach?
- The Cost of equity from the Capital asset pricing model CAPM?
- 6. Cost of borrowing.
- 7.Cost of funds and the Cost of funds index (COFI).
Defining, Explaining, and Calculating Seven "Cost of" terms
A firm's Cost of capital is the cost it must pay to raise funds—either by selling bonds, borrowing, or equity financing. Organizations typically define their own cost of capital in one of two ways:
- Firstly, Cost of capital is simply the financing cost the organization must pay when borrowing funds, either by securing a loan or by selling bonds, or equity financing. In either case, cost of capital appears as an annual interest rate, such as 6%,or 8.2%.
- Secondly, when evaluating a potential investment (e.g., a major purchase), the Cost of capital is the return rate the firm could earn if it invested instead in an alternative investment with the same risk. As a result, Cost of capital is essentially the opportunity cost of investing capital resources for a specific purpose.
In many organizations cost of capital (or, more often weighted average cost of capital WACC) serves as the discount rate for discounted cash flow analysis. Note especially that financial specialists will want to see a discounting analysis when the entity proposes investments, actions, or business case scenarios. WACC also appears sometimes as a hurdle rate, or threshold return rate, that a potential investment must exceed in order to receive funding.
Cost of capital percentages vary greatly between different firms or organizations, depending on such factors as the entity's credit worthiness and prospects for survival and growth. In 2016, for example, a company with an AAA credit rating, or the US treasury, can sell bonds with a yield somewhere between 4% and 5%. As a result, this percentage is essentially the cost of capital for these organizations. At the same time, organizations with lower credit ratings, whom the bond market views as "speculative9quot;, might have to pay 10% - 15%, or more.
A firm's cost of capital from various sources usually differs somewhat between the different sources of capital. Cost of capital may differ, that is, for funds raised with bank loans, sale of bonds, or equity financing. As a result, Weighted average cost of capital (WACC) represents the appropriate cost of capital for the firm as a whole. WACC is simply the arithmetic average (mean) capital cost, where the contribution of each capital source is weighted by the proportion of total funding it provides.
WACC is not the same thing as cost of debt, because WACC can include sources of equity funding as well as debt financing. Like cost of debt, however, the WACC calculation is usually shown on an after-tax basis when funding costs are tax deductible.
Calculating WACC is a matter of summing the capital cost components, multiplying each by its proportional weight. For example, in simplest terms:
+ (Proportion of total funding that is debt funding) x (Cost of Debt)
x (1 – Corporate tax rate)
In brief, WACC shows the overall average rate (average interest rate) an entity pays for raising funds. In many organizations, WACC is the rate of choice for discounted cash flow (DCF) analysis for potential investments and business cash flow scenarios. However, financial officers may use a higher discount rate for investments and actions that are riskier than the firm's own prospects for survival and growth.
The term Cost of borrowing might seem to apply to several other terms in this article. In business, and especially in the financial industries, however, the term refers the total cost a debtor pays for borrowing. Cost of borrowing usually appears as an amount in currency units such as dollars, euro, od pounds.
When a debtor repays a loan over time, the following equation holds:
Cost of borrowing may include, for instance, interest payments, and (in some cases) loan origination fees, loan account maintenance fees, borrower insurance fees, and still other fees. As an example, consider a loan with the following properties: