Cost of Capital
The term cost of capital refers to the minimum returns on the capital employed in business expected by shareholders. The returns are in simple words, the profit made by the firm with the help of the capital invested in it by the shareholders and the lenders. The cost in the capital ratio has a significant role to play in an organization. It acts as a decider for the shareholder during investment.
In other words, the term can be referred as returns to capital employed. It is the overall profit made by the firm through its business activities with the help of using the capital invested by the shareholders and lenders. Earning some part of dividend or interest is the prime expectation of the investors from the firm.
Investment is the most preferred option by a common person in recent times. It is known by everyone that investing dead asset (cash) in any concern will help them to earn some profit rather than keeping it in the bank for minimum interest earnings.
However, the decision of investment is a wise one but the more significant noticeable point is that you must consider certain aligning market factors that help you in making the final investment decisions. The factors that should be considered are the economic market conditions, government policies, past financial records of the company, etc.
Keeping in mind this cost, an investor has to check in the returns on the capital-employed ratio of the firm before investing in the concern. The minimum expected returns on capital employed by an investor is the cost of capital that provided by the firm in a financial year. Checking the ratio of the last 2 to 3 years of a concern will give an estimate to the investor, whether investing into the firm will be profitable or not.
There is no standard ratio of returns on capital employed to decide whether the concern is in profitable stage or not. Thus, higher the ratio better is the company's position. The company can be selected for investing your valuables safely if it has the record of good returns on the capital employed in the past and is more than the cost of capital expected by you.
Not only must the past financial records of the company, but you also consider the current financial market conditions to decide the returns on the capital provided by the firm. If the economy of the market is in boom, and the government policies are supporting the company's activities, then it can be estimated, that the company will give a higher rate of return on the capital.
The procedure of calculating returns to the capital ratio of a firm is easy. It is the total profits earned by the company excluding any interest and taxes paid divided on the total capital employed, which includes investment from shareholders, lenders, banks, etc.
If the ratio you get is negative and below one, then it is advisable that you do not invest your money into the firm as a safety precaution. The return's ratio must be positive and more than one to go for next decision process of cost of capital fixation.
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