Cost of capital is described as the total return that a new investment would require to be profitable
When looking towards investments that provide a greater rate of return than cost of capital, it is important to look more towards the whole picture of the portfolio. Cost of capital is described as the total return that a new investment would require to be profitable (Kenton, 2021). The cost of capital is found by taking a summation of all forms of debt and equity used to finance a new venture (Kenton, 2021). When rate of return is higher than the cost of capital it seems that this would be a smart investment on a straight-forwards profitability standpoint, but this may only be in the short-term. The issue is this is not always the case; a financial manager must also assess the cost of debt for the venture; between interest rates on bank loans and return rates on bonds, the long-term cost of debt may be greater than the rate of return on a new venture (Block, et. al., 2019). Costs of preferred stock and cost of equity also play into this long-term cost for the company. A financial manager must look into all of these number before making a decision as to whether investment into a new venture will actually be profitable in the long-term. On top of that, the more debt a company takes out the higher the risk is for the lender which shoots up interest rates causing further long-term cost for the company. Overall, financial managers need to take a holistic approach when seeing if an investment will be low risk and will have long-term profitability.
Block, S. B., Hirt, G. A., & Danielson, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com/
Kenton, W. (2021). Cost of capital definition. Investopedia. Retrieved from https://www.investopedia.com/terms/c/costofcapital.asp
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