Cost of Capital question...?

Question

Why do why have to assign cost to debt? to retained earnings? to common equity? and to preferred equity?

our teacher explained the principle of opportunity cost relating to Cost of Capital but i didn't get it.. please help!

Thank you so much!

Answer 1

Every time you invest in a project, you are borrowing money to use as capital. The costs associated with this borrowing are termed as costs of debt, retained earnings, and preferred equity depending on the method you choose to take to raise the required capital.

The concept of opportunity cost is that all the money you use to fund a project could get you a return somewhere else. The only reason you would invest in a project is because it would give you the highest possible return for that investment. The second best alternative for investing that amount is the opportunity cost of that investment. You can also think of it as the best alternative foregone because of this investment that you made.

For example, a company can invest in purchasing a new building for operations which will increase the number of units it produces. This would be the investment. The alternative is that it lets the money sit in a bank account, which would earn interest. The opportunity cost here is the amount of interest you could have earned had you not invested in the building.

Most large companies use multiple sources of financing (debt, equity, preferred shares). The net cost of borrowing in the weighted average cost after factoring all the sources of financing, also known as Weighted Average Cost of Capital (WACC).