Article by Anthony Banks, Advisory Services Senior Manager, "Cost of Capital Inputs," Featured in South Florida Legal Guide
South Florida Legal Guide
The appropriate cost of capital for an investment is a common issue attorneys encounter in business appraisals for litigation, estate tax, gift tax, and bankruptcy as well as lost profits.
The cost of capital is arguably one of the most important concepts in all of finance. It is the essential link that allows one to convert a stream of expected income into its present or future value. Armed with the cost of capital, one can make informed decisions regarding the purchase or sale of assets and compare one investment opportunity to another through quantification.
The cost of capital is defined as the expected rate of return that the market requires in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment in an opportunity cost – the cost of foregoing the next best alternative investment. In this sense, it relates to the economic principle of substitution; an investor will not invest is a particular asset if there is a more attractive substitute. The estimation of the cost of capital therefore is the pricing of risk, where small differences in risk pricing can result in significant differences in the conclusion of value.