• Explanation

Cost of capital (COC) The financing cost that an entity pays to issue long-term debt and/or equity (new and existing common stock, preferred stock, retained earnings). is the minimum rate of return that an entity (or division) must earn before it begins to generate profit. Entities finance their operations using a mixture of debt and equity financing (ie, capital structure). Once a project generates returns above the cost of financing, it becomes profitable.

COC is used to evaluate and compare potential capital investments. The goal is to maximize profit while minimizing risk. To cover additional risk, high-risk divisions typically have a higher COC than low-risk divisions. If a company-wide COC is used to compare projects, it will be a blend of all the risk levels. The end result is the risk that the company-wide rate will reduce the "real" COC for high-risk divisions and increase the COC for low-risk divisions.

For example, if the company-wide COC is 10%, a high-risk division requiring 12% will overinvest, in new projects but a low-risk division requiring only 8% will underinvest (Choices B, C, and D). Ideally, each division should have a unique COC based on that division's level of acceptable risk and required profit.

Things to remember:
Cost of capital (COC) is the minimum rate of return that an entity (or division) must earn before it begins to generate profit. Use of a company-wide COC blends the individual risks of each project, masking the "true" risk rates. As a result, high-risk divisions might overinvest in new projects, and low-risk divisions might underinvest in new projects.