## Cost of Capital and Risk

Dec 12th, 2008 by Scott Hebert

The *Oxford Reference* (1997) defines the cost of capital as “the average costs of a company’s various types of capital” (para. 1). A company’s capital can take various forms such as stock, loans, and retained earnings. Cost of capital is most frequently represented as the weighted average cost of capital. This method combines the cost of capital for all of a company’s capital and weights the costs based on what percentage each type of capital has in the company’s capital structure (“Cost of capital,” 1997). The weighted average cost of capital better estimates the expected rate of return on an investment since it averages the cost of all capital rather than one kind.

Market risk describes how an investment is affected by factors outside the control of the investment. In other words, if an investment is heavily affected by external factors such as political events, it is said to have a high market risk. As a form of nondiversifiable risk, market risk can be measured with the capital asset pricing model as represented by the beta coefficient. The beta coefficient tracks an investment’s return as it relates to changes in the market. It is found by plotting an investment’s return on a market return – asset return graph and generating a characteristic line to represent the investment’s performance. The slope of the characteristic line is the beta coefficient. The higher the beta coefficient, the more risky the investment. A company’s market risk is an important factor when it comes to raising capital. If a company is perceived as high risk, the cost of capital will increase (Gitman, 2009).

There are two statistical terms that are useful in measuring risk: standard deviation and coefficient of variation. Both terms describe the dispersion of results around the expected return value. If the dispersion is great, meaning a higher standard deviation or coefficient of variation, then the risk is higher since it is more likely the investment’s return will fall at a greater distance from the return. The difference between standard deviation and coefficient of variation relates to the expected return value. Standard deviation measures dispersion from a single value, while the coefficient of variation measures dispersion from investments with different expected return values (Gitman, 2009).

References

Cost of capital. (1997). In Oxford Reference Online. Retrieved December 12, 2008.

Gitman, L. J. (2009). Principles of managerial finance (12th ed.). Boston: Pearson.